U.S. v. Adlman, 95-2 USTC

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

The Court of Appeals for the 2nd Circuit has affirmed a district court decision finding the attorney-client privilege inapplicable, and enforcing an IRS summons directed to Sequa Corporation (Sequa), to produce a memorandum prepared by Arthur Anderson (AA) at the request of a Adlman, an officer and attorney of Sequa, in connection with a corporate reorganization.  U.S. v. Adlman, 95-2 USTC.

Sequa argued unsuccessfully that the memorandum was privileged since Adlman, acting as attorney, had sought the advice of AA concerning the proposed reorganization.  AA had been Sequa’s accountant and auditor at the time.

Most of the documentation which Sequa had provided in court consisted of contemporaneous affidavits of Adlman and other officers of Sequa, as well as persons at AA, which purportedly corroborated Adlman’s contention that he, acting as Sequa’s attorney, was “not an expert in the highly complex corporate reorganization provisions of the tax code” and had consulted with AA in order to “interpret” those Code provisions.

Sheehen, who prepared the memo for AA, also insisted that Adlman was “using the AA Memo to help him evaluate the transaction and to assist him in giving legal advice to Sequa’s management.” Sequa thus contended that AA’s advice came within the attorney-client privilege under US v. Kovel, 296 F.2d 918 (2d Cir. 1961), because it was rendered to Adlman to assist him in giving legal advice to his client Sequa.

The district court determined, however,  that Sequa had failed to meet its burden of establishing the attorney-client privilege. The court found that the objective evidence contradicted Sequa’s claim of privilege, since Sequa had not produced  “contemporaneous evidence,” such as a separate retainer agreement, distinguishing this memo from other work which AA had performed.

Judge Leval, writing for the unanimous appellate panel concurred, stating that the purpose of the privilege is to encourage clients to be candid in order that the attorney is sufficiently well-informed to provide sound legal advice. The court did allow that in “certain circumstances…the privilege for communication with attorneys can extend to shield communications to others in order to assist  the attorney in understanding their client’s financial information.”

Noting that the party claiming the benefit of the privilege has the burden of proving it, the appeals court found Sequa’s argument susceptible to “competing” interpretations. The evidence, “in many respects” supported the conclusion that Sequa had consulted AA for tax advice, and not that Adlman had consulted AA for “help… [in] furnish[ing] legal advice.”

Also damaging to Sequa was the fact that AA appeared to have assumed the role of tax advisor in its letters to Sequa, one point offering to “discuss all related matters with a view toward…prompt implementation [of the restructuring plan].” The court’s opinion seems to imply that the attorney must play a significant role in the final decision in order to claim the privilege.

The Adlman decision may not herald the demise of the privilege where an attorney seeks sophisticated advice from an tax accountant. It might mean, however, that an attorney seeking to invoke the privilege would be well advised to draft his own memorandum in which he could discuss the advice of the accountant, and thereby imbue upon his transaction his own legal expertise. After Adlman, a separate retainer agreement for the specific matter for which confidentiality is sought also seems essential.

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

Taxpayer Bill of Rights 2 (May 1996)

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

New legislation governing the relationship between the IRS and the taxpayer has been approved by the House Ways and Means Committee. Given its wide congressional support, enactment seems likely, perhaps by as early as by next fall. The Taxpayer Bill of Rights 2 significantly expands upon rights taxpayers acquired under the original legislation.

The centerpiece of the new bill is the creation of the “Office of Taxpayer Advocate,” which would report directly to the Commissioner. The primary duties of the Taxpayer Advocate would be to assist taxpayers in resolving problems with the IRS, and to propose changes in the administrative practices of the Service to mitigate problem areas.

Other important aspects of the new legislation include proposals to:

¶  Grant taxpayers the right to seek administrative review of an IRS decision to terminate an installment agreement, before any action were taken.

¶  Permit the IRS to abate interest where its own actions contributed to the interest accrual, and grant the Tax Court jurisdiction to review an IRS failure to abate interest.(Under current law, interest is only rarely abated.)

¶  Require the IRS to disclose in writing to divorced spouses whether collection activities have been taken against the other spouse, and the amount, if any, collected.  collected.

¶  Expand the circumstances in which liens and levies could be released by the IRS would be expanded, by permitting the Service to withdraw a notice of lien or release a levy (and require the IRS to so advise credit reporting agencies and banks) if (1) the lien were filed prematurely, (2) the taxpayer agreed to pay the liability, (3) the withdrawal would facilitate collection, or (4) the Taxpayer Advocate Consented. he consent of the Taxpayer Advocate.

¶  Allow offers in compromise of up to $50,000 to be approved without the Chief Counsel’s consent.  (Under current law, offers over $500 can only be accepted if supported by an opinion of the IRS Chief Counsel.)

¶  Impose damages in an amount equal to the greater of $5,000, or any actual damages sustained by the aggrieved person, as a proximate result of an individual’s filing of a fraudulent informational return.

¶  Require the IRS to conduct a reasonable investigation of information returns the accuracy of which the taxpayer has reasonably disputed, and impose upon the IRS the burden of producing reasonable information concerning the deficiency.

¶  Conclusively presume that an IRS position was not “substantially justified” for purposes of imposing attorney’s fees where the IRS failed to follow its own regulations, revenue procedures, notices or advice issued to the taxpayer, such private letter rulings. (Currently, it is extremely difficult to show that an IRS position was not substantially justified.)

¶  Increase IRS exposure for actions of its officers or employees who intentionally or recklessly disregard Code or Regulation provisions in collecting tax would increase to $1 million from $0.1 million.

¶  Require the IRS to send annual notices to taxpayers with outstanding tax balances to prevent taxpayers from being lulled into a false belief that claim had been abandoned.

¶  Require the IRS to notify the taxpayer of a third-party summons served upon an attorney or accountant, and permit the taxpayer to contest it.

¶  Bar the IRS from seeking retroactive application of its regulations. [The Tax Court, in Tate & Lyle, Inc. v. CIR, 103 T.C. 656 (1994), declared that retroactive application of regulations violated the Due Process Clause, as interpreted by the Supreme Court.]

Taxpayers would also be permitted to use receipts from qualified (e.g., FEDEX) private-delivery companies as proof of mailing.

Posted in IRS, IRS Audits, Taxpayer Rights During Audit | Leave a comment

2007 Regs., Rulings and Pronouncements

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

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).

Posted in Gift & Estate Tax Decisions of Note, Tax News & Comment | Leave a comment

Tax-Exempt Entities

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

Often referred to as “nonprofit” organizations, certain corporations and trusts are exempt from federal income tax. The earliest manifestation of tax exemption in common law traces to the British Statute of Charitable Uses in 1601. Most  present exemptions in Subchapter F, found in IRC §§ 501-528, were enacted as part of the Revenue Act of 1894.

Two fundamental types of exempt organizations exist for federal tax purposes: “public service organizations” and “mutual benefit organizations.”

Public service organizations, commonly referred to as “501(c)(3) organizations,” are organized and operated exclusively for religious, charitable, scientific, literary or educational pruposes. Common examples of 501(c)(3) organizations include churches or synagogues, organizations to prevent cruelty to animals, and organizations devoted to curing diseases.

Mutual Benefit Organizations, described in IRC § 501(c)(6), as their name implies, although not operating for profit, serve the interests of members seeking to pursue professional or personal objectives. Such organizations woudl include social clubs, fraternal societies, labor unions, trade associations, or homeowners’ associations. A common example of a trade association would be the American Bar Association.

While both 501(c)(3) and 501(c)(6) organizations generally enjoy tax-exempt status, important differences exist in the taxation and governance of such entities. For example, the deductibility of contributions to these entities differs markedly. While charitable contributions to 501(c)(3) organizations are deductible under IRC § 170, contributions to 501(c)(6) entities are deductible, if at all, as ordinary and necessary business expenses under IRC § 162. This difference may play a critical role in the deciding whether to seek qualification under 501(c)(3) or 501(c)(6).

The Regulations impose additional requirements for these tax-exempt entities. To qualify under 501(c)(3), the organization must limit activities to the pursuit of its exempt purposes, and must not attempt to influence legislation. To illustrate, The ASPCA could not, consistent with its tax-exempt charter, operate a chain of motels for profit, and could not attempt to influence legislation concerning greenhouse gases.

To qualify under 501(c)(6), the organization must promote a common business interest, and its activities must be directed to improve business conditions in one or more “lines of business.” The ABA, for example, consistent with its charter, could not operate to improve the business conditions of the film industry, nor could it open a law firm for profit. However, trade associations are free to pursue political activities and in fact are often formed to promote a legislative agenda.

501(c)(6) organizations risk losing their exempt status if they operate regular businesses, even if income is sufficient only to sustain the organization. 501(c)(3) organizations are accorded more latitude in this regard, and may pursue business activities provided the business is in furtherance of the organization’s exempt purpose, and the organization is not operated primarily for carrying on an unrelated trade or business. Although both types of organizations risk losing tax-exempt status engaged in business activites, imposition of tax on unrelated business income at ordinary corporate or trust rates is a less severe sanction imposed by the Code.

Reporting requirements for 501(c)(3) organizations are more stringent than for 501(c)(6) organizations; the former is required to submit annually balance sheets, names and addresses of substantial contributors, as well as names and addresses of officers, directors and trustees.

A futher distinction must be made among organizations qualifying under 501(c)(3). Public charities receive most funding through contributions from the general public. If contributions from private funding reaches a certain threshold, the entity is a private foundation. Various reporting and excise tax penalties are imposed on private foundations, as these entities are perceived to present a threat tax abuse.

Under New York State law,  organizations which solicit public contributions — generally 501(c)(3) entities — are required to register with the Attorney General under EPTL §8-14. Although 501(c)(6) organizations are generally exempt from such registration, their applications must be approved by the Antitrust Bureau of that office.  The formation, operation and governance of tax-exempt entities are regulated by NY Not-for-Profit Corporation Law.

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Defining the Scope of Trustee Powers

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

A.     Introduction

Early predecessors of modern trusts appeared in connection with land conveyances in England. Prior to the Statute of Wills, enacted by Parliament in 1540, it was impossible for a landowner to devise title in land to heirs. Moreover, under the harsh common law rules of primogeniture, if a landowner died without living relatives, his land would escheat to the Crown. To avoid these difficulties, title was often conveyed to a third person “to the use” of the owner during his life, and then to the beneficiary. The “trustee” of this passive trust had no duty except to hold and convey title.

Modern trust law also developed in England, in the 12th and 13th centuries. For practical reasons (i.e., payment of taxes), landowners leaving to fight in the Crusades might convey title in land to another person. However, English law did not recognize the claim of the returning Crusader forced to sue if the legal owner refused to revest title in the original owner. Turned away at courts of law, some Crusaders then petitioned the King, who referred cases to the Courts of Chancery. These equitable courts often compelled the legal owner (the “trustee”) to reconvey the land back to the Crusader, (the “beneficiary” or cestui que trust) who was deemed to be the equitable owner.

Equitable remedies first recognized by Chancery Courts exist today in the form of injunctions, temporary restraining orders, declaratory judgments, which remedies may be sought where there is no remedy at law. Despite the formal merger of law and equity in New York in 1848, the Court of Appeals has observed that “[t]he inherent and fundamental difference between actions at law and suits in equity cannot be ignored.” Jackson v. Strong, 222 N.Y. 149, 118 N.E. 512 (1917).

The principles of recognition and enforcement of trusts enunciated by Courts of Chancery form the basis of modern trust law. A trust is thus a fiduciary relationship with respect to specific property, to which the trustee holds legal title for the benefit of one or more persons, who hold equitable title as beneficiaries. Thus, two forms of ownership — legal and equitable — exist in the same property at the same time. [Restatement of Trusts, §2]. Trustees are responsible, inter alia, for ensuring that trust property is made productive for beneficiaries. The trust instrument defines the scope of discretionary powers conferred upon the trustee. With respect to discretion involving distributions, the trust may grant the trustee (i) no discretion; (ii) discretion subject to an ascertainable standard; or (iii) absolute discretion. The scope of discretion granted has profound tax and non-tax consequences, especially if the trustee is the grantor.

B.     No Discretion

The trust may provide that the trustee “distribute to Lisa annually the greater of $1,000 or all of the net income from the trust.” In this situation, the grantor (also known as the trustor, settlor, donor, or creator) of the trust could name himself as trustee with no adverse estate tax consequences, since he has retained no powers which would result in the property being considered part of his gross estate. (However, if Lisa were given a limited power to appoint income to which she would otherwise be entitled to another person, a gift tax could result.)

Obviously, eliminating trustee discretion with respect to distributions provides certainty to beneficiaries, and reduces the chance of conflict. However, the trustee will be unable to increase or decrease the amount distributed in the event circumstances change. Another problem arises: Some jurisdictions, such as New York and Delaware, authorize a trustee to appoint trust property in favor of another trust. These “decanting” statutes permit trustees to “decant” trust assets into new irrevocable trusts drafted with dispositive provisions which reflect changed circumstances. However, EPTL § 10-6.6(b) provides as a statutory prerequisite that the trustee must have unfettered power to invade the principal of the trust. A trust granting the trustee no discretion with respect to distributions could not avail itself of the “decanting” statute.

C.     Absolute Discretion

At the opposite end of the spectrum lie trusts which grant the trustee unlimited discretion. If the grantor were trustee this trust, estate inclusion would result under IRC §2036 — even if the grantor could make no distributions to himself — because he nonetheless would have retained the proscribed power in IRC §2036(a)(2) to “designate the persons who shall possess or enjoy the property or the income therefrom.”

Disputes among beneficiaries (or between beneficiaries and the trustee) could occur if the trustee possesses absolute discretion with respect to trust distributions. However, by adding the term “unreviewable” to “absolute discretion,” the occasion for court intervention would appear to be limited to those extreme circumstances where the trustee has acted unreasonably or acted with misfeasance.

The “decanting” statutes in all states which have enacted them, including New York, permit the creation of new irrevocable trusts where the trustee has been granted absolute discretion with respect to distributions. One significant advantage of utilizing a decanting statute is that no beneficiary consent is required and no court supervision is necessary in order to create a new trust. Nor is there is a need to demonstrate a change in circumstances.

D.   Ascertainable Standard Discretion

In the middle of the spectrum lie the most common trusts, which grant the trustee distribution discretion limited to an ascertainable standard. As is the case with trusts granting no discretion to the trustee, if the trustee’s discretion is limited by an ascertainable standard, no adverse estate tax consequences should result if the grantor is named trustee. Since this degree of discretion affords the trustee with some flexibility regarding distributions without adverse estate tax consequences, most grantors find this model attractive.

Although no adverse estate tax are likely if the grantor is trustee, adverse income tax consequences are nevertheless possible. For example, if the trustee determines that no distribution is required for the beneficiary’s health, education, maintenance and support, trust income will be taxed at compressed income tax rates. This problem might be minimized by creating another class of contingent beneficiaries, to whom the trustee, guided by the same ascertainable standard, could shift income. However, such an arrangement may occasion disputes among beneficiaries.

Despite the flexibility afforded by trusts whose distributions are determined by reference to an ascertainable standard, issues may arise as to what exactly is meant by that term. Is the trustee permitted to allow the beneficiary to continue to enjoy his or her accustomed standard of living? Should other resources of the beneficiary be taken into account? The trust should address, for example, with some specificity, what the accustomed standard of living of the beneficiary is, when invasions of trust principal are appropriate, and what circumstances of the beneficiary should be taken into account in determining distributions pursuant to the ascertainable standard. If the trust fails to address these issues, the possibility of disputes among current beneficiaries, or between current and future beneficiaries, may increase.

“Decanting” statutes in some jurisdictions, such as Delaware and Alaska, permit the appointment of irrevocable trust assets into a new trust where the trustee has significant — but not absolute — discretion with respect to distribution of trust assets. However, EPTL §10-6.6(b) requires that the trustee have unfettered power to invade principal in order to vest trust assets in a new irrevocable trust. Therefore, an “ascertainable standard” trust established in New York could not avail itself of the decanting statute.

E.      Investment Discretion

Investment of trust assets is also an important consideration of the grantor. While the grantor may be content with delegating discretion for distributions to the trustee, he may have an investment philosophy which he wishes to be employed by the trustee. Unless otherwise stated in the trust instrument, the trustee is granted broad discretion with respect to the investment of trust assets. New York has not enacted the Uniform Prudent Investor Act. However, New York has enacted its own rule, found in EPTL §11-2.3, entitled the “Prudent Investor Act.” Under the Act, the trustee has a duty “to invest and manage property held in a fiduciary capacity in accordance with the prudent investor standard.” The prudent investor standard comprehends the philosophy that the trustee will exercise reasonable care in implementing management decisions for the portfolio, taking into account trust provisions. The trustee should pursue a strategy that benefits present and future beneficiaries in accordance with the “risk and return objectives reasonably suited to the entire portfolio.” If the grantor believes that the named trustee can make distribution decisions, but requires assistance in investing trust assets, the instrument may authorize the trustee to engage a financial advisor to provide professional guidance in making investment decisions.

F.      Trust Protectors

Some jurisdictions permit the use of trust “protectors” to provide flexibility in the administration of trusts. This is particularly important given the state of flux in the estate tax. The Uniform Trust Code recognizes the principle that an independent person may be vested with the authority to direct the trustee to perform certain actions. Powers granted to the protector could include the power to (i) remove or replace a trustee; (ii) direct, consent or veto trust distributions; (iii) alter, add or eliminate beneficiaries; or (iv) change trust situs and governing law. To avoid adverse tax consequences, a trust protector should not be a member of the grantor’s family. Attorneys, accountants, siblings or friends  could be named as a trust protector. Corporate fiduciaries may not be a good choice, since their ability to exercise authority may in practical terms be constrained by the institution.

G.     Disputes

Various avenues exist for disgruntled beneficiaries to challenge the manner in which a trust is being administered. Problems may arise where a beneficiary is also serving as co-trustee with an independent trustee. The most drastic step is to remove the trustee. In fact, discretionary trusts often provide for removal of the trustee, and replacement by the grantor or trust beneficiaries. However, the retention by the grantor of the power to remove the trustee may imbue the trust with tax problems. Rev. Rul. 79-355 stated that a retained power by the grantor to remove a corporate trustee and appoint another corporate trustee was in essence the retention by the grantor of the trustee’s powers. The retained power would constitute an “incident of ownership,” and would cause the entire life insurance trust to be included in the grantor’s estate.

However, the IRS in TAM 9303018 opined that the removal of a trustee “for cause,” would not result in the power being attributed to the grantor. Some of the removal “for cause” powers cited include (i) the legal incapacity of the trustee; (ii) the willful or negligent mismanagement of trust assets; (iii) the abuse or inattention to the trust by the trustee; (iv) an existing federal or state criminal charge against the trustee; or (v) a relocation of the trustee.

Posted in Estate Planning, Trustees, Trusts | Leave a comment

Buy-Sell Agreements Facilitate Family Business Planning

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

A traditional buy-sell agreement may enable the estate of an owner of a closely held business to raise cash to fund testamentary bequests and pay estate taxes. The agreement may also be effective in valuing an estate for tax purposes. Typically these agreements are funded by life insurance. However, a traditional buy-sell agreement for a family-owned business may be impractical, especially where only the immediate family operates the business.

Of course, the business may simply be sold following the death of the parent. However, it is unlikely that the family will receive adequate consideration from the sale of a single-owner business.

Another alternative is for the business to be carried on by the spouse and children of the owner. If among two or three children only one wishes to remain active in the business, this creates estate planning issues, since the business may comprise most of the weath of the estate. In this case, leaving the business to the child interested in continuing the business may be unfair to the other children, not to mention the surviving spouse. Simply leaving the business to the surviving spouse, a tempting option, is fraught with its own potential perils, since the surviving spouse may have no conception of how to manage the business.

One method of “equalizing” an estate which is comprised primarily of a family business is to create additional estate assets by purchasing life insurance. In this manner, each child can be left assets of approximately equal value, and the surviving spouse can be adequately provided for. If structured properly, the proceeds of the life insurance would not be part of the owner’s gross estate.

Another solution would be for the parent and child to enter into a modified buy-sell agreement. The parent would be obligated to sell, and the child to purchase, the business at a price determined under the contract. The consideration for purchase could again be provided for by life insurance carried on the owner’s life. An installment note could also be used in lieu of, or in conjunction with, a life insurance policy. In this case, the child would be obligated to make cash payments to the estate from cash flow generated by the business.

If the business is to be continued, it is likely that some variation of a buy-sell agreement will be utilized. To avoid family discord, professional appraisals of the business should be obtained initially and at regular intervals. The IRS will also be more likely to accept a value specified in the contract if buttressed by a professional appraisal.

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Qualified State Tuition Programs Enhanced

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

IRC Section 529 plans (“529 plans”) permit parents – or anyone else – to establish and fund an account administered by individual states to pay future college expenses. Like a Roth IRA, contributions are not deductible, but neither is investment return taxed when used for qualified higher education expenses. Previously, the earnings component was taxable to the child when distributed. However, under the 2001 Tax Act, qualified distributions will also be tax-free as of January 1, 2002. Many states, including New York, also impose no income tax on qualified withdrawals. Under the Act, contributions may now be made to both an Education IRA and a 529 plan without an excise tax.

Thirty-five states currently have 529 plans, which are generally open to nonresidents. However some states, including New York, offer income tax incentives only to residents. New York allows an annual $5,000 income tax deduction ($10,000 for a couple) for contributions. New York’s plan, considered excellent, is administered by TIAA, which imposes an annual management fee of 0.65% on net asset value. TIAA, which manages over $280 billion in assets, has also been chosen to manage twelve other states’ plans. (www.nysaves.org; 877-697-2837). Fees range from that of Utah, 0.31%, to that of Oregon, 2.24%.

Most states’ 529 plans permit multiple accounts to be opened by multiple account owners for a single designated beneficiary. However, no more than $100,000 may be contributed to all accounts for one beneficiary in New York. Moreover, once the account balance reaches $235,000, no more contributions may be made regardless of whether the $100,000 threshold has been met. No age restrictions are placed upon who may be the beneficiary of a 529 plan: a parent can open an account for a high school age child or even for himself or herself.  However, at least 36 months must elapse before taking qualified withdrawals.

Most states’ plans have multiple investment options.  For example, New York now has four investment options: (i) one guaranteeing a 3% rate of return; (ii) two age-based managed allocation options which shift from stocks to bonds as the child nears college age; and (iii) one high equity option. Federal law prohibits changing an investment option. To overcome this limitation, new investments in new plans may be made with a new investment option. Alternatively, an account can be rolled over to another state’s plan;  of course, individual state tax benefits may be lost.

529 plans compare favorably to trusts created under a state’s UTMA to pay for college expenses. UTMA assets must generally be distributed at age 21. In contrast, 529 plan assets need not be distributed unless the child matriculates college. It appears that UTMA funds may be rolled over into a 529 plan.

If no matriculation occurs, the funds can be rolled over without adverse tax consequences to another “family member,” which is broadly defined to include even parents and first cousins. If the child dies or becomes disabled, funds can also be withdrawn without tax or penalty. However, if no matriculation or rollover occurs, federal and New York state income tax will be imposed on the earnings portion of the “nonqualified distribution,” together with a 10% penalty on those earnings.

Qualified higher education expenses generally include tuition, fees, supplies, books, and equipment required for enrollment. Most room and board expenses are also covered. However, qualified expenses will be reduced by expenses used to claim tax credits, and by scholarships or allowances.

The tax-free compounding within a 529 plan is most advantageous to higher bracket taxpayers. While lower tax bracket taxpayers will also benefit from tax-free compounding and distribution, extra caution must be exercised if the child may apply for need-based financial aid. Plan assets are considered parents’ assets until money is withdrawn. At that point hey are considered student assets. Accordingly, a 529 plan may be unattractive for a child who might otherwise qualify for aid. Nevertheless, 529 plan assets will not be considered in determining the eligibility for New York State-administered financial aid programs.

Contributions to 529 plans are  also treated favorably for federal gift tax purposes. Up to $50,000 ($100,000 for a married couple) may be contributed without current gift tax consequences, provided the gift is spread over five years. 529 plans therefore compliment an estate plan which seeks to maximize gifts at little or no transfer tax cost. [New York repealed its gift tax effective January 1, 2000.]

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Determining Whether Exchange Property is of “Like Kind”

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

A.     Introduction

Determining whether exchange property is of “like kind” necessitates a review of IRS pronouncements, decisional case law, and the Regulations.  Regs. § 1.1031(a)-1(b) provides that the words “like kind”

[h]ave reference to the nature or character of the property and not to its grade or quality. one kind or class of property may not be exchanged for property of a different kind or class. [however,] whether any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. (emphasis added).

As the Regs state, exchanges involving real estate enjoy rarefied status. Regs. §1.1031(a)-1(c) further provides that the exchange of a fee interest with a 30 year lease, or the swap of city real estate for a ranch or farm, are exchanges of “like kind” property. The exchange of a fee interest for coop shares would also appear to qualify under Section 1031. See also PLR 943125, stating that a lot held for investment is of like kind with a townhouse to be used as rental property.

Rev. Rul. 67-255 stated that a building is not of like kind to a building  and land. It may therefore be difficult to strip a building from the underlying land and engage in an exchange. However, if the building includes an easement or lease, the building and lease might together qualify as real property for purposes of a like kind exchange.

IRC §1031(h)(1) provides that “[r]eal property located in the United States and real property located outside the United States are not property of a like kind.” Although nonresidents may engage in like kind exchanges, Section 1031 applies only to exchanges of United States property interests for interests in property the sale of which would be subject to United States income tax. IRC §897 provides for the treatment of gain or loss realized by a nonresident individual or foreign corporation who disposes of a United States real property interest. IRC §1445 (subject to some exemptions) requires withholding of 10 percent of the amount realized in a transaction subject to IRC § 897.

Rev. Rul. 2004-86 expanded the scope of “like kind” real property by finding that real property, and interests in a Delaware Statutory Trust which itself owns real property, are of like kind. This result occurs because the owner of an interest in a Delaware Statutory Trust (DST), which is a grantor trust under IRC §671 et seq, is treated as owning assets which are owned by the trust. Therefore, such an exchange actually consists of the exchange of real property interests, rather than the exchange of a real property interest for a certificate of trust, which would be barred under  IRC §1031(a)(2)(E).

The IRS blessed the exchange of cooperative shares in PLR 20063112.  While acknowledging that “New York case law might suggest that there are conflicts concerning whether a cooperative interest in real property is real property [citations omitted],” the ruling remarked that “various New York statutes treat an interest in a cooperative as equivalent to an interest in real property.” Accordingly, the ruling held that interests in cooperative apartments in New York are of like kind to improved and unimproved realty.

B.     Tangible Personal Property

In contrast to exchanges involving real property, exchanges of tangible personal property will qualify under Section 1031 only if the properties bear a strong resemblance to one another. In making this determination, the “similar or related in service or use” test of IRC §1033(a)(1), rather than the rules developed for determining whether real estate is of like kind, appears to be the standard called for in the Regulations. Rev. Rul. 82-166 states that gold bullion and silver bullion are not of like kind since “silver and gold are intrinsically different metals . . . used in different ways.” Regs. § 1.1031(a)-2 provides that depreciable tangible personal property qualifies for exchange treatment if the properties are of “like kind” or “like class.” Properties are of “like class” if on the exchange date they are of the same (i) “General Asset Class” or (ii) “Product Class.”

Regs. § 1.1031(a)-2(b)(2) provide a list of thirteen General Asset Classes. Under Regs § 1.1031(a)(2)(b)(2), a light general purpose truck is not of the same General Asset Class as a heavy general purpose truck. Nor is a computer of the same General Asset Class as office furniture (or equipment). However, an automobile and a taxi are of the same General Asset Class, as are noncommercial airplanes (airframes and engines) and “all helicopters.” The origin of the regulations appears to be Rev. Proc. 87-56, which lists asset classes for purposes of depreciation.

Product Class was formerly determined by reference to the 4-digit Standard Industrial Classification (SIC) codes published in the Office of Management and Budget’s SIC Manual, modified every five years. The SIC codes for Product Classes have been replaced by the North American Industrial Classification System (NAICS) (and Manual) with respect to exchanges after August 13, 2004. Regs. §1.1031(a)-2(b)(3) (superseded). Under the new regime, the NAICS Manual provides that depreciable tangible property is listed within a 6-digit product class. Categories contained in the NAICS Manual are narrower than in the SIC Manual formerly used.

IRC §1031(h)(2) provides that personal property used predominantly in the United States is not of like kind to personal property used predominantly outside of the United States. Predominant use is based on the 2-year period preceding the exchange, with respect to relinquished property, and the 2-year period following the exchange, with respect to replacement property. IRC § 1031(h)(2)(C).

C.     Mixed Property Exchanges

Some exchange property may itself be comprised of both real and personal property. For example, an exchange may involve an apartment building or restaurant that contains furniture, fixtures, equipment or other assets. Since real property cannot be exchanged for personal property, the IRS views such transactions as exchanges of multiple assets rather than exchanges of one economic unit. The properties transferred and properties received must be separated into “exchange groups” by matching properties of like kind or like class to the extent possible. After the matching process is completed, if non-like kind assets remain, gain recognition may be required with respect to those assets. Regs. § 1.1031(j)-1.

At times, it may be difficult to determine whether exchange property is real property or personal property. This determination is not one of federal tax law: it is based on the law of the state in which the property is located. Aquilino v. U.S., 363 U.S. 509 (1960); Coupe v. Com’r., 52 T.C. 394 (1969). A dispute involving a similar issue of characterization of exchange property arose in Peabody v. Com’r, 126 T.C. No. 14 (2006). There, the IRS argued that a coal supply contract itself, and not the mine supplying the coal, possessed most of the value of property being exchanged. Accordingly, the IRS urged that upon the receipt of replacement property consisting of a gold mine, a good exchange occurred, but that since the supply contract was not of like kind to the gold mine, the taxpayer received boot. However, the Tax Court held the right to mine coal and sell coal is inherent in the fee ownership, and the two cannot be separated. Thus, the exchange was held not to produce boot.

D.     Intangible Property

Although like kind exchanges are most often associated with real property or tangible personal property (e.g., an airplane), exchanges involving intangible personal property, consisting of customer lists, going concern value, assembled work force, and good will may also occur. An exchange of business assets requires the transaction to be separated into exchanges of its component parts. Rev. Rul. 57-365, 1957-2. Unlike the case involving exchanges of real property or tangible personal property, no regulatory guidance is provided for exchanges of intangible property. Whether such an exchange qualifies under Section 1031 is therefore reduced to an inquiry as to whether the exchanged properties are of “like kind” under the words of the statute itself. In published rulings, the IRS has imported concepts from the regulations dealing with real property exchanges. As might be surmised, exchanges of intangible personal property are at times problematic.

Regs. §1.1031(a)-2(c) provides that whether intangible personal properties are of like kind depends on the nature and character of (i) the rights involved and (ii) the underlying property to which the intangible personal property relates. The Regs take the position that the goodwill or going concern value of one business can never be of like kind to the goodwill or going concern value of another business. Therefore, such exchanges would always produce boot. The Regs state that a copyright on a novel is of like kind to a copyright on another novel. However, a copyright on a song is not of like kind to a copyright on a novel since, although the rights are identical, the nature of the underlying property is substantially different. The objective in an exchange of businesses will therefore be first to demonstrate that the intangible assets being swapped do not consist of goodwill. The taxpayer must then demonstrate that both the rights and the underlying properties involved are also of like kind.

TAM 2000035055 stated that the exchange of a radio license for a television license qualified for exchange treatment. The rights involved, and the property to which the rights related, involved differences only in “grade or quality,” rather than in their “nature or character.” Both licenses enabled the licensee to broadcast programming over the electromagnetic spectrum, making the rights “essentially the same.” The underlying property related to the use of the radio transmitting apparatus rather than the apparatus itself. The ruling concluded that although the bandwidth of radio and television broadcasts are different, those differences constituted differences only in grade or quality, rather than differences with respect to nature or character.

Recently issued TAM 200602034 takes a more restrictive view of exchanges involving intangible personal property, stating that the rule for intangibles is “still more rigorous” than for tangible personal property. The rationale for this conclusion appears questionable.

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

Rolling GRATs

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

A GRAT is a grantor trust for a term of years in which the grantor retains a fixed annuity interest and makes a gift of the remainder interest. The present value of the remainder interest is the amount of the taxable gift. The taxable gift is computed by subtracting the fixed annuity from the principal. A higher value for the fixed annuity leads to a lower taxable gift. The value of the fixed annuity is calculated by reference to IRS actuarial tables issued pursuant to Code Sec. 7520. The Section 7520 rate for December 2001 is 4.8%. The annuity for purposes of a GRAT equals 120% of the Section 7520 rate. Even so, if the grantor can achieve rates of return over ten percent, the taxable gift will not reflect a substantial amount of the appreciation which will pass to beneficiaries. The greater the difference between the Section 7520 rate and the expected rate of return, the greater the attractiveness of GRATs.

Utilizing successive short-term (rolling) GRATs in a high annuity payout results in a small taxable gift, yet can remove substantial assets from the grantor’s estate, especially if the assets appreciate rapidly. Other techniques used in combination such as the transfer of an LLC interest to a GRAT, can further leverage the gift tax savings. (Please see the enclosed spreadsheet which illustrates the relative advantages of a two-year GRAT.)

The use of short-term GRATs also reduces the likelihood that the grantor will die during the trust terms. Recall that the premature death of the grantor of a GRAT will cause inclusion of the entire trust in the grantor’s estate under Code Sec. 2036 or 2039. Thus, with a ten-year GRAT, all of appreciation of the first nine years will be included in the grantor’s estate. With four two-year GRATs, all of the appreciation occuring during the first three trust terms will be removed from the grantor’s gross estate. (Even in the event of premature death, any GRAT entails little risk since even if trust assets are ultimately included in the grantor’s estate, any unified credit exhausted at the beginning of the trust term is reinstated.)

A rolling GRAT is also much less sensitive to poor investment returns than are longer-term GRATs. For example, if an investment in a ten-year GRAT produces low rates of return in the initial years, requiring the trustee to dip into principal to pay the annuity, the investment may never recover enough to achieve significant estate tax savings. Conversely, if a two-year rolling GRAT yields a poor investment return in the first year, the loss of estate tax-savings is contained; investments in the second GRAT in a series of rollings GRATs may fare better and achieve the desired estate tax freeze.

Posted in Estate Planning, GRATs, Trusts | Leave a comment

IRS and NYS Announce Disaster Relief

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

In the wake of the terrorist attacks, the IRS has announced that all taxpayers in the five boroughs of NYC, as well as other taxpayers “directly affected” by the attacks, regardless of where they reside, will be entitled to tax relief.

Those entitled to IRS relief should designate in red ink on the top of the returns they file:  “September 11, 2001 — Terrorist Attack.”  The IRS has also stated that it will suspend many enforcement activities, such as levies, seizures and summonses to affected taxpayers.

Affected taxpayers who have an original filing deadline between September 11, 2001 and November 30, 2001, will be granted an additional six months plus 120 days to file a return and make any payment due. Taxpayers currently on extension that expires between September 11, 2001 and November 30, 2001 will have an additional 120 days to file.

Affected individual taxpayers who are required to make estimated tax payments on September 17, 2001 may postpone that payment by including the amount with their final estimated payments for tax year 2001, due on January 15, 2002. Affected corporate taxpayers who face an estimated tax payment after September 10, 2001, and before January 15, 2002, may postpone that payment until January 15, 2002.

NYS-DTF has also extended certain filing and tax payment deadlines for taxpayers both within and outside New York “who were afflicted by this atrocity.” Businesses or individuals who were afflicted should mark “WTC” on the top center of the front page of any late filed return, extension, declaration of estimated tax, and should include a brief explanation of the circumstances that affected their ability to meet the tax deadline.

Specifically, the Department has postponed deadlines from September 11, 2001 through December 10, 2001 for (i) filing any returns; (ii) paying any tax or installment of tax; (iii) filing a petition for credit or refund, or for a redetermination of a deficiency, or application for review of a decision; (iv) allowing a credit or a refund; (v) assessing tax; (vi) giving or making a notice or demand for payment of tax; (vii) collecting tax by levy or otherwise; (viii) bringing suit by NYS for any tax liability; and (ix) by any other act required or permitted under the Tax Law or regulations.

NYS estimated personal income tax required to be filed between September 11, 2001 and December 20, 2001, may be made on or before December 20, 2001 without the imposition of penalty or interest. Individuals, fiduciaries or partnerships who received an additional extension to file their NYS returns where the extended date is between September 11 and December 20 may also file on or before December 20, 2001 without the imposition of penalties or interest.

NYS employers required to file and make payments of withholding taxes from September 11, 2001 through December 20, 2001 may file and make payments on or before December 20, 2001. NYS taxpayers unable to file declarations of estimated corporate tax by September 11 through December 10, may file such declarations and make such installment payments by December 10, 2001.

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Tax and Estate Planning with S Corporations

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

A.     Introduction

Although LLCs and partnerships possess attractive tax attributes, the fact remains that in 2004, 48.1 percent more returns were filed by S corporations than were filed by entities taxed as partnerships. An S corporation is a domestic small business corporation with respect to which an election has been made. The S corporation passes through to its shareholders items of income, gain, loss, deduction and credit in proportion to their ownership interest.

S corporations and partnerships share common tax and legal attributes. Contributions of property to both in exchange for an ownership interest are generally tax-free. Both are tax “conduits” which pass entity income through to owners. The character of income of both is determined at the entity level. Owners of both (except for the general partner of a partnership) are insulated from entity liability. However, the partnership’s existence as a separate taxable entity is more ephemeral than that of an S corporation. IRC §701 provides that a partnership “as such shall not be subject to the income tax imposed by this chapter.” A single member LLC is entirely disregarded for federal income tax purposes. Subchapter S does not go so far: IRC §1363 states only that “[e]xcept as otherwise provided . . . an S corporation shall not be subject to the taxes imposed by this chapter.”

B.     Stock Basis and Reporting Gain

An S corporation shareholder has both stock basis and debt basis. At the close of each taxable year, stock basis is increased by the shareholder’s share of income items; and decreased by the shareholder’s share of (a) nontaxable distributions; (b) nondeductible expenses; and (c) loss and deduction items. Distributions will generally be nontaxable provided the shareholder has sufficient stock basis. Distributions exceeding basis are taxed as capital gain. Therefore, having reported a pro-rata share of income, which results in a basis increase, subsequent distributions generally incur no further tax. However, the shareholder must report income without regard to whether the S corporation actually distributes anything. Distributions sufficient only to cover the shareholder’s current tax liabilities are termed “tax distributions”.

Distributions from an S corporation with accumulated earnings and profits (which can arise only when a C corporation converts to an S corporation) involve the Accumulated Adjustments Account (“AAA”), which represents undistributed income. The effect of the computation procedure is to treat as dividends that part of the distribution which reflects the accumulated earnings and profits of the predecessor C corporation.

C.     Debt Basis

Although partners (and LLC members) receive basis for their share of partnership debt under IRC §752(a), no correlative provision exists in Subchapter S. For this reason (and also for reasons relating to liquidations) LLCs are preferable to S corporations for real estate investments.

A shareholder’s share of S corporation losses and deductions is deductible to the extent of the shareholder’s combined stock basis and debt basis. While S shareholders do receive debt basis for their loans made directly to the S corporation, a shareholder’s mere guarantee of a bank loan to the corporation will not result in debt basis. Therefore, instead of merely guaranteeing a bank loan, the shareholder may prefer to borrow the money from the bank directly and then, in a separate transaction, loan the funds to the S corporation. (However, even if the shareholder has sufficient stock and debt basis, losses may be disallowed under IRC §465(a) to the extent the shareholder (or the S corporation itself) is not “at risk” with respect to the activity.)

D.      Permissible Shareholders

In 2004 the number of permissible S corporation shareholders was increased to 100. Since members of a “family” are treated as a single shareholder, and that term includes ancestors and lineal descendants, and current and former spouses of lineal descendants and ancestors, the 100-shareholder limitation is in some respects a paper tiger.

The Code prohibits S corporation stock ownership by C corporations, partnerships, multi-member LLCs, or other business entities. Only U.S. residents, certain trusts, certain estates, certain other S corporations, and single member LLCs, may own S corporation stock. The effect of an ineligible person owning S stock is that the S election is voided, likely with adverse tax consequences. However, relief may be available if an inadvertent S termination occurs. Since a nonresident may not own S corporation stock, the intended investment might be accomplished by the nonresident investing in a separate LLC together with the S corporation.

Four types of trust may own S corporation stock: (i) grantor trusts; (ii) testamentary trusts; (iii) qualified subchapter S trusts (QSSTs); and (iv) electing small business trusts (ESBTs).

A grantor trust is a trust deemed to be owned by the grantor under IRC §§671-678. A grantor trust is effectively disregarded for federal income tax purposes because its income is taxed to the grantor. Therefore, transfers of S corporation stock to a wholly owned grantor trust should not jeopardize the S corporation election.

Testamentary trusts may own S corporation stock for the two-year period beginning on the date the stock is transferred to the trust. Following that two-year period, the trust must qualify as a QSST, an ESBT, or a grantor trust for the S election to continue. During the two-year period in which the trust owns S corporation stock, tax must be paid by the trust itself if no other person is deemed to be the owner for federal income tax purposes.

A qualified subchapter S trust (QSST) is a domestic trust with only one income beneficiary (a U.S. citizen or resident) during that beneficiary’s life (unless each beneficiary has a separate share of the trust). To become a QSST, the beneficiary must make a QSST election. The current income beneficiary reports all items of S corporation income. The QSST instrument must provide that (i) distributions of principal may be made only to the current income beneficiary during that beneficiary’s lifetime; (ii) no person other than the beneficiary may be entitled to distributions of income or principal during the trust term; (iii) no payments may be made from the trust which discharge another person’s obligation to support the income beneficiary; (iv) the income beneficiary’s interest shall terminate at his death or at an earlier fixed time; and (v) if the QSST terminates during the current income beneficiary’s lifetime, all assets must be distributed to him.

The fourth eligible trust is an electing small business trust (ESBT), which may qualify if it has only individuals, estates, or qualified organizations as present, remainder or reversionary beneficiaries. Three significant limitations apply: First, a trust cannot qualify as an ESBT if any person acquired an interest in the trust by purchase; second, each potential current beneficiary must be an eligible S corporation stock shareholder; and third, the trust cannot be a charitable remainder trust or otherwise exempt from income tax. While it is somewhat easier for a trust to qualify as an ESBT rather than a QSST, there is a trade off:  a flat tax of 35 percent is imposed on the ESBT’s taxable income attributable to S corporation items.

E.       One Class of Stock Rule

An S corporation may have only one class of stock. In practical terms, this means that the legal and tax flexibility afforded by the partnership form must be foregone if the decision is made to incorporate and elect S status. However, the apparent harshness of the one class of stock rule is tempered by the fact that differences in voting rights are disregarded in applying the rule. Therefore, in an estate planning context, if both voting and nonvoting shares exist, the nonvoting shares (which may be discounted for transfer tax purposes) could be sold or given to family members without loss of control by the parent over the business. If only voting shares exist, the transfer could be preceded by a tax-free recapitalization into voting and nonvoting shares.

Determining whether the single class of stock rule has been satisfied begins with an inquiry into the corporation’s governing provisions, which include the corporate charter, bylaws, and agreements. However, the governing instruments themselves may not be dispositive with respect to the issue of whether only a single class of stock exists: If an event occurs which indicates the existence of a second class of stock, S corporation status may be nullified. For example, a disproportionate distribution would indicate a second class of stock. So too would a constructive distribution, which could occur where a shareholder receives unreasonably high compensation. Even shareholder loans to the corporation may be reclassified as a second class of stock if the loan resembles equity. To avoid recharacterization the debt owed to shareholders should be (i) in proportion to stock holdings or should be (ii) “straight debt” (i.e., a written, unconditional obligation to pay a sum certain on demand or at a specific date for a fixed rate of interest).

F.     Electing S Status

All shareholders must consent to an S election. Once made, the election is effective for the taxable year following the year of election, except that an election made within the first two and a half months of a year will be effective for that taxable year. A separate election must be made with the NYS Department of Taxation. A partnership wishing to avail itself of S corporation status would first convert to a C corporation and then elect S status.

Electing S corporation status will not operate to negate inherent gain before the S election was made. IRC §1374 imposes tax on “built in gains,” during each of the ten years following the S election. Built-in gains are gains attributable to taxable years before the S election was made. Any disposition, whether it be by sale or by distribution to shareholders, will trigger this gain. IRC §311(b); §1375(d)(2)(A).

Two other provisions may also discourage an existing C corporation from making an S election: First, IRC §1363(d) operates to recapture as ordinary income certain inventory. Second, IRC §1375 imposes a penalty tax on “accumulated earnings and profits” which preceded the S corporation election, if the the S corporation’s “passive investment income” exceeds 25 percent of its gross receipts. The penalty operates to impose the highest IRC §11 rate of tax (currently 35%) on the corporation’s “excess net passive income”. If the IRC §1375 penalty tax is imposed for three consecutive years, the S election is revoked.

An election may be terminated by (i) agreement among the shareholders; (ii) operation of law if the corporation ceases to qualify as a small business corporation; or (iii) as noted, if the S corporation has earnings and profits for three consecutive years and, during those years derives more than 25 percent of its gross receipts from investment income.  IRC §1362(d)(3).

G.     Other Considerations

S corporation shareholders risk losing certain employment benefits if their stock holdings become too great. Thus, if an employee owns more than two percent of the S corporation’s stock, he may no longer receive certain employee benefits tax-free. IRC §1372(a). Some benefits not excludable from income by a two percent shareholder rule include the cost of health insurance (IRC §§105 and 106), meals and lodging furnished for the convenience of the employer (IRC §119), and cafeteria plans (IRC §125).

One significant advantage of operating a one-person business as an S corporation rather than a single member LLC or a sole proprietorship relates to self-employment tax. While salary paid to the sole shareholder of an S corporation is subject to employment tax, other operating income is not. Rev. Rul. 73-361. A recent Treasury report found that the percentage of S corporation profits paid to sole shareholder-employees was 41.5 percent in 2001. (Statement of J. Russell George, Treasury Inspector General for Tax Administration; Senate Finance Committee (May 25, 2005). The Joint Committee on Taxation estimated that treating all net income from partnerships and S corporations as self-employment income would generate revenues of $57.4 billion from 2006 through 2014. (Options to Improve Tax Compliance and Reform Tax Expenditures (JCS-02-05) (2005) at 426). The rules relating to estimated tax payments may also be less burdensome for a business operating as S corporations rather than one operating as a sole proprietorship.

Posted in Corporate Tax, S Corporations | Leave a comment

Senators McCain and Obama Offer Differing Tax Visions

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

Senators McCain and Obama offer starkly differing tax philosophies. Mr. Obama favors a middle-class tax cut but not “a permanent tax cut for Americans who don’t need them.” Citing the inequity of  hedge fund managers who pay less tax than “their secretaries,” Senator Obama favors increasing the capital gains rate. In opposing estate tax repeal, Mr. Obama observes that “[w]e have to stop pretending that all tax cuts are equivalent.” The $1 billion cost would not be “responsive to the needs of ordinary Americans.” Although it “wouldn’t be fair” to blame the economic plight of middle class families entirely on the Bush Administration, Mr. Obama states that “in the past three years, corporate profits have increased more than 60 percent. Workers are being paid just 3% more.”

Senator McCain believes that the present tax system is “fair” since “the bulk of taxes are paid by wealthy people.” Mr. McCain appears to favor extending the Bush tax cuts even though he was one of only three Republicans to oppose them initially, calling them “fiscally reckless” at the time. Mr. McCain states that his record in opposition to tax increases is “very clear,” but unlike all of his former Republican rivals, he will not “pledge” not to increase taxes. The position of Mr. McCain with respect to the estate tax is not clear, although he appears to oppose its elimination, and appears to favor increasing the exemption amount to $5 million. Although Senator McCain does not appear to favor increasing the capital gains tax rate, neither does he appear to favor its reduction or elimination.

Senate Finance has proposed legislation that would (i) provide a one-year AMT patch (and allow the use of personal credits against the AMT); and (ii) extend a series of expiring tax incentives (i.e., research and development credit, deductions for state and local taxes, college tuition tax credits, and renewable energy tax credits). The cost of the measure is estimated to be $55 billion.

On April 15th, the House approved by a vote of 238 to 179 tax legislation which would (i) reduce Code complexity (whose volume increased by more than 10,000 pages from 2001 through 2006); (ii) require that distributions from health savings accounts (HSA) for qualified medical expenses be excluded from gross income only to the extent such expenses are substantiated; and (iii) prohibit the IRS from engaging private third-party debt collectors whose cost, Democrats argue, exceeds revenues collected.

On April 3rd, Senate Finance held a third hearing for reforming the estate tax. Prior to 2001, gift and estate taxes were unified. Under current law, the limit on lifetime gifts is $1 million, while the limit on testamentary gifts (reduced by lifetime gifts) will increase to $3.5 million in 2009. Experts at the hearing, including Dennis I. Belcher, partner of McGuire Woods LLP, expressed support for the reunification of the estate and gift tax. Shirley L. Kovar, Fellow, American College of Trust and Estate Counsel, advocated the concept of “portability” of the unused applicable exemption amount to the surviving spouse. She believes this would provide security to a surviving spouse and would accomplish by statute what a married couple could achieve through sophisticated estate planning.

New York Legislative Developments

New York’s budget enactment (S.B. 6807; 4/9/08) included the following provisions: (i) LLC and LLP filing fees will be based on New York source income, rather than the number of partners or members, and will range from $25 to $4500; (even federal disregarded LLCs will pay a filing fee of $25); (ii) a voluntary disclosure program will enable “eligible taxpayers” to avoid certain penalties and criminal prosecution provided disclosure is made before the Department has “determined, calculated, researched or identified” the tax liability; (iii) the corporate franchise tax under the capital base is reduced from 0.178% to 0.15%; (iv) for tax years after 2008, the first estimated tax installment payment for corporate franchise and other business taxes will be increased to 30% (from 25%) where the preceding year’s tax exceeded $100,000; (v) tax preparers who prepared 100 or more returns on or after January 1, 2007, will be required to file electronically. (However, the requirement will not apply to New York State and New York City personal income tax individual filers.); (vi) a rebuttable presumption has been established that certain sellers using New York residents to solicit sales are “vendors” required to collect sales and use tax; (vii) the MTA surcharge will be extended; (viii) New York City will be authorized to permanently impose an additional 1% sales and use tax; and (ix) the cigarette tax will be increased to $2.75 per pack (from $1.25).

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Repeal Sharpens Need for Estate Planning

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

On January 1, 2002, the gift and estate tax exemption amounts will each increase to $1 million. The estate and GST exemptions will increase again to $1.5 million in 2004, to $2 million in 2006, and to $3.5 million in 2009, but the gift tax exemption amount will be frozen at $1 million. Complete repeal of the estate and GST tax (but not the gift tax) is scheduled to occur on January 1, 2010.

Since the estate tax exemption will increase to $3.5 million, but the gift tax exemption will remain at $1 million, testamentary planning becomes more important for larger estates. Through leveraging, e.g., QPRTs, GRATS, FLLCs, lifetime gifts may also continue to play a prominent role in estate planning.

The federal credit for state death taxes will be reduced by 25% in 2002, by 50% in 2003, by 75% in 2004, and will be repealed entirely for decedents dying after December 31, 2004. However, new IRC §2058 will allow an unlimited estate tax deduction for state death taxes paid. Since the elimination of the federal credit precedes the reduction and then elimination of the estate tax, states will bear the brunt of lost revenues in the coming decade. New York raised $1.07 billion, or 3% of total revenues, from the estate tax in 1997.

Although New York adopted a “sop” tax in February 2000, the reference to the federal credit was frozen at $1 million. Since the federal rate decreases will be outpaced by the decrease in the federal credit for state death taxes, estate taxes for wealthy New York residents will actually increase in the next few years. Moreover, even New York residents whose taxable estates does not exceed the prevailing federal credit will continue to owe New York estate tax. To illustrate, a New York resident dying in 2004 with a taxable estate of $1.5 million will owe no federal tax, but will owe New York estate tax, since New York estate tax liability is  computed as if the federal credit were limited to $1 million. In 2010, when the federal estate tax is scheduled to be repealed, New York will still impose a 16% top estate tax rate, unless new legislation is enacted. To counteract the loss of the federal credit for the first $1 million, New York would be required to enact a new estate tax statute. Florida’s constitution, in contrast, bars the imposition of death taxes.

Another significant change in estate taxes involves basis at death. After December 31, 2009, when the estate tax is scheduled to be repealed, property within a decedent’s estate will no longer receive a step-up in basis pursuant to Sec. 1014. Rather, the basis of such property will the FMV — or adjusted basis if lower — at the decedent’s death. The character of built-in gain (e.g., recapture) will also carry over to the heirs. However, the new rule is tempered by allowances given to the executor adjust upward (to FMV) the basis of (i) $1.3 million in assets passing to anyone (the $1.3 million is itself increased further by certain capital losses which, but for the decedent’s death, would have been carried over), and (ii) $3 million of “qualified” assets (i.e., nonterminable interests) passing to a surviving spouse.

To prevent manipulation of the basis adjustment rules, no basis increase will be allowed with respect to property gifted to the decedent within three years of death, or with respect to property over which the decedent held a general power of appointment. However, the three-year rule does not apply to intraspousal gifts, unless the spouse making the gift herself received the property by gift within three years of the decedent’s death.

The new basis rules may deter the use of QTIP or general marital deduction trusts. A QTIP election results in the property being included in the estate of the surviving spouse. However, it appears that the basis adjustment rules to not apply to such property. In contrast, property gifted outright to the surviving spouse would be entitled to the basis adjustment. However, since the decedent may insist upon the use of a trust, one way of mitigating the harsh result may be to include a  provision permitting the trustee to distribute appreciated assets to the surviving spouse before her death, thus qualifying the property for basis step-up.

As of 2003, the little-used and inscrutable qualified family-owned business interest (QFOBI) deduction under Sec. 2057 will be repealed. A somewhat ironic twist awaits those brave enough to have utilized Sec. 2057, but whose property ceases to qualify for the QFOBI deduction within ten years after the decedent’s death: the entire estate tax benefit will be recaptured, even though the estate tax itself will have been reduced or repealed.

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Unanimous Supreme Court Bars Tax Refund Suit

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

Reversing the Court of Federal Claims, the Supreme Court held that the Claims Court was without jurisdiction to hear the taxpayer’s refund claim since the taxpayer had not complied with refund procedures articulated in the Internal Revenue Code. U.S. v. Clintwood Elkhorn Mining Co., et al., No. 07-308; 4/15/08; Certiorari.

[IRC §7422 provides that prior to bringing suit against the government for taxes illegally assessed, an administrative claim must be filed within 3 years of the filing of the tax return, or within 2 years of the date when the tax was paid, whichever is later. Elkhorn Mining paid tax on coal exports under a Code provision later held to be unconstitutional. However, Elkhorn Mining had not complied with refund procedures in the Code.]

Writing for a unanimous Court, Chief Justice Roberts stated that the time limits for filing administrative claims were set forth in the Code in “unusually emphatic form.” Noting that the term “any” appeared five times in one sentence (i.e., “[n]o suit . . . shall be maintained in any court for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund . . . has been duly filed with” the IRS), the Court concluded that Congress intended that the statute have “expansive reach.”

Although the taxpayer argued that its claim arose under the Tucker Act (enacted in 1887, the U.S. waived sovereign immunity from constitutional claims where the government was a contractual party) which provided for a longer six-year limitations period, the Court held that the shorter period provided by the Code was appropriate because claims for recovery of taxes “impede the administration of the tax laws.” If such suits were allowed, the “refund scheme in the Code would have no meaning.” The Court concluded that even where the constitutionality of a tax is challenged, Congress should not be deprived of its power to protect its taxing interest.

In C.M. Ballard v. CIR, CA-11, 2005-2 USTC ¶50,621, the 11th Circuit remanded a Tax Court determination for a second time.  The case involved an executive who participated in a kickback scheme resulting in unreported income. Tax Court Rule 183 authorizes the Tax Court to assign a case involving a deficiency of more than $50,000 to a special trial judge who prepares a report. After parties are given an opportunity to file objections to the report, the case is decided by a regular Tax Court judge. The report of the special trial judge absolved the taxpayers from deficiencies and penalties. However, this determination was reversed by the Tax Court judge. On appeal, the 11th Circuit found that the Tax Court judge, in rejecting the special trial judge’s report, had made independent determinations, thereby violating Rule 183(d), which provides that due regard must be given to the determination of credibility and findings of fact of the special trial judge. Holding that the findings of the special trial judge were supported by the record, the 11th Circuit ordered the Tax Court to vacate the opinion of the Tax Court judge, and adopt the report of the special trial judge as the opinion of the Tax Court.

The Fifth Circuit, affirming a district court decision, held that the IRC §7520 actuarial tables must be used to value annuities received by virtue of a structured settlement of a personal injury lawsuit. Anthony, Administratratrix v. U.S. (CA 5 3/4/2008).

[James Bankston was the beneficiary of three annuities which guaranteed payment for at least 15 years. The annuities could not be “sold, assigned or encumbered.” After Bankston’s death in 1996, his estate determined the present value of the annuities to be worth $468,078, using IRC §7520 actuarial tables, which provide an interest factor and a mortality factor. After an IRS audit (resulting in additional tax of $142,605) and payment of  taxes in installments between 1997 and 2001, the Estate made a claim for refund to the IRS which was denied. The Estate then brought a refund suit in district court, which it lost. The instant appeal followed.]

On appeal, the Estate argued first that the restrictions on transfer caused the structured settlement to constitute a “restricted beneficial interest” under Regs. §20.7520-3(b)(1)(ii) whose value could not be determined under the annuity tables. The court rejected this argument, holding that the restricted beneficial interest exception applied only where the income stream from the annuity was itself in jeopardy, noting also that the Regs made no mention of “marketability” or “transferability” restrictions.

The second argument was that annuity tables were inapplicable because they would produce an “unreasonable and unrealistic” result. Some Circuits have justified departure from the IRC §7520 actuarial tables in the context of lottery payouts. However, the Fifth Circuit, in Cook (2003, CA5) AFTR 2d 2003-7027, has not, and was controlling in the instant case. Cook held even an alleged disparity between the fair market value of the lottery winnings (which were assignable) and the value determined under IRC §7520, did not justify departure from the actuarial tables.

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In fiscal year 2006-2007, the NYS Division of Tax Appeals rendered 100 determinations. Of those, 65 sustained the deficiency asserted by the Department of Taxation. In the other 35 cases, the deficiency was cancelled or modified in some respect (e.g., reduction in tax, waiver of penalty or reduction of audit period). In 12 of those 35 cases, the deficiency was cancelled outright. Either the taxpayer or the Department may appeal all or part of a determination to the Tax Appeals Tribunal by filing a “Notice of Exception.” In fiscal year 2006-2007, the Tribunal issued 36 decisions. Of those, 26 (72.2%) sustained the deficiency or other action taken by the Department, while in 10 cases (27.8%), the Tribunal cancelled (4 cases or 11.1%) or modified the deficiency (6 cases or 16.7%). (NYS Division of Tax Appeals Annual Report Fiscal Year 2006-2007.)

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Recent IRS Developments — June 2008

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

Steven T. Miller, Commissioner of the IRS Tax Exempt and Government Entities Division, stated that the IRS will ensure that charities are furthering a charitable purpose in a manner commensurate with their financial resources. Public charities, unlike private foundations, are not required to spend a minimum amount of their resources on charitable activities. Senate Finance has expressed concern that IRC §6103, which protects the confidentiality of charitable returns, creates a public perception of “imbalance” in IRS enforcement. The IRS also issued guidance reminding IRC §501(c) organizations that they may not engage in political campaign activities in the election year. (IR-2008-61).

The IRS has proposed regulations providing guidance concerning standards in determining whether a transferor or a transferor’s estate should be granted an extension of time to allocate the generation-skipping transfer (GST) exemption to a transfer pursuant to IRC §2642(g)(1). (NPRM REG 147775-06).

The 2007 annual report of the IRS Oversight Board acknowledged progress in modernization, enforcement, and taxpayer service, but concluded that improvement was still needed. Through modern electronic tax administration services, the IRS can provide more opportunities for taxpayers and tax professionals to communicate with the IRS. However, the report concluded that the IRS must modernize its information technology, which is hampered by “archaic computer systems.”

The IRS will issue guidance concerning the special 50 percent depreciation allowance (enacted as part of the Economic Stimulus Act of 2008) under which the taxpayer may take a depreciation deduction equal to 50 percent of the adjusted basis of qualified property (most tangible personal property and computer software) placed in service after 12/31/07 and before 1/1/09. The new depreciation allowance is similar to “bonus depreciation” previously available for certain property placed in service before 1/1/05. Given the similarity in provisions, the IRS guidance will allow taxpayers to generally rely on Regs. §1.168(k)-1. New increased expensing limits will also be addressed. (IR-2008-58).

Treasury has issued proposed regs clarifying IRC §6323, which addresses the priority of federal tax liens against other creditors. Under IRC §6321, the amount of any unpaid tax liability becomes a lien in favor of the United States by operation of law “upon all property and rights to property, whether real or personal.” In some circumstances, the IRS may file the tax lien, in others, not. (It may be in the best interest of the IRS not to file a tax lien where the taxpayer’s ability to earn income would be impaired.) In any event, IRC §6323 provides that the lien imposed by IRC §6321 “shall not be valid” against purchasers or security holders who are without “actual notice” of the lien. Under the proposed regs, if a state requires that a deed be recorded in a public index before being valid, a notice of federal tax lien (NFTL) will not be valid until it is both filed and indexed in the appropriate office. (NPRM REG-141998-06).

The IRS has issued guidance regarding preparer penalty provisions under IRC §6694. (Notice 2008-46). Exhibit 1 of the Notice adds 19 tax returns to the previous list, including Form 1040-SS, and various Forms 1120. Exhibit 2 adds various forms relating to foreign corporations. Exhibit 3 adds two forms to those that would subject the preparer to penalties only if willfully prepared to understate tax liability. Those forms relate to withholding taxes by foreign persons with U.S. real property interests.

Rev. Proc. 2008-16 clarifies situations in which vacation homes will qualify for like kind exchange treatment by establishing a “safe harbor” for determining whether a vacation home meets the “for productive use in trade or business” requirement of IRC §1031. The safe harbor is met if (i) the vacation home is owned continuously by the taxpayer throughout the qualifying use period; and (ii) within each of the two 12-month periods comprising the “qualifying use” period (i.e., 24 months before and 24 months after the exchange), the taxpayer rents the vacation home to another person or persons at fair rental value for 14 days or more, and the period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at fair rental value. Since Rev. Proc. 2008-16 is only a safe harbor, a good exchange could presumably occur in other circumstances as well.

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