Minimum Distribution Rules in 2002

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

The new minimum distribution rules are now mandatory for distributions from qualified plans or traditional IRAs in 2002. Minimum distributions must begin by the Required Beginning Date (RBD), which is April 1st of the calendar year following the later of the calendar year in which the participant attains the age of 70½ or retires. To maximize income tax-deferral, most participants elect to take installment distributions in the form of a Required Minimum Distribution (RMD), rather than a lump-sum payment.

Under the new rules, the RMD is calculated by dividing the participant’s benefit by the distribution period found in the Uniform Table (Prop. Reg. § 1.401(a)(9)-5, A-4). If the sole Designated Beneficiary (DB) is a spouse more than ten years younger than the participant, the distribution period is calculated by reference to Table VI of Reg. § 1.72-9, which provides for slightly longer distribution periods.

To illustrate, the distribution period for a participant 70 years of age is 26.2. At the RBD, the participant would be required to take a minimum distribution of x/26.2, where x equals the plan benefit at the RBD. Thereafter, upon reaching the age of 80, the minimum distribution would be (x – y)/17.6, where x equals the plan benefit at the RBD, y equals the sum of previous plan distributions, and 17.6 is the distribution period for a person 80 years of age. Accordingly, the Uniform Table is used to determine the RMD during the participant’s life, irrespective of whether a DB has been named.

The failure by a participant to take the annual RMD commencing at the RBD will subject the participant to a 50% excise tax measured by the difference between the RMD and the actual distribution. IRC § 4974(a). New reporting requirements require IRA trustees and issuers to report the RMD for each calendar year to the IRS (as well as to the IRA owner and beneficiary.)

If the participant dies before the RBD, RMDs must be made either over the life expectancy of the nonspouse DB using the single life annuity table initially and subtracting 1 in each subsequent calendar year or, if no DB has been named, within 5 years after the participant’s death. If the DB is the surviving spouse, the distribution period is recalculated each year using the single life annuity table, which is preferable.

If the participant dies after the RBD, the RMD for a nonspouse DB is determined using the single life annuity tables and is reduced by 1 for each subsequent year. The RMD for a spouse DB is also determined under the single life annuity tables, but the distribution period is recalculated each year. If no DB has been named, the five-year rule does not apply. Instead, the distributions can be spread over the participant’s remaining life expectancy at his date of death (notwithstanding his actual death), utilizing the single life table. In subsequent years, the applicable distribution period is reduced by 1 for each year which has elapsed.

Under the new rules, a DB is determined as of the Designation Date (DD), which is the last day of the calendar year following the calendar year of the participant’s death. Any person who was a beneficiary as of the participant’s death but who is not a beneficiary as of the DD (e.g., by reason of the person’s (i) disclaimer; (ii) receipt of entire benefit to which she is entitled; or (iii) death) is not taken into account in determining the participant’s DB.

If there are multiple beneficiaries, at least one of whom does not qualify as a DB, and separate accounts have not been established, the participant will be deemed not to have selected a DB. However this rule is tempered with some leniency. To illustrate: An estate or charity may not be a DB. Assume a charity is entitled to $25,000 and separate shares have not been established. If $25,000 is distributed to the charity prior to the DD, the child will be considered the only remaining beneficiary entitled to a plan benefit, and the child’s life expectancy may be used.

A DB may be an individual or a beneficiary of certain irrevocable trusts. If there are multiple beneficiaries, the DB with the shortest life expectancy is used to calculate the distribution period. The trustee of the trust must, by the DD, provide the plan administrator with a copy of the trust and a final list of all trust beneficiaries (including contingent and remaindermen with a description of their entitlement).

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Perspective on 2001 Tax Act

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

The 2001 Act repeals the estate and GST tax for decedents dying after December 31, 2009. The top marginal estate tax rate, now 55%, will decrease incrementally to 45% in 2007. The estate tax exemption, now $1 million, will rise in three stages to $3.5 million in 2009, before complete repeal in 2010. The GST exemption will mirror the estate tax exemption beginning in 2004.

The gift tax exemption, $1 million for 2002, will not rise again. After 2009, the gift tax will remain, with a marginal rate of 35%. Until 2010, gift and estate taxes will remain partially unified, in that lifetime gifts will reduce the estate tax exemption.

Under the Act, new IRC §2632(c) will automatically allocate a donor’s GST exemption to lifetime transfers made to generation-skipping trusts if those transfers are not direct skips. However, various exceptions apply. For example, no automatic allocation will occur if the trust provides for distribution or withdrawal by a person under 46 of more than 25% of the trust corpus (or before a specified date reasonably expected to occur before the individual reaches 46). Also under the Act, new IRC §2632(d) permits a retroactive allocation of GST exemption to a transfer in trust under certain circumstances.

New §§1014(f) and 1022 resurrect carryover basis provisions for inherited property after 2009. However, the executor will be able to designate specific assets whose basis equals $1.3 million which will receive a stepped-up basis. The $1.3 million amount is increased by unused capital losses and net operating losses. Also, “qualified spousal property” with a basis of up to $3 million passing to a surviving spouse will be entitled to a basis step-up. Accordingly, even after repeal in 2010, it may still be desirable for wills and trusts to provide for a separate marital share to utilize the $3 million basis allotment. Likewise, it may also be prudent to specify whether the executor should allocate the lowest value of assets necessary to absorb the $3 million additional basis adjustment, or whether the assets set aside for the marital share should be representative of total appreciation and depreciation. Without such a provision, the potential value of the marital share could fluctuate significantly, creating problems for the executor.

Under the Act, the state death tax credit will be reduced in 25% increments until it is eliminated in 2005. However, beginning in 2005, state death taxes will be deductible under new IRC §2058. New York’s estate tax, though a “sponge” tax, is correlated to federal law as it existed in 1998. Accordingly, New York will continue to impose a death tax on estates which exceed $1 million. An estate of $1.5 million could therefore incur no federal estate tax, but a substantial state death tax. In fact, unless New York law is changed, a New York death tax could be owed even after repeal of the federal estate tax.

The Act also imposes new reporting requirements for lifetime gifts and transfers at death. Donors of lifetime gifts will be required to furnish donees with a written statement detailing information on the gift tax return. Similarly, with respect to transfers at death of non-cash assets in excess of $1.3 million, the executor would be required to include on the decedent’s final income tax return certain information, including the name and taxpayer ID of the recipient of the property, a description of the property, and the adjusted basis and fair market value of the property at the decedent’s death. Failure to comply with reporting requirements would result in the imposition of substantial penalties unless reasonable cause was established.

The Qualified Family Owned Business deduction of §2057 is repealed for estate of decedents dying after 12/31/2003.

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Supreme Court Holds Punitive Damages Not Excludible (July 1997)

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

The Supreme Court, resolving a conflict among the circuits, has held that the exclusion from gross income provided for by IRC Sec. 104(a)(2) for the “amount of any damages received…on account of personal injuries” does not extend to punitive damages.  O’Gilvie v. U.S., 117 S.Ct. 452 (1997). The petitioners in this case, the husband and children of a woman who died of toxic shock syndrome, had received a jury award of $1,525,000 in actual damages and $10 million in punitive damages. The petitioners paid income tax on the punitive award, then sought a refund.

Justice Breyer, writing for the majority, agreed with the government’s argument that the punitive portion of the damage award was not “received … on account of” the personal injuries, but rather was awarded “on account of” the defendant’s reprehensible conduct, and the jury’s need to punish and deter it.

The Court also found the Government’s reading “more faithful to the history of the statutory provision as well as the basic tax-related purpose that the history reveals.” The Court observed that when the statute was enacted, the Supreme Court “had recently decided several cases based on the principal that a restoration of capital was not income. Punitive damages, according to the Court, fell outside the scope of a mere restoration of income.

The taxpayer had argued that from the perspective of tax policy, noncompensatory punitive damages should stand on equal footing with compensatory damages, which are excludible. However, the court reasoned that the “language and history” of the statute indicated that even the exclusion from income of compensatory damages was an “anomaly” in the general tax scheme. That circumstance would not, according to the court, warrant “extension of the anomaly or the creation of another.”

The court also rejected the taxpayer’s argument that the exclusion from income of punitive damages was warranted as such a construction would avoid “administrative problems” which could occur when trying to separate punitive and separate portions of a global settlement. Noting first that “[t]ax generosity has its limits,” the Court then discounted the severity of the administrative problem in distinguishing punitive from compensatory elements. Finally, the Court observed that the problem of “identifying the elements of an ostensibly punitive award does not exist where, as here, relevant state law makes clear that the damages at issue are not at all compensatory, but entirely punitive.”

Congress amended Code Sec. 104(a)(2) in 1996 to provide that excludible damages consist (only) of amounts received “on account of personal physical injuries or physical sickness.” Thus, damages for emotional distress will not be excludible from gross income, except if the damages arise out of a claim for physical injury or sickness. After O’Gilvie, punitive damages appear to be taxable regardless of the nature of the claim from which they arose. Damages arising from wrongful death would continue to be excludible from gross income.

Since the application of Sec. 104, as well as the rule announced in O’Gilvie, apply with equal force to amounts received as a result of a judgment or a settlement, it appears axiomatic — at least from a tax perspective — that settlements awards which maximize nonpunitive physical elements are preferable.

Thus, the 8th Circuit held in an earlier case that the portion of a payment received by the seller of a business in settlement of claims for misrepresentation was excludible from income as damages received on account of personal injuries, since under Kansas law, misrepresentation was a tort. J.R. Fitts, CA-8 (unpublished opinion), 95-1 USTC ¶50,254. However, Fitts was decided before Code Sec. 104 was amended to require that only physical elements of personal injury awards were excludible.

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2001 Gift and Estate Tax Decisions of Note

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

The 5th Circuit, in Estate of Jameson v. Comr., 267 F.3d 366, made further inroads into the doctrine of precluding valuation discounts for built-in capital gains. Reversing the Tax Court, it held that a full discount for accrued capital gains tax liability should have been allowed when assessing the value of the estate’s holdings in a privately held C corporation.

Although family holding entities are often created to achieve valuation discounts, the Tax Court allowed a 30% fractional interest discount for undivided minority interests in real estate held outright. The court cited the “limited pool of potential buyers” and the likely costs of partitioning various parcels. Est. of Forbes, T.C. Memo 2001-72.

Est. of Simplot, 249 F.3d 1191, was reversed by the 9th Circuit. Tax Court had ascribed an astronomical value to a small percentage of voting shares. The appellate decision cast doubt on the IRS theory of a swing-vote premium  (PLR 9436005) and also soundly rejected the Tax Court’s view that an enormous premium, measured as a percentage of the total value of the company, could be ascribed to a relatively small percentage of a company’s stock.

The IRS suffered a string of defeats in the FLLC-FLP context: Church v. U.S., 268 F.3d 1063, decided that an FLP created shortly before death was not a sham, despite a failure to file proper state documents until after the decedent’s death. Est. of Jones, 116 T.C. 121, rejected the gift on formation argument and held that limitations on transfer and withdrawal are not “applicable restrictions” under §2704. Knight v. Comr, 115 T.C. 506, upheld a 44% discount for lack of control and marketability, despite the fact that the partnership kept no records and the children’s trusts never participated in management. The Tax Court reasoned that the agreement was valid under state law, and could not be disregarded because a hypothetical buyer or seller would not disregard it. 115 T.C. 506. Estate of Strangi, 115 T.C. 478, held that a partnership validly existing under state law must be respected for estate tax purposes, despite doubtful nontax motives. Finally, Est. of Dailey, T.C. Memo 2001-263, rejected the IRS’s appraisal, and allowed a 40% discount in an FLP holding only marketable securities.

Est. of True, T.C. Memo 2001-67, held that a buy-sell agreement, which adopted a book value formula designed by the family accountant who was not a professional appraiser, although legitimate as a business arrangement, did not establish estate tax values. The court reasoned that the same formula was used to value different companies, the agreement failed to provide for re-evaluation, and the children had no opportunity to negotiate its terms.

Est. of Rosano, 245 F.3d 212, held that checks used to make annual exclusion gifts were includible in the estate when they were deposited, but not cashed before the donor’s death. Est. of Swanson, 46 Fed. Cl. 388, held that gifts made pursuant to a durable power of attorney were includible in the decedent’s estate since that power was not expressly stated and could not be implied. This decision suggests that it would be prudent to expressly include such language in New York durable powers if these gifts are contemplated.

Hahn v. Comr, 110 T.C. 140, held that a decedent’s gross estate includes the full value of property jointly owned by the decedent and the surviving spouse where the decedent had contributed the entire consideration in 1972, prior to the enactment of the automatic 50% rule of IRC § 2040(b)(1) in 1981. Thus, the surviving spouse was entitled to a higher income tax basis at no estate tax cost, due to the unlimited marital deduction. The Tax Court followed the rule first enunciated in Gallenstein v. U.S., 975 F.2d 286. The IRS has acquiesced to the decision.

O’Neal v. U.S., 258 F.3d 1265, held that post mortem events must be ignored when valuing unpaid income taxes for estate tax purposes. (Income taxes had been paid on an assessed estate tax deficiency. When the estate tax dispute was eventually settled, an income tax refund was claimed.) Similarly, the 10th Circuit, in McMorris v. Comr, 243 F3d 1254, reversed the Tax Court and, quoting Regs. §20.2053-1(b)(3), held that an estate may properly deduct amounts that are “ascertainable with reasonable certainty” at death. The estate had deducted income tax on disputed capital gains which, after resolution, actually resulted in a taxable loss. Est. of Smith v. Comr., T.C. Memo 2001-303, similarly held that an estate may properly deduct income taxes that it may never pay.

Branson v. Comr., 264 F.3d 904 held that an estate may equitably recoup an overpayment income taxes, despite the expiration of the statute of limitations.

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2001 REGS, IRS RULINGS & PRONOUNCEMENTS

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

The National Office in FSA 200119013 held that where the decedent’s estate included 50% of the shares of a closely held corporation, as well as a general power of appointment over 44% of the shares pursuant to a marital deduction trust, the value of both blocks of stock must be aggregated, and will reduce, minority discounts. The IRS reasoned that a general power of appointment is equivalent to ownership for estate tax purposes. It distinguished the result from that involving a QTIP trust, where the surviving spouse lacks an unlimited power of disposition. To preserve minority discounts, a QTIP disposition may be preferable for nonmarketable assets.

FSA 200049003 explained various lines of attack which the IRS might pursue challenging FLP and FLLC discounts. Although many of the arguments advanced have been dismissed by the courts, the advisory serves as a reminder of the skepticism with which the IRS views these discounts. Accordingly, the planner would be well advised to use a professional appraisal, document nontax motives, and avoid forming these entities when the donor is seriously ill.

PLR 200120012 approved grantor trust provisions which give an independent trustee the power to pay income taxes of the trust. Planners had worried that this provision, which has been included in grantor trusts in response to IRS private rulings, could have resulted in a taxable gift to the grantor if the trust paid the grantor’s income taxes.

Rev. Proc. 2001-38 announced that the IRS will treat as void certain QTIP elections which do not benefit the estate, such as when the election was made with respect to an estate already sheltered by the exclusion. If the election was not ignored in this situation, the QTIP trust would be included in the surviving spouse’s estate.

The IRS has issued new regulations which allow an automatic six-month extension to file a Form 706, without showing reasonable cause. Payment of estimated tax must still be timely.

FSA 200122011 rejected a formula clause in a partnership agreement intended as a protective mechanism in the event of an IRS valuation dispute. The advisory held that such clauses violated public policy.

Final Regs. §§ 25.2702-3(b) et seq. prohibit the use of notes as GRAT or GRUT payments. The regs. also require that the governing instrument itself contain an express prohibition against the use of notes. Indirect loans are also barred.

Infamous “example 5” of Regs. §25.2702-3(e) was invalidated by the Tax Court in Walton v. Comr,115 T.C. 589. The decision (if not successfully appealed by the IRS) paves the way for zero-tax GRATs. Note that if the grantor dies during the term of this GRAT, the entire trust will be part of the decedent’s estate, even though the trust will continue. Therefore, trust assets will be unavailable to pay estate taxes.

In response to new state unitrust statutes, the IRS issued proposed regs. with a new definition of trust income. Amounts allocated between income and principal pursuant to applicable state law will be respected if state law allows apportionment between income and remainder beneficiaries of the total return of the trust, taking into account ordinary income, capital gains, and unrealized appreciation.

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United States International Taxation

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

The U.S. international income tax rules are among the most complex in the Code.  The purpose of this article will be to set forth in a comprehensible manner the essence of those rules. Part I will discuss how a foreign person may become subject to U.S. tax, and the distinction between foreign and domestic “source” income. Part I will also introduce the concept of income “effectively connected” with a “U.S. trade or business.” Part II, appearing in the next issue, will conclude a discussion of the trade or business concept, and will  discuss the foreign tax credit, the impact of treaties, and other issues.

The Code taxes persons either on the basis of their presence in the U.S., or on the basis of the geographic source of their income, irrespective of their presence. Imposition of U.S. income tax on most persons is based upon their personal relationship with the U.S. Thus, Boris Yeltsin would not be subject to U.S. income tax on income earned as President of Russia, despite the fact that he has visited the U.S. However, a Russian citizen possessing a green card, though not a U.S. citizen, would nevertheless be a U.S. “person” for U.S income tax purposes, and would be taxed as a U.S. citizen. The tax law goes even further: any alien physically present in the U.S. for more than 183 days in the calendar year will be taxed as a resident, irrespective of the bona fides of his presence in the U.S. under the immigration laws.

Conversely, a U.S. citizen living overseas, even permanently, must pay tax on all earned income — this is considered a price of U.S. citizenship. Code Sec. 61 provides that “gross income means all income from whatever source derived.” Thus, a U.S. attorney working for a French law firm in Paris must report all income, notwithstanding the fact France without doubt imposes tax on the same income.

[If the foreign earned income is taxed by France, the foreign tax credit may operate to avoid the incidence of double taxation. The foreign tax credit is nonrefundable: if France taxes the income at rate higher than the U.S., the Treasury will not refund the difference. The credit will also not operate to reduce U.S. tax liability: if France taxes the income at a rate lower than the U.S., the U.S. will credit the tax imposed by France, but will also impose such additional tax as is necessary to ensure that the taxpayer pays the full U.S. rate. [The foreign tax credit will be discussed further in Part II.]

The second independent basis for imposition of U.S. income tax is the geographical source of income. A Russian attorney from Moscow working briefly for a New York law firm, but not spending the requisite 183 days in the U.S., and not in possession of a green card, would clearly taxed on income paid by the New York firm. However, income which the attorney earned working for a Moscow firm having no affiliation with the U.S. firm would not be subject to U.S. income tax. The Russian attorney is taxed on his income earned in New York not because of his personal relationship with the U.S. — which is fleeting — but rather on account of the geographical source of that income, and the fact that the income is “effectively connected with a U.S. trade or business.” (See discussion, infra.)

Much like nonresident alien individuals, foreign corporations are subject to U.S. tax on the basis of their U.S. source income. Would a foreign corporation with only foreign source income elude U.S. tax if no earnings were repatriated to U.S. shareholders? Possibly. Foreign corporations owned in substantial part by U.S. persons have long been a source of irritation to the IRS, since a corporation’s earnings are not taxable to shareholders unless and until distributed.

Rather than change the general rule with respect to corporation taxation, Congress enacted Code provisions which impose tax on earnings of controlled foreign corporations (CFC) whether or not the earnings are repatriated to the U.S. shareholders. (A CFC is a foreign corporation of which greater than 50% of the value of the voting stock is owned by U.S. individuals or corporations.)

The Code provides detailed rules which determine whether income is geographically foreign or domestic source. These operation of these rules are critical: although a nonresident alien, such as Michael Gorbachev, must pay U.S. tax on U.S. source income, he is not required to pay U.S. tax on foreign source income, since he is not a US “person.” A nonresident alien may therefore prefer that income be sourced as foreign, (particularly if the alien resides in a jurisdiction with low taxes), since no U.S. income tax liability will arise.

Six general categories of source income are enumerated in the Code: interest, dividends, personal services income, rents and royalties, gains from the disposition of real property, and gains from the sale of personal property. Deductions associated with some types income are permissible, provided there exists a “factual relationship” between the income and deductions. No deductions are permitted for investment income, i.e., dividends or interest.

Interest payments made by a U.S. resident or a U.S. corporation are U.S. source income. An exception exists for a company 80% or more of whose income is derived from the active conduct of a foreign trade or business. In that case, the interest income received by a nonresident alien will be foreign source.

All dividends paid by a U.S. corporation are U.S. source income. Dividends paid by foreign corporations are U.S. source if 25% or more of the corporation’s gross income, for the preceding three years, was effectively connected with the conduct of a trade or business in the U.S.

Compensation for personal services income, such as the income earned by the Moscow attorney working in New York, is U.S. source income. An exception exists, and the income will be foreign source, if the nonresident alien is temporarily in the U.S. for 90 days or less, less than $3,000 is earned, and the services are performed for a foreign payor not engaged in a U.S. trade or business.

Compensation for services performed outside the U.S. is foreign source income. Therefore, if the Moscow attorney performed consulting work for the U.S. firm in London, that income would not be subject to U.S. tax.

All rents and royalties from property (tangible and intangible) located in the U.S. are U.S. source income. Conversely, rents and royalties from property located or used outside the U.S. are foreign source income.

Gains from the disposition of a U.S. real property interest are U.S. source. Gains from the sale of property located outside the U.S. are foreign source.

Gains from the sale of personal property (e.g., a piano or a share of stock) are sourced at the residence of the seller. If the Moscow attorney sold the New York attorney a piano which the Russian purchased at a bargain in New York, gains realized from such sale would be not be taxable. However, if the Moscow attorney was in the business of selling pianos, then the result would be different: inventory is sourced where the sale takes place.

After determining whether a nonresident possesses U.S. source income, it must then be determined whether that income is “effectively connected” with a “U.S. trade or business.” Effectively connected income (net of deductions) is generally taxed at regular individual (or corporate) rates. The determination of whether a trade or business exists requires consideration of the alien’s profit motive, as well as the quantitative aspects such as frequency, substantiality, and duration of the activities. Aliens engaging in sales of U.S. real property can no longer avoid U.S. income tax by failing to meet the U.S. trade or business requirement, since gains derived from the sale of a U.S. real property interest are conclusively presumed to constitute income effectively connected with a U.S. trade or business.

Income not effectively connected with a U.S. trade or business may constitute investment income, which is  taxed at a flat 30% rate, with no deductions allowed. Income which is neither either effectively connected business income nor investment income — and which is not earned by a “U.S. person” — would escape U.S. tax, regardless of its U.S. source. An example of this would be the speaking fee received by a foreign statesman who makes one isolated speech in the U.S.

As noted, the United States reserves the right to tax all U.S. “persons” on worldwide income. For U.S. taxpayers living and working abroad, however, this can result in double taxation. The foreign tax credit, which is elective, can ease the burden placed upon those taxpayers by eliminating the U.S. tax on foreign source income to the extent that income has already been taxed in the foreign jurisdiction.

If the foreign tax is lower than the U.S. tax, the IRS imposes tax on the amount of the difference. If the foreign tax is higher, the IRS will not issue a refund.

Some important limitations apply to the use of the foreign tax credit:

¶  Only U.S. persons are entitled to claim the foreign tax credit;

¶  Only foreign “income” taxes or taxes imposed “in lieu” of an income tax are creditable.

¶   To ensure that the IRS collects tax on U.S. source income, the Code operates to prevent the credit from reducing U.S. tax liability on U.S. source income. Without this limitation, a U.S. taxpayer operating in a high-tax foreign jurisdiction could generate a foreign tax credit large enough to offset U.S. tax on U.S. source income. (However, credits disallowed because of this limitation may be carried back and carried forward to other tax years.)

¶  To reduce the risk of tax fraud, the taxpayer claiming the credit must comply with stringent requirements in order to show that the foreign tax was actually paid.

Treaties operate to coordinate the tax laws of the U.S. and other countries. Treaties also refine the issues involved in the foreign tax credit so that the object of the credit, i.e., to remove tax barriers on U.S. persons investing abroad, and foreign persons investing in the U.S. Article VI of the Constitution provides that treaties and legislative enactments are of equal force.

Treaties interact closely with the effectively connected income rules discussed in Part I of this article. For example, residents of foreign jurisdictions whose country has a tax treaty with the U.S. may avoid tax on their effectively connected business income unless the taxpayer has a permanent establishment, i.e., an office or factory, in the U.S. Conversely, a U.S. taxpayer with business income in a foreign country which has entered into a tax treaty with the U.S. will not be taxed on that foreign source income unless the taxpayer operates out of a permanent establishment there.

The foreign tax credit  operates exclusively with respect to foreign income taxes. However, treaties apply to all foreign taxes. Thus, treaties also operate to remove uncertainty about whether the foreign tax levy falls within the “income tax” definition for purposes of the foreign tax credit. Treaties also free the taxpayer from filing returns and paying taxes to foreign jurisdictions that would ultimately be credited by the U.S. anyway.

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New York Revised Legislation Re: Revocable Inter Vivos Trusts (October 1997)

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

New York attorneys have often looked closely at what revocable inter vivos trusts (RIVTs) have to offer as a testamentary substitute only to ultimately recommend against their use in favor of a Will. Although immensely popular in California and Florida, “living trusts” have yet to gain a significant presence as a testamentary substitute in New York.

A major factor accounting for the relegated status of RIVTs in New York has probably been the lack of clear statutory guidance involving their use. Recently, however, Governor Pataki signed legislation which resolves many of the questions that had previously plagued the use of RIVTs. The new law applies to RIVTs executed after June 25, 1997.

New EPTL §7-1.15 provides that “[e]very estate in property may be disposed of by lifetime trust.” RIVTs are inherently attractive since they permit title to assets to be passed to beneficiaries without probate. New EPTL §7-1.16 provides that a lifetime trust instrument must specifically designate the trust as revocable. Otherwise, it will be deemed irrevocable. Although the new law also applies to irrevocable inter vivos trusts, this article will focus on revocable trusts. (Irrevocable trusts are often used to hold appreciating assets, such as life insurance policies, or real property. Property placed in an irrevocable trust is generally excluded from both the probate and taxable estates. Thus, these trusts can also serve important estate planning purposes.)

RIVTs bear a close resemblance to Wills, in that both may be revoked or amended by the grantor (or testator) at any time before death. In certain important respects, however, RIVTs are more flexible than Wills. For example, testamentary trust provisions appearing in Wills do not operate until death, since the Will itself does not “speak” until death. Dispositive provisions of RIVTs, on the other hand, accomplish important lifetime estate planning objectives, since RIVTs also operate during the grantor’s life.

The “merger” doctrine had previously discouraged the use of RIVTs. Under this doctrine, a person who purported to create a trust in which he was the sole beneficiary and sole trustee, had actually created no trust, since the interests “merged.” New EPTL §7-1.1 abolishes the merger doctrine in the context of RIVTs. It provides that where the same person is both “the sole trustee and sole holder of the present beneficial interest, the trust is valid if one or more other persons holds a beneficial interest.”

Another problem with RIVTs was the lack of statutory guidance governing their execution. Execution of Wills has always been governed by strict statutory requirements, and Wills executed in the presence of an attorney are presumed to have been validly executed. The new law addresses this void, imposing requirements less rigorous than those governing the execution of Wills. RIVTs created prior to December 25, 1997 are governed by existing law, and, strictly speaking, need not be revised. Such revision, however, would likely be judicious in light of the new procedures, described below.

Under new EPTL §7-1.7(a), a RIVT must be (1) in writing; (2) signed by a grantor at least 18 years of age; and (3) acknowledged by a notary or signed in the presence of two witnesses. (Note: (i) acknowledgment must be in the manner required for the recording of a conveyance of real property; and (ii) although the statute is silent, it is probably best to have the RIVT acknowledged within 30 days.)

Under new EPTL §7-1.17(b), amendments or revocations of a RIVT must also be signed and witnessed or acknowledged in the manner identical to that required for their execution. (The creator can, however, provide in the trust instrument for different formalities of revocation or amendment.)

New EPTL §7-1.17(b) requires that all trustees be notified in writing of any amendment or revocation within a “reasonable” period of time. Although failure to provide such written notice will not void the amendment or revocation, no trustee who acts without having received such notice can be held liable for any actions taken. New EPTL §7-1.16 also provides that a subsequent Will may revoke a amend a RIVT. To accomplish this, however, the Will must specifically refer to the trust or trust provision in question. New EPTL §7-1.17(b) also provides that a trustee of a lifetime trust is protected from liability if assets are distributed in good faith without knowledge that the trust was revoked or amended by the testator’s Will.

Another previously uncharted area concerned transfer of assets into the RIVT. New EPTL §7-1.18 provides in general that a trust is valid “as to any assets therein to the extent the assets have been transferred to the trust.” Previously, a mere declaration by the grantor of an intent to transfer certain assets into the RIVT may have sufficed, without formal title or registration changes. Typically, this was accomplished by inserting a provision in the trust instrument assigning to the trustee “those assets listed in Schedule A annexed hereto.”

The new law requires more. New EPTL §7-1.18 provides that “[f]or purposes of this section … transfer is not accomplished by recital of assignment.” However, specific statutory guidance is provided only with respect to RIVTs in which the grantor is also the sole trustee. Here, effective transfers require that (i) titles of bank accounts be changed; (ii) stocks be reregistered; and (iii) real estate be transferred and the deed be recorded. Failure to adhere to these formalities will render the transfers ineffective.

If the grantor is not the sole trustee, the  transfer would probably be deemed complete under the new statute provided the grantor delivers the assets to the trustee with the intent to make a transfer in trust. Nevertheless, adhering to the more stringent requirements appears to be preferable: reregistering the assets and transferring title to real estate while the grantor is alive are fairly simple tasks. After the grantor’s death, these tasks become procedurally more difficult and more time consuming.

What if the grantor dies having validly executed a RIVT, but before having legally transferred property into the trust? Disposition of those assets will not be governed by the RIVT, which property would instead pass by Will or intestacy. This problem can be avoided by drafting a Will containing dispositive provisions identical to those contained in the RIVT with respect to the property intended to be transferred to the RIVT. However, since a Will may amend an existing RIVT, it is best to execute the Will first in this situation.

It is not necessary to amend a preexisting Will after the property transfers have been made to the RIVT since a Will can only dispose of property within the probate estate. Property effectively transferred to a RIVT is no longer within the probate estate. Put another way, an ineffective devise does not affect the validity of a Will. Still, executing a codicil in this situation does no harm, and may well mollify the testator. (Thus, the proverbial devise of the Brooklyn Bridge to heirs is ineffective, but will not invalidate the Will — although it might raise questions of testamentary capacity.)

Some tangible property, such as a coin collection, cannot be registered. In this situation, an instrument of assignment must be prepared which describes the asset with particularity. Although trusts funded prior to December 25, 1997 will be governed by prior law, it is probably advisable to comply with the more rigorous funding requirements under the new law even with respect to previously executed RIVTs.

Another advantage of the RIVT is that a challenge based on mental competence, to be successful, would probably be required during the grantor’s lifetime, when he could still defend against such a challenge. Being a contract, courts may require a lower degree of mental capacity to execute a RIVT. In any event, a challenge to a RIVT based on mental capacity after the grantor’s death (which is when it would most likely come from frustrated heirs) would probably be viewed by a court with considerable skepticism, given the likely passage of time since the trust’s execution.

Another problem associated with RIVTs was posed by EPTL §10-10.1, which prohibits a trustee from making discretionary distributions to himself. This severely limited the utility of RIVTs, since the grantor and trustee of a RIVT were often the same person. To avoid this problem, RIVTs were required to name two trustees, one of whom could still make discretionary distributions to the grantor-trustee. The new law amends the above section to the extent that the bar against discretionary lifetime distributions does not apply if the trustee also has the power to revoke the trust. By definition, this condition is always met with RIVTs.

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Taxpayer Relief Act of 1997

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

Capital gains tax rates were substantially reduced by the 1997 Tax Act. Capital assets held for 18 months and sold after after July 28, 1997 are eligible for the new 20% tax rate. The old 28% rate continues to apply to long-term capital gains property held for more than a year but less than 18 months. Short-term capital assets (i.e., holding period less than a year) will continue to generate ordinary income. A special rule applies to capital assets sold between May 7 and July 28 of 1997: The 20% rate applies if they were held for one year (rather than 18 months).

The new capital gains rules relating to home sales will help most taxpayers, but certainly not all. A $500,000 exclusion for capital gain realized on the sale of a principal residence is now available to joint filers ($250,000 a single filer). The home must have been the primary  residence of at least one spouse for the previous 2 years. (The 2-year rule can be finessed if “unforeseen circumstances” necessitated the move. However, the exclusion amount will be reduced, pro rata, to reflect the actual amount of time spent in the home.) Note that couples selling a home and realizing a gain of more than $500,000 ($250,000 for single filers) will no longer be permitted to “roll over” that gain by purchasing a more expensive new home within 2 years. [The new law applies to sales or exchanges of primary residences after May 6, 1997. However, taxpayers may elect to apply the old law with respect to sales or exchanges between May 7 and July 28, 1997.]

The 1997 Act also addresses estate and gift taxes. The lifetime exemption amount will rise to $625,000 in 1998. It is scheduled to reach $1 million in 2006, after yearly increments. The $10,000 annual exclusion has been indexed for inflation, in $1,000 increments. Small businesses are eligible for an estate tax exemption of up to $1.3 million, which amount includes the regular exemption. Estate tax attributable to small businesses may also be paid in installments for up to 14 years.

Other important provisions in the 1997 Tax Act:

¶  Self-employed individuals may deduct 40% of health insurance premiums in 1997. This amount is targeted to rise to 50% in 2000, and 100% by 2007.

¶  Doctors and others who conduct most of their business away from home will no longer see home office deductions fall prey to the “principal place of business rule.” The definition of principal place of business now includes “a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer…”

¶  IRA rules have been changed:

First, rules relating to current IRAs have been modified. The 1997 Act raises the phase-out range to $30-40k for individuals, and $50-60k for joint filers, for taxpayers (or their spouses filing jointly), who are covered by a pension plan at work.

The new “Roth” IRA allows no deductions for contributions, but neither are withdrawals taxed if the account has been held for at least 5 years and the individual is at least 59 years old. Income limits of $95-110k for individuals and $150-160k for couples apply.

The new “education” IRA allows nondeductible contributions of $500 per child under 18 per year, in addition to contributions made to other IRAs. Withdrawals for higher education expenses are not taxed. Phaseout levels are the same as for the Roth IRA.

¶  A controversial provision governing independent contractors was dropped from the 1997 Tax Act. Critics claimed that the law would make it too easy for employers to classify workers as independent contractors, thus denying them health and pension benefits, as well as wage, hour and workplace safety protections.

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Depreciation Recapture

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

The recent reduction in capital gains tax rates underscores the importance of taxpayers planning their transactions to avoid recharacterization of Code Sec. 1231 capital gain to ordinary income when disposing of certain depreciable property. Section 1231 property is property used in a trade or business that is real property or depreciable property held for more than one year.

Net Sec. 1231 gains are taxed as long-term capital gains, while net Sec. 1231 losses are taxed as ordinary losses. Thus, ordinary income can be sheltered by Sec. 1231 losses. However, TRA 1984 reduced the advantage of Sec. 1231 by providing that any net Sec. 1231 gain is recharacterized as ordinary gain to the extent of any nonrecaptured net Sec. 1231 losses for the previous five years.

In accomplishing their purpose, the recapture provisions also operate to reduce Sec. 1231 gains. Once Sec. 1231 realized gains have been determined for a given year, it is then necessary to determine whether any gain must be recaptured under Sections 1245 and 1250. This recaptured gain is treated as ordinary income. After adjusting downward realized Sec. 1231 gains with gain recaptured as ordinary income, gains and losses of Sec. 1231 property are netted. Sections 1245 and 1250 thus apply before netting occurs under Sec. 1231.

Code Sec. 1245 greatly reduces the allure of Sec. 1231. All gain from the disposition of Sec. 1245 property is treated as ordinary income. However, gain recaptured as ordinary income can never, of course, exceed realized gain. Accordingly, Sec. 1245 has no operation where assets are sold or exchanged at a loss. The most disadvantageous aspect of Sec. 1245 is that it applies to the total amount of depreciation taken, regardless of which method of cost recovery was used.

Section 1245 property includes depreciable personal property such as equipment, automobiles, and other tangible real property. Section 1245 property also includes nonresidential real estate placed in service after 1980 and before 1987 under ACRS rules unless the straight-line depreciation was elected.

Code Sec. 1250, another recapture provision, also operates to convert what would have been Sec. 1231 gain into ordinary income. However, Sec. 1250 applies only with respect to depreciable real property other than Sec. 1245 property. The section computes an amount referred to as “additional depreciation,” and converts that amount to ordinary income. Additional depreciation is the amount by which ACRS depreciation exceeds straight-line depreciation.

Code Sec. 291 contains additional depreciation recapture rules applicable solely to corporations which dispose of depreciable real estate. This recapture is in addition to any recapture first calculated under Sec. 1250. In order to calculate Sec. 291 recapture, it is first necessary to compute the difference between the amount of recapture under Sec. 1250, and the amount that would (hypothetically) be recaptured under Sec. 1245. The amount of additional recapture under Sec. 291 is 20% of that difference.

Code Sec. 1239 operates to recharacterize gain in the context of related party transactions. A person is “related” to any corporation (or partnership) in which the individual owns, actually or constructively, more than 50% of the value of the outstanding stock (or has a capital or profits interest in excess of 50%).

Code Secs. 1245 and 1250 generally take precedence over other provisions of the tax law. A gift or devise of appreciated depreciable property will not, however, trigger recapture. Recapture will occur, however, if the donee of a lifetime gift later disposes of the property. By contrast, a bequest at death vanquishes recapture potential.

Boot received in a Code Sec. 1031 like-kind exchange results in gain recognition to the extent of boot received, or realized gain, if less. Gain recognized in such an exchange in which Sec. 1245 or 1250 property is involved is recharacterized as ordinary income to the maximum amount subject to the recapture provisions. If no gain is recognized, then the recapture taint carries over to the replacement property.

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Estate Planning Checklist

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

The level of sophistication of estate plans varies with the size and complexity of an individual’s estate. A carefully drafted Will or revocable inter vivos trust is the starting point for many plans. The revocable inter vivos trust is highly regarded due to its ability to effectuate testamentary dispositions without the necessity of probate. However, it still requires the effective legal transfer in trust of all testamentary property during the grantor’s life. The estate planner who utilizes only an inter vivos trust runs the risk of failing to transfer (or to effectively transfer) all property into the trust.

Despite its drawbacks, the inter vivos trust is very useful in conjunction with a Will. For example, the inter vivos trust may serve as a “standby” trust, to be funded with assets in the event of the incapacity of the grantor. The grantor may also wish that property be managed and distributed by a professional trustee, e.g., a bank, during his lifetime. The Will, which is dormant until death, cannot accomplish this. When the inter vivos trust is used in conjunction with a “pour over” Will as a testamentary instrument, its shortcomings are also minimized.

The following relatively simple documents may be important in the event of disability or incapacity: the health care proxy appoints an agent to make medical decisions in the event of incapacity. The living will states whether or not extraordinary means are to be used to keep one alive. The durable power of attorney, for financial transactions, survives incapacity, so that guardianship can be avoided. The durable power of attorney can be used to place assets into an existing inter vivos trust in the event of the incapacity of the grantor.

To accomplish the objectives of wealth transfer, business succession, and asset protection, the LLC has emerged as the clear entity of choice. The LLC can be used to shift income to lower bracket taxpayers, to shift wealth while leveraging the unified credit, and to effectively protect assets from claims of creditors. Favorable basis rules make the LLC an extremely attractive vehicle for real estate. The LLC operating agreement can provide for succession of a family business after the death of a member.

Life insurance purchased by an irrevocable trust can provide wealth to beneficiaries at no estate tax cost. Premiums may be funded by gifts qualifying for the annual exclusion. Other irrevocable trusts may be formed to hold property in trust for children, to be distributed to them in the event of the unexpected loss of their parents, or to be held until they reach mature years.

Split interest trusts offer the potential to transfer assets of substantial value at little or no gift tax cost. The grantor may also retain a fixed annuity, a right to yearly income, or a right to enjoy property transferred to the trust. At the time of creation of the trust, a taxable gift is made only to the extent of the gifted remainder interest. Charitable trusts, also useful, are discussed in this issue.

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Charitable Remainder Trusts

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

Extremely useful in estate planning, charitable remainder trusts (CRTs) provide for specified distributions at least annually to one or more beneficiaries for life or for a term of years, with an irrevocable remainder interest passing to a designated charity. The grantor receives these benefits: an immediate income and gift tax deduction for the value of the charitable remainder interest; a continuing yearly income stream; eventual estate tax savings; immediate capital gains tax relief; the avoidance of probate (with respect to gifted property); and an ultimate charitable gift.

Only charities meeting the requirements of IRC Sec. 170(c), which includes religious organizations, public charities, educational institutions, and libraries, may be the recipient of a charitable remainder interest. Tax-exempt status under IRC Sec. 501(c)(3) can be sought for a private foundation to remain in existence after the last income stream beneficiary has received his last payment.

The IRS has issued safe harbor trust agreements which can serve as the starting point for drafting a CRT. Sample agreements modified to comport with local law and practice, to define legal relationships, or to pass property by bequest, will be considered “substantially similar” to IRS sample forms. Failure to come within the safe harbor does not necessarily mean that a trust is disqualified as a CRT; only that there is no assurance that the trust shall qualify. Regardless of the trust agreement used, all CRTs must meet all statutory requirements and file yearly income tax returns.

Although the grantor himself may serve as sole trustee, this may entail risk. Under IRC Sec. 674, the retention by the grantor of certain powers, such as the power to allocate income among income stream beneficiaries, would result in the loss of the trust’s tax-favored status. This risk can be lessened if the approval or consent of an independent co-trustee is required for all decisions made by the grantor which affect beneficial enjoyment of the trust property.

Transferring property to a CRT results in an immediate charitable income tax deduction based on the present value of charitable remainder interest gifted. This, in turn, is a function of the age of the grantor at trust creation and the income stream provided by the trust. Thus, an older grantor retaining a small income stream for his life only would be entitled to a larger deduction than would a younger grantor retaining a larger income stream over joint lives.

[The amount of the charitable deduction allowed in a given year may be limited by the “contribution base,” which is a function of the type of charity, the type of property contributed, and the grantor’s AGI. However, the result of this limitation would not result in a permanent loss of the deduction, but would require the grantor to amortize the deduction over five years.]

The CRT may provide an income stream for the life of the grantor, the joint lives of the grantor and spouse, for other beneficiaries for a period of years not to exceed 20 years, or for a combination of a life term and a term of years. The trustee may also be given the power to allocate or “sprinkle” income among income stream beneficiaries, as he deems appropriate.

Between 5 and 50 percent of the yearly trust income must be distributed. At trust termination, the remainder interest — which must constitute at least 10 percent of the initial fair market value of all property placed in the trust — must pass to the designated charity. The loss to the grantor’s heirs of their legacy may be minimized if the donor purchases term life insurance, whose premiums could be funded by the income tax savings generated by the CRT.

IRC Sec. 664(c) provides: “[a] charitable remainder annuity trust … shall for any taxable year, not be subject to any tax imposed by this subtitle.” Thus, one of the most attractive features of the CRT lies in its ability to neutralize the capital gains tax on appreciated property. Highly appreciated property can be contributed and then sold by the trust with no capital gains tax. The entire proceeds can then be used to provide an income stream to the grantor or other beneficiaries.

The tax-exempt nature of the trust will also cause the trust assets to appreciate quickly. Furthermore, if the trust sells appreciated property and then invests in tax-exempt securities, the noncharitable beneficiaries’ yearly annuity will also be tax-exempt. The  result of these favorable tax rules may be that the granter could enjoy a higher rate of return by utilizing a CRT than he would by selling the property himself and then paying capital gains tax. As noted, the tax savings so generated may be more than sufficient to purchase a life insurance policy whose proceeds at death could equal or exceed the value of the property the grantor’s heirs would inherit but for the CRT.

Encumbered property should generally not be contributed to a CRT, since taxable gain will result to the extent debt exceeds basis. In addition, CRT income is taxable in any year in which the trust has any unrelated business taxable income (UBTI). Since rental real estate subject to acquisition indebtedness is by definition UBTI, encumbered rental real estate should not be contributed.

Two transfer tax issues warrant careful consideration: first, the trust must not provide the grantor with any retained interest (i.e., “incidents of ownership”) which would cause inclusion in his gross estate. Second, if the grantor executes a trust which provides an income stream to his children, he will be making a taxable gift. By comparison, an income stream provided to the grantor himself results in no taxable gift; and one to the grantor’s spouse, though taxable gift, is shielded by the unlimited marital deduction.

All beneficiaries receiving an income stream must report their income. The character of distributions to noncharitable beneficiaries is determined by the character of that income to the trust. Each payment therefore constitutes ordinary income, capital gain, tax-exempt income, or a return of principal. Since a trust may have various types of income in a given year, the regulations provide ordering rules to determine the characterization of particular distributions.

CRTs are comprised of two types: the annuity trust and the unitrust, differentiated primarily by the determination of yearly income stream. The income stream of the annuity trust is a fixed dollar amount or percentage of the trust at inception. This remains constant over the life of the trust. Conversely, the income stream of a unitrust is a fixed percentage of the fair market value of the trust each year. The property constituting the unitrust will thus require a yearly appraisal, and the income stream will vary. Only the unitrust is permitted to be funded with additional property in later years.

The grantor is treated as making a taxable gift of the present value of the noncharitable annuity at trust inception. When a married donor creates a joint and survivor CRT, the grantor will also receive a gift tax marital deduction. Thus, no gift tax liability will arise from the transfer. Although the value of the trust will eventually be included in the donor’s gross estate under IRC Sec. 2036, the estate may claim a marital deduction for the surviving spouse’s annuity interest, and a charitable deduction for the remainder interest. Thus, the entire trust will escape estate tax in the donor’s estate. Since the surviving spouse never possesses more than a life estate in the trust property, no estate tax will be imposed on the surviving spouse’s estate.

If other beneficiaries, such as children, will ultimately receive income streams, this contingent interest would cause the gift to the grantor’s spouse to constitute a “terminable interest,” rendering the marital deduction unavailable. The grantor may deem the loss of the marital deduction to be less important than providing guaranteed payments to his children. If, however, the loss of the marital deduction would unduly complicate the grantor’s estate planning, another option exists: income tax savings generated from the charitable deduction could be used to purchase a joint and survivor life insurance policy. If placed in an irrevocable life insurance trust, this “wealth replacement trust” would serve as substitute for the interest which passes to the charity rather than the grantor’s children, and would be excluded from the grantor’s gross estate.

The CRT can also serve as a quasi-retirement plan, deferring income to the grantor. To accomplish this, the yearly annuity to the grantor would be fixed at the lesser of (a) the income earned or (b) a fixed percentage of the net fair market value of trust assets. This formula will not violate Code provisions if the “deficiency,” i.e., the difference between the fixed percentage of the value of assets, and the income earned, is made up in later years. A “deficiency” can be created by causing the CRT to invest in low current-yield assets, such as low dividend stock, or vacant real property.

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Avoiding Inclusion of Life Insurance Proceeds in Estate

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

IRC Sec. 2042 provides that all policies of insurance received by or “for the benefit of” the estate are included in the decedent’s gross estate. Proceeds paid to beneficiaries are also includible if the decedent assigned the policy but possessed any “incidents of ownership” at the time of death. Since the definition of that term is not particularly intuitive, it is essential not to run afoul of the definition as understood by the IRS.

Incidents of ownership include (a) a reversionary interest worth more than five percent of the value of the policy immediately before the decedent’s death; (b) the right to change a beneficiary; (c) the right to surrender or cancel the policy; (d) the right to revoke the policy; or (e) the right to obtain a loan from the policy. Although some incidents of ownership, such as retaining the right to borrow from the policy, clearly benefit the insured, Reg. Sec. 20.2042-1(c)(4) provides that the hallmark of “incidents of ownership” is the power to change beneficial enjoyment, rather than the retention by the insured of a beneficial interest. Generally, the grantor should avoid naming himself as sole trustee in order to avoid retaining unwanted “incidents of ownership.”

A gift in trust requiring the beneficiary to use the proceeds to pay estate tax obligations is “for the benefit” of the estate, and is includible. To avoid this problem, the trustee should be given the the power, exercisable in his absolute discretion, to lend money to the estate or to purchase assets from the estate. Since the trustee would not be under a legal obligation to lend money to the estate, the insurance proceeds would not be included in the decedent’s gross estate. If utilized, this technique may avoid the necessity of the executor selling a family business or other assets which might be difficult of valuation, or illiquid, to pay estate taxes.

If the decedent retains ownership or incidents of ownership, or dies within three years of making an assignment of an insurance policy, the insurance proceeds will be included in the gross estate. It is therefore important that the decedent’s Will make provision for whether or not the beneficiary is liable for estate taxes attributable to the insurance proceeds. If the Will is silent, IRC Sec. 2206 provides that the executor may recover from the beneficiary a pro rata portion of the total federal estate tax paid. New York case law follows this rule. However, if the decedent wishes that the beneficiary retain all proceeds with the estate tax liability to be paid by the residuary estate, the Will should so state.

To avoid the three year rule when the grantor wishes to make a gift in trust of an insurance policy, the grantor should direct the trustee (other than the grantor) of a newly formed irrevocable life insurance trust (in which the grantor retained no incidents of ownership) to purchase a new life insurance policy on the life of the grantor. Since the grantor never owns the policy, even if he dies within three years, the policy proceeds will not be included in his gross estate. This technique will only work with a new policy, however.

Avoidance of estate tax in the surviving spouse’s estate is also  important. The decedent’s Will may direct that the proceeds of his policy be held in trust, with the surviving spouse allowed an income interest in trust assets. If a QTIP election were made by the decedent’s executor, or if the surviving spouse were granted either a power to invade the corpus of the trust or a general power of appointment, inclusion in her estate would be unavoidable. Conversely, if no marital deduction were claimed by the estate of the decedent, and the surviving spouse’s right to invade the trust corpus were limited by an “ascertainable standard” for her health, education, support, or maintenance, inclusion in her estate could be avoided. Moreover, the surviving spouse could be given a noncumulative yearly right to withdraw the greater of 5 percent of the balance of the proceeds, or $5,000, without risking inclusion in her estate.

Premiums paid for by the trustee from funds provided by the grantor will result in no taxable gift if the $10,000 annual exclusion is utilized. To convert the future gift of premiums into one of a “present interest” which qualifies for the annual exclusion, each beneficiary must be given a yearly right of withdrawal in writing. This right may lapse after 60 days.

Posted in Estate Planning, Life Insurance Trusts, Tax News & Comment, Trusts | Leave a comment

2002 Tax Act

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

The 2002 Tax Act provides $38.7 billion in tax incentives; most for businesses with modest incentives for individuals. Of particular interest is a new provision which allows an additional 30% depreciation deduction in the first year. The Act also contains various provisions intended to clarify the 2001 tax legislation. Most provisions are effective in 2002, though some relate back to 2001 and may therefore require amending returns. The Act also provides $5 billion in tax relief to areas of lower Manhattan.

Most types of business property with a recovery period of 20 years or less, purchased between September 11, 2001 and September 10, 2004 are eligible for the additional first year depreciation deduction of 30%, with the notable exception of real estate. The provision applies to new property; however, improvements to used property, including qualified leasehold improvements, will qualify. No deleterious effects will occur for AMT purposes since there is no AMT adjustment for qualified property recovered under new IRC § 168(k), which provides for the additional 30% first-year depreciation allowance. Section 168(k) is not elective — bonus depreciation applies to qualified property unless the taxpayer affirmatively elects for the provision not to apply. The election out may be made for any tax year for any class of property.

In computing basis and depreciation, the new bonus is applied first, reducing the property’s basis. Regular depreciation allowances are then computed.  A different rule applies if the property is also eligible for  IRC § 179 expensing: in that case, the Section 179 deduction precedes the reduction in basis for the bonus depreciation. To illustrate, assume a business purchases 5-year MACRS property worth $100,000 and eligible for Section 179 expensing on September 11, 2001. In computing depreciation, $24,000 would be expensed, reducing the property’s basis to $76,000. The 30% bonus depreciation of $22,800 would further reduce the property’s basis to $53,200. Finally, regular depreciation of 20% would yield a deduction of $10,640. Thus, the total amount of deductions allowed in the first year would be $57,440.

The 2002 Act temporarily increases the NOL carryback period of 2 years (3  years for NOLs arising from casualty or theft losses) to 5 years for losses arising in tax years ending in 2001 and 2002. Although the provision is mandatory, the taxpayer may irrevocably elect to carry the NOL back only 2 years. (The election might be advantageous if the taxpayer was in a higher tax bracket in the second carryback year than in the fourth or fifth carryback year.)

The Act also statutorily reverses the quirky Supreme Court decision in Gitlitz v. Com’r., 531 US 206, which allowed S corporate shareholders the benefit of adjusting their basis in corporate stock upward for items of income that were discharged under IRC § 108. Since such income was excluded under IRC § 108(a), in effect the shareholders were allowed a basis increase (which could offset losses), with respect to income that the S corporation was never required to report.

Also enacted were the following:

¶ A clarification that a taxpayer who utilizes the “deemed sale and repurchase election” with respect to a principal residence cannot also claim the IRC § 121 exclusion.

¶  A provision allowing Form 1099 information returns to be sent electronically — provided the recipient agrees.

¶ A temporary two-year extension, until December 31, 2003, of many tax credits which expired on December 31, 2001, including for example, the Work Opportunity Tax Credit and various energy incentives.

¶  Additional tax relief, consisting of enhanced depreciation and other tax incentives, to taxpayers situated in a special “Liberty Zone” in southern Manhattan.

¶   An increase in the maximum first-year depreciation for business automobiles  placed in service from 9/11/01 to 9/10/04 of $4,600, to $7,660.

¶  A provision making permanent the use of the child tax and adoption credits against regular tax liability and AMT.

The following major provisions were not enacted, but appear to have substantial support and may be the subject of another tax bill this year: (i) an immediate reduction in the individual 27% income tax rate to 25%; (ii)  an immediate acceleration of the 100% deduction for self-employed health insurance premiums; (iii) a complete repeal of the corporate AMT; (iv) a reduction in payroll taxes for small businesses; and (v) an increase in IRC § 179 expensing to $50,000.

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

Supreme Court Holds IRS Lien Encumbers Entireties Property

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

Departing starkly from a body of decisional law burnished by time in the lower courts, the Supreme Court, in United States v. Craft, No 001831(4/17/02) reversing the 6th Circuit, held that a spouse’s interest in entireties property constitutes property or rights to property to which a federal tax lien may attach. Five Justices concurred in an opinion written by Justice O’Connor.

[The IRS filed a federal tax lien against husband, who then quitclaimed his interest in the property held as tenants by the entirety to his wife. Subsequently, IRS agreed to release the lien upon the condition that half the net proceeds be held in escrow pending determination of the government’s claim. Wife then brought an action in District Court to quiet title, which was dismissed. The Sixth Circuit reversed, holding that no lien attached because the husband had no separate interest in the entireties property under Michigan law.]

The Court first observed that because the federal tax lien statute itself creates no property rights, state law must be consulted to determine whether state-created rights qualified as property or rights to property under IRC § 6321, which provides that the amount of any tax owed becomes a lien against “all property and rights to property, whether real or personal, belonging to such person.” Next, the Court found that Michigan law gave the husband a bundle of rights, including the right to use the property, to alienate it, or to block the spouse from unilaterally encumbering or selling it.

The Court found that the rights conferred upon the husband under Michigan law qualified as property or rights to property under IRC § 6321. Even though the husband could not unilaterally alienate the property, he still possessed a substantial degree of control over the property. Moreover, the Court found that excluding property from a federal tax lien simply because the taxpayer could not unilaterally alienate it would exempt an undue amount of property from the reach of the lien statute. Finally, the Court reasoned that if the husband had no lienable interest in the property, the wife’s interest, which was no greater than her husband’s, would also not be subject to the lien. This “absurd” result, in which entireties property would be beyond the reach of the lien statute, would “facilitat[e] abuse of the federal tax system.”

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The 3rd Circuit, in Tolve v. CIR, No. 00-2289 (3/22/02), held that the Tax Court erred in finding that a Form 872-A consent to extend the period to assess “tax” included penalties and interest. Applying contract principles, the court found that limiting language added to the consent form distinguished it from unrestricted consent.

Est. of Fontana v. CIR, 118 T.C. No. 16 (3/28/02), held that stock subject to a decedent’s general power of appointment must be aggregated with stock owned outright by the decedent for estate tax purposes.

Est. of Adams v. CIR, T.C. Memo 2002-80, held that an estate was not required to include proceeds of an insurance policy owned by a general partnership in which the decedent was a one-third owner, where the partnership was required to buy, and the estate to sell, the decedent’s interest in the partnership, since the the proceeds facilitated the partnership’s obligation to purchase the interest.

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REGS, IRS RULINGS & PRONOUNCEMENTS — June 2002

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

Final Regs. governing required minimum distributions (RMDs) from qualified plans and IRAs adopt, in modified form, the simplified rules proposed in 2001. Among them: (i) new tables of life expectancies for calculating RMDs; (ii) a new date for determining the designated beneficiary: September 30th (rather than December 30th) of the year following the year of the participant’s death; and (iii) a new requirement that a beneficiary’s disclaimer comply with the disclaimer rules of IRC § 2518. T.D. 8987, 67 Fed. Reg. 18987 (4/17/02).

Expenses for a weight-loss program (but not diet food) are deductible as a medical expense if incurred pursuant to a doctor’s direction to lose weight or to treat disease. Rev. Proc. 2002-19.

A deemed sale of capital assets pursuant to § 311(e) will not be treated as a disposition of the taxpayer’s entire interest in a passive activity. Notice 2002-29.

The Industry Issue Resolution (IIR) program has been made permanent and expanded to include small businesses and self-employed individuals. Submissions for guidance should describe the issue and the number of taxpayers affected. If material issues are present, and tax uncertainty involves a significant number of taxpayers, the Service may issue a revenue ruling,  revenue procedure, or other guidance. Notice 2002-20.

Employers maintaining various fringe benefit plans, such as cafeteria plans under IRC §125 or educational assistance programs under §127 are no longer required to file annual information returns (Schedule F) attached to a completed Form 5500 pursuant to IRC § 6039D. Notice 2002-24.

A grantor’s power to replace an independent trustee will not render the gift to the trust incomplete and similarly, the reserved power will not result in inclusion of the trust property in the grantor’s estate under IRC § 2038. PLR 200213013.

Former spouse who was custodial parent was entitled to claim exemption notwithstanding court order granting taxpayer such right. Presumption under IRC §152(e) is that custodial parent is providing over one-half of child’s support. A claim for exemption may be released under §152(e)(2), but Form 8332 must be executed by the releasor. FSA 200211004.

Rev. Proc. 2002-18 provides the terms for a change in accounting method imposed by IRS, while Rev. Proc. 2002-19 (modifying Rev. Proc. 2002-9) sets forth procedures for eligible taxpayers to obtain advance consent or automated consent to change a method of accounting.

Compensation of medical residents does not qualify for the FICA exception  for students, since residents are receiving “on-the-job-training” rather than incident to a course of study. CCA 2002212029.

IRS deputy associate chief counsel Lewis J. Fernandez, responding to a specific query from the ABA Tax Section, stated that businesses hurt by the 9/11 attacks may receive gifts from charities on a tax-free basis. However, the businesses may not deduct business expenses (e.g., payroll) to the extent allocable to the excluded gifts.

The IRS will no longer seek to tax in-kind benefits relating to the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel.  Announcement 2002-18.

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