TAX PLANNING FOR DIVORCE: PART II

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

Tax planning in the context of divorce requires familiarity with IRC §§ 71 and 1041, the first of which governs the taxation of alimony (support) payments and the second of which sets forth the general rule of nonrecognition with respect to property transfers incident to divorce. Careful tax planning can result in a lower overall tax burden between divorcing spouses, especially if a significant tax rate differential exists.

IRC § 71 gives divorcing spouses considerable flexibility. For example, by structuring support obligations to continue beyond what would normally be a terminating event, difficulties associated with illiquid marital estates may be surmounted. Or, if parties contemplate that payments should diminish as children mature, the regulations provide a safe harbor for preventing the application of IRC § 71(c), which would otherwise operate to preclude those amounts from being treated as alimony for federal tax purposes. The structuring of alimony payments thus presents an opportunity to achieve a fair and tax-favored result for both parties.

Under IRC § 1041, no gain or loss is recognized on the transfer of property from an individual to a spouse or former spouse incident to divorce, whether or not consideration is present. Since no gain or loss is recognized, the transferee spouse must take a carryover basis in the property. If marital assets consist of properties with varying degrees of appreciation, equity would suggest that each party receive a mix of property with the same relative degree of built-in gain. If this is not possible (e.g., one spouse retains the personal residence with a higher basis), the parties may wish to compensate the spouse who takes the lower basis property since the sale of that property will generate future capital gains tax.

IRC § 1041 overrides some familiar tax principles. For example, a recent ruling, Rev. Rul. 2002-22 held that the assignment of income doctrine is inapplicable with respect to transfers of nonstatutory stock options or rights to deferred compensation between divorcing spouses. Instead, IRC § 1041 dictates the counterintuitive tax result that the recipient spouse will be taxed when the options are exercised or the deferred compensation is received, even though she did not earn that income. Rev. Rul. 2002-22 provides, however, that until November 9, 2002, parties to a new or existing agreement may elect to tax the transferor under familiar assignment of income principles, even many years later when the realization event occurs, provided certain technical requirements are met.

After November 9, 2002, assignment of income principles may no longer be “elected”.  Thereafter, the transfer of nonstatutory stock options and deferred compensation will result in income to the transferee when the options are exercised or the income is actually or constructively received. To make matters worse, the transferee will also be treated as the employee for FICA and FUTA employment tax purposes. Since the transferee spouse may not have expected to pay income or employment taxes upon the exercise of stock options or receipt of deferred compensation, the tax implications of the transfer could affect the terms of the overall agreement.

¶ Divorcing spouses should also not overlook a planning opportunity involving the sale of a personal residence: The $250,000 exclusion provided for by IRC § 121 has been increased to $500,000 for married couples filing a joint return. To preserve the full $500,000 exclusion, the couple is required to file a joint return. Therefore, it may be prudent for the sale to occur in a taxable year in which the parties are married and can still file a joint return.

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Article 81 Guardianships

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

Article 81 of the Mental Hygiene Law provides for the appointment of a guardian to satisfy personal or property management needs of a person who may require some assistance but does not require a traditional conservatorship and judicial committee. Guardianship is intended to operate in the least restrictive manner and without the loss of civil rights.

A guardian may be appointed after a hearing if the person for whom appointment is sought agrees to such appointment and the court finds that a guardian is necessary. On the other hand, if the alleged incapacitated person (AIP) objects to the appointment, a judicial finding of incapacity must be made. If a person’s physical disability necessitates the appointment, the person may welcome guardianship assistance. In fact, the AIP may self-petition for guardianship. See, e.g., Matter of De France, 710 N.Y.S.2d 612 (2nd Dept. 2000).

The Supreme Court has primary jurisdiction over guardianship proceedings, while the Surrogate’s Court has jurisdiction to entertain petitions for guardianship if a person otherwise before the court appears to be under a disability. Venue is proper in the county in which the AIP resides, or is physically present.

A guardianship proceeding is commenced by the filing of a petition together with an order to show cause. It may be commenced by the AIP, a “distributee” (e.g., family member) or any person concerned with the welfare of the AIP. Upon the filing of the petition, the court is required to set a return date no more than 28 days from the date of the filing, and must designate in the order to show cause the name of the court evaluator. Both the petition and show cause order must be personally served on the AIP, the AIP’s spouse, siblings, and adult children.

The court evaluator, appointed from a list maintained by the court, is charged with the responsibility of (i) meeting with the AIP and explaining the nature and possible consequences of the proceeding; (ii) advising the AIP of the general powers and duties of a guardian; and (iii) determining whether the AIP desires legal counsel. The court must appoint counsel if the AIP desires counsel or contests the petition.

A determination of whether the appointment of a guardian is necessary is made only after a hearing at which any party may call witnesses and present evidence. The AIP has a right to be present at the hearing unless the AIP resides out of state or is “completely unable” to participate in the hearing. If the AIP is physically unable to come to the courthouse, the hearing must be conducted where the AIP resides.

If the petition is ultimately granted, fees for the court evaluator are paid by the estate of the AIP.  If the petition is denied, the court may require both the AIP and the petitioner to pay the court evaluator’s fee, in such proportion as the court deems just. If not indigent, the AIP must pay for his or her own legal counsel. However, if the petition is denied or dismissed, the court may in its discretion direct that the petitioner pay legal fees for the AIP.

Following a determination after hearing that the appointment of a guardian is necessary, the court will indicate in the record (i) the specific powers to be granted the guardian which constitute the least restrictive form of intervention consistent with the person’s functional disabilities; (ii) whether the guardian is necessary to provide for the personal needs of the AIP or to manage property and financial resources of the AIP; and (iii) the duration of the appointment.

Recent cases illustrate a trend to afford the AIP greater procedural and substantive due process rights. The Law Revision Commission Comments state that the court must consider “all the evidence including the information and independent observations provided by the court evaluator’s report as to the person’s condition, affairs and situation,” and cogently adds that the court should regard guardianship as a “last resort . . . deciding on a guardianship only when . . . the alternatives are not sufficient and reliable to meet the needs of the person.”

Courts appear extremely reluctant to permit care providers to utilize the guardianship process to effect changes in patient care against the patient’s wishes. Thus, in Matter of Louis Koch, N.Y.L.J. 11/29/99, a hospital sought the appointment of a guardian to effectuate the discharge of a patient who refused to leave. The court rejected the petition, finding the patient, although a “difficult personality,” had a “sharp mind” and continued to manage his finances even while hospitalized. Similarly, in Matter of Presbyterian Hospital, N.Y.L.J. 7/2/93, a hospital sought guardianship for an 80 year old blind woman who refused the hospital’s request to transfer her to a residential health care facility. Finding no justification for the appointment of a guardian, the court noted that the woman’s own arrangements in procuring assistance from neighbors demonstrated that the AIP appreciated her functional limitations.

Guardianship need not be permanent: upon restoration of capacity guardianship may cease. Thus, in In Re Penson, 735 N.Y.S.2d 51 (1st Dept. 2001), the former AIP was restored to capacity status upon a record indicating that he was living in Florida, understood his limitations and had sought the assistance of an attorney and financial professionals.

At one time, it was not clear whether guardianship was appropriate with respect to a minor with a mental disability which was expected to continue into adulthood. Although parents are a child’s natural guardians until they reach majority, they are not vested with legal authority to manage large estates. In In re Marmol, 940 N.Y.2d 969 (1996) the court found that although the guardianship law was intended to meet the needs of elderly persons, “nothing in the statute precludes its use for the young.” That court appointed the parent as guardian under Article 81.  Since Marmol, many courts have appointed Article 81 guardians for minors with disabilities, frequently to manage estates created by personal injury awards.

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Split Interest Trusts

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

Split interest trusts can effectively remove appreciating assets from the grantor’s estate at little or no transfer tax cost. They can also serve to shift income, since all income generated by the property held in trust will continue to be taxed to the grantor during the trust term. As discussed in Part I, these trusts also possess attractive asset protection features. Because of their ability to reduce transfer taxes, split interest trusts have been the subject of treasury regulations and also recent proposed legislation.

In creating a split interest trust, the grantor transfers property to a trust and retains a “qualified annuity interest” in the case of a Grantor Retained Annuity Trust (GRAT), or a “qualified unitrust interest” in the case of a Grantor Retained Unitrust (GRUT). The trust continues for a predetermined length of time, which the grantor is expected to outlive.

At the inception of the trust, the grantor makes a taxable gift of a remainder interest, the value of which is calculated by reference to IRS valuation tables. This gift will not be brought back into the grantor’s gross estate provided the grantor outlives the trust term. If the grantor does not outlive the trust term  (or if the trust does not qualify as a GRAT, GRIT or GRUT), then the estate would owe gift tax on the entire value of the property transferred to the trust, not just on the present value of the remainder interest.

At the end of the designated trust term, the property will pass to trust beneficiaries without imposition of gift tax. Moreover, since the value of the gifted remainder interest (and the donor’s corresponding gift tax liability), is computed at the beginning of the trust term, to the extent the trust property has appreciated in value during the trust term, this appreciation will also escape gift tax.

Effective for gifts and certain other transfers made after April 30, 1989, and for estates of decedents dying after that date, the present value of any annuity, interest for life or for a term of years, or a remainder or reversionary interest, is determined by reference to IRS tables found in IRC Sec. 7520. These tables are based on an interest rate that is 120 percent of the applicable federal midterm rate (AFR) for the month in which the valuation date falls and for the most recent mortality experience available. The AFR for May 1998 is 6.8 percent.

To illustrate, assume the grantor transfers property worth $1,000,000 to a GRAT, and retains the right to receive $100,000 in yearly income, with payments to be made annually at the end of the year. Assume further the AFR in effect for the month the trust is created is 9.6 percent. From this, one calculates the present value of the remainder interest to be $374,840. This amount must be reported as a gift by the grantor on a Form 709 gift tax return. (Since the statute of limitations for transfers to split-interest trusts is suspended if the transfer is neither shown as a gift nor disclosed in adequate detail, the gift tax return should be accurate and detailed.) If the grantor outlives the trust term, he will have divested his estate of property worth $625,160 (and also any appreciation in the value of the property during the trust term) at zero gift tax cost. (The remainder interest and the amount of the taxable gift when property is transferred to a GRUT is determined in a similar fashion, but with reference to different IRS valuation tables.)

In deciding whether to use a GRAT or a GRUT, it is instructive to note that the GRUT requires yearly revaluations, while the GRAT does not. Another factor to consider is which type of trust will yield the smaller taxable gift at the outset. One must finally consider whether the assets funding the trust are likely to outperform the Sec. 7520 interest rate during the trust term.

As noted, the valuation table used to value the remainder interest in a GRAT is based the Sec. 7520 rate at the inception of the trust. To the extent the trust assets outperform that rate — currently 6.8% — the present value of the remainder interest for gift tax purposes will be undervalued. As the difference between the asset performance and the Sec. 7520 rate increases, so too does the value of the property which will ultimately pass to the remaindermen free of gift tax. Conversely, to the extent the Sec. 7520 rate exceeds the rate of growth of the assets in the GRAT, the present value of the remainder interest will be overvalued at the outset, and the actual gift tax liability will be greater than the gift tax liability based on the value of property actually received by the remaindermen at trust termination.

The GRAT is therefore most attractive when the trust assets are expected to significantly outperform the Sec. 7520 rate. Assuming that the trust assets will outperform the Sec. 7520 rate, and a GRAT is chosen, the grantor must next determine the annuity amount. Choosing an annuity amount that is sufficiently high such that the remainder interest is zero will result in a “zeroed-out GRAT.” If a zeroed-out GRAT is used, none of the grantor’s lifetime exemption will be depleted. However, if the trust assets do not outperform the Sec. 7520 rate, the remainder interest at trust termination will be zero, and the trust beneficiaries will be left with nothing.

If trust assets are not likely to outperform the Sec. 7520 rate, the GRUT is preferable since the trust assets will be revalued on a yearly basis. Their failure to appreciate at the Sec. 7520 rate will be reflected in a lower annuity paid to the grantor. The grantor and the remaindermen thus share in both the appreciation or depreciation in the value of the assets transferred to the trust. The GRUT is generally preferable when the appreciation of the trust assets cannot be predicted at the outset of the trust term. By virtue of the yearly revaluation of trust assets comprising a GRUT, the unitrust amount received from the grantor may fluctuate if the value of assets themselves change significantly on a yearly basis. Since yearly revaluations will be required, assets funding a GRUT should be readily capable of yearly revaluation, and should not require an appraisal.

Having chosen the type of trust, the grantor must next choose the length of the trust term. Recall that if the grantor fails to outlive the trust term, a portion of the trust property will be included in his gross estate by virtue of the retained life estate rule of IRC Sec. 2036(a). This result would negate the tax savings sought in using the split interest trust. On the other hand, using an excessively short trust term is also self-defeating, since the value of the remainder interest which is subject to gift tax increases as the trust term decreases. Accordingly, the length of the trust term should be one which the grantor is likely to outlive, yet should not be so short that the grantor’s outliving the term would result in only marginal gift tax savings. If the grantor cannot be expected to live at least ten years, then the use of a split interest trust may not be warranted.

The split interest trust also results in the gift tax-free shifting of the income tax liability of the trust. This result is dictated by the grantor trust provisions of the Code, which treat all income of such trusts as taxable to the grantor. To the extent trust income exceeds the annuity (or unitrust) amount, the remaindermen benefit, since the grantor is paying income taxes on property that they will eventually receive. However, the flip side is that grantor may be required to pay tax on “phantom” income which is not distributed to him.

The qualified personal residence trust (QPRT) is a split interest trust in which the grantor’s interest is in the form of use of a personal residence or vacation home for a term of years. Although recent regulations place significant restrictions on its use, the QPRT continues to be an effective vehicle for transferring ownership of a residence to family members at a reduced gift tax cost. Since the grantor of a QPRT is treated as the property owner for tax purposes, all deductions and elections available to the grantor, e.g., exclusions from gain on sale, like-kind exchanges, and deductions for real estate taxes, are available to the grantor, as if no trust had been formed. The remainder interest of a QPRT may also be protected from the claims of creditors, thus imbuing the trust with asset protection value.

Although recent Treasury Regulations prohibit the transfer of a residence from a QPRT to the grantor or the grantor’s spouse either during the income term or at its expiration, the grantor may nevertheless lease the property at the expiration of the term. In order to avoid inclusion in the grantor’s estate, however, the lease should be at fair market value.

A QPRT may provide that the grantor’s spouse receive the residence upon the death of the grantor either during the income term or at its expiration. The grantor may also retain a power of appointment, exercisable in his Will, in which he may direct distribution of the residence to any person, including the grantor’s estate.

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Tax Court Rejects Sale-Leaseback; Upholds $87 Million Assessment

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

In a lengthy opinion, the Tax Court voided the claimed tax benefits of an intricate sale-leaseback transaction involving foreign partners presumed immune from U.S. tax, and upheld an IRS income assessment of $87 million and a disallowance of $50 million in depreciation deductions. Andentech, LLC et al v CIR, T.C. Memo 2002-97.

Andentech (A), a Wyoming LLC, was formed by two Belgian citizens with $200,000 in borrowed funds. A purchased (subject to existing leases) 40 IBM mainframe computers from Comdisco (C), a large publicly traded computer leasing company, for $122 million. Consideration consisted of $15 million in cash (borrowed from UBS, a Swiss Bank) and $107 million in notes. Simultaneously, A leased the computers back to C. One month later, A sold a portion of rents due from C to Nationsbank for $87 million, which accelerated an $87 million portion of A’s note to C. This recognition event resulted in $87 million of current income to A, which flowed through to A’s Belgian partners, who claimed a treaty exemption.

Shortly thereafter, in a transaction intended to qualify under IRC § 351, the Belgian partners relinquished their interest in A in exchange for preferred stock (with a liquidating preference) in RD Leasing (RDL), a subsidiary of Norwest Equipment Finance Inc. (NEFI), itself a subsidiary of Norwest, a bank holding company traded on the NYSE. The change in ownership of A resulted in an acceleration of A’s senior $15 million note to UBS. NEFI then contributed $15 million in cash to RDL for RDL common stock and the UBS note was extinguished. On its 1993 return, A reported income of $87 million, all of which was allocated to (presumed) treaty-exempt Belgians. In 1994, A claimed $50 million in depreciation deductions.

The Tax Court, upholding the assessments, (i) disregarded A, finding that the Belgians, having received preferred stock in NEFI, were never at risk of losing their $200,000 investment, which was “comparably minimal” in comparison to the nonrecourse funds borrowed by A; (ii) (alternatively) disregarded the participation of the Belgians under the step-transaction doctrine; and (iii) found the sale-leaseback transaction a “sham,” fueled entirely by a desire to achieve tax benefits, with no economic substance and no profit potential.

The court was clearly concerned that the transaction “stripped” $87 million in rental income to treaty-exempt non-U.S. persons, and generated more than $50 million in depreciation deductions (utilized by Norwest on its consolidated return) with no offsetting rental income. A, moreover, seeking only to maximize deductions, had never “bargained” with C over the purchase price of the computers. This failure to negotiate demonstrated the lack of a business purpose other than obtaining tax benefits.

The court was also troubled by other factors, including (i) the failure of C to notify A (the “owner”), pursuant to the sales contract, that one end-user had exercised an option to purchase one of the computers; (ii) the large amount of nonrecourse debt, which indicated a lack of “economic substance”; (iii)  “overvalued” residuals assumed by A, which cast into doubt the profit motive; and (iv) the insertion of other “entities” solely for “tax-avoidance” reasons.

While a treaty should not “shield” the taxpayer from the step-transaction doctrine, neither should a court substitute its judgment for that of Congress, which granted certain non-U.S. persons a treaty exemption. Assuming, arguendo, that an appeals court found the requisite profit potential, would reversal be warranted? If so, perhaps Comdisco and Norwest erred not in seeking tax benefits clearly accorded by treaty, but rather by pursuing them without the quid pro quo of imbuing the transaction with real risk of economic loss. Perhaps a sale-leaseback structured in part to obtain tax benefits but also evidencing economic risk and real profit potential would have survived Tax Court scrutiny. As the court emphasized, tax benefits alone do not evidence a business purpose.

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President Clinton Submits 1999 Budget Proposal

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

President Clinton’s 1999 budget proposal contains the first balanced budget in thirty years. The proposal recommends $23 billion in tax cuts, which include tax reductions for environmental cleanup, child care, retirement savings and educational incentives. Revenue proposals made by Mr. Clinton include measures designed to increase taxes on corporate owned life insurance, and to curtail popular estate and asset planning techniques which reduce gift and estate taxes.

A child care credit proposal would increase the dependent care tax credit from 30 percent to 50 percent beginning in 1999. The 50 percent rate would be decreased by one percentage point for each $1,000 of AGI over $50,000.

A new employer child care credit would allow employers to claim a tax credit of 25 percent of qualified expenses for employee child care.

Mr. Clinton’s proposal also contains a mix of tax incentives to promote environmental improvement. The following tax credits would be allowed: (i) $3,000 to $4,000 for fuel efficient cars; (ii) $2,000 for rooftop solar systems; and (iii) $2,000 for energy efficient homes. The bill would also permit employees to elect to receive transit and “vanpool” benefits instead of wages.

Educational incentives relating to employer-paid educational assistance, currently set to expire in 1999, would be extended until June 1, 2001, and would be expanded to now include graduate level courses, as well as undergraduate courses.

The proposal also liberalizes rules relating to retirement savings. Under the proposal, an exclusion from income of up to $2,000 could be taken for contributions made to an IRA through payroll deductions. A new type of defined benefit pension plan would also be sanctioned for small businesses, i.e., the “Secure Money Annuity or Retirement Trust.” The SMART plan would complement existing defined contribution SIMPLE or SEP plans now available to small businesses. The budget proposal would also require that matching employer contributions to 401(k) plans be either fully vested after the employee had completed three years of service, or provide for incremental 20 percent vesting between years 2 and 6.

Budget proposals designed to raise revenue pose a frontal assault on three common estate planning techniques:

First, Mr. Clinton proposes to eliminate the Crummey power, which converts a gift of a future interest to one of a present interest, thereby enabling the donor to claim the $10,000 annual gift tax exclusion. (Gifts to minors under a uniform act would, however, continue to be deemed a gift of a present interest.)

Second, valuation discounts for minority interests in family limited partnerships that hold only marketable securities would be eliminated, by imposing an active business requirement.

Third, the gift tax exemption for qualified personal residence trusts (QPRTs) would be eliminated. Mr. Clinton’s rationale for the elimination of this exemption is the belief that the grantor’s retained interest is often overvalued because the grantor continues to pay insurance, maintenance and property taxes.

The proposal would also eliminate the corporate-owned life insurance (COLI) exception to the proration rules for contracts covering employees, officers or directors. A related proposal would tax the exchange of a life insurance or annuity contracts for variable contracts.

Multinational businesses would also be targeted for substantial revenue increases through new rules relating to foreign built-in losses, U.S. withholding of 80/20 corporations, and the prevention of tax abuse through controlled foreign corporations (CFCs).

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FINAL PENSION REGULATIONS ISSUED

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

Final regulations have been issued which govern required minimum distributions from IRAs and qualified plans. They generally follow the scheme articulated in the proposed regulations issued in January, 2001. Their use is mandated on January 1, 2003, but optional for calculating required minimum distributions in 2002. The final regulations dispense with the new reporting requirements until 2004.

The required minimum distribution for a participant is the account balance on December 31 of the prior year divided by the “applicable divisor” from the Uniform Lifetime Table, modified in 2002 to reflect longer life expectancies. For example, the applicable divisor for a person 70 years of age has been increased to 27.4 years from 26.2 years. Thus, the required minimum distribution of a participant 70 year of age required to take a distribution in 2002 from an account whose balance was $27,400 on December 31, 2001, would be $1,000. A longer (and more favorable) payout period would apply if the participant’s spouse were more than 10 years younger than the participant.

A participant must begin taking money out of an IRA or qualified plan by the “required beginning date,” which is generally the year the plan participant reaches the age of 70½. (If a participant owns less than 5% of a company which maintains a qualified plan, the required beginning date for withdrawals with respect to that plan is the later of age 70½ and the date of retirement.)

If the participant dies after the required beginning date, distributions to beneficiaries must commence by December 31 of the year that follows the year of the participant’s death. The distribution period for a nonspouse designated beneficiary is his remaining life expectancy, reduced by one in each subsequent year. If the participant’s spouse is the sole designated beneficiary, the distribution period is her single life expectancy, recalculated annually. (After her death, the distribution period for her named beneficiaries is her life expectancy in the year of her death, reduced by one in each succeeding year.)  A special rule applies if the owner has failed to name a designated beneficiary: in that case, the distribution period is the owner’s remaining life expectancy in the year of his death, reduced by one in each subsequent year.

If the participant dies before the required beginning date, the distribution period is calculated in the same manner as if the participant died after the required beginning date, with one rather unpleasant exception: if no beneficiary designation was made, the account must be entirely distributed by December 31 of the fifth year following the participant’s death. Thus, it is important that a beneficiary designation be made before death, especially if the participant has not attained the required beginning date.

Under the final regulations, the date for “determining” the designated beneficiary is September 30 of the year following the year of the participant’s death. However, this does not mean that a failure to make a beneficiary designation prior to death can be cured during this time: The regulations point out that the period between death and the beneficiary determination date is a period during which beneficiaries can be eliminated, but not replaced. The failure to make a beneficiary designation before death is therefore a fait accomplis, despite the flexibility afforded by the new regulations in winnowing out designated beneficiaries after death.

Post-mortem planning to eliminate certain designated beneficiaries is important in achieving the longest payout period for all beneficiaries. It might be desirable to cash out a beneficiary with a short life expectancy before the designated beneficiary determination date, since the age of the oldest beneficiary is used in determining the payout period. Alternatively, it may be possible to split a single account into multiple accounts, so that the oldest beneficiary’s life expectancy does not result in an excessively short payout period for younger designated beneficiaries. (However, the regulations state that the separate account rules are not available to beneficiaries of a trust.) Matters of convenience aside, it may be critical to cash out a beneficiary such as a charity, whose presence as of the determination date would “taint” the designated beneficiary status of all individual beneficiaries. This would result in a mandatory 5-year required payout.

A surviving spouse who receives a distribution from an IRA or a qualified plan may, within 60 days, roll over that distribution into her own plan to the extent the distribution is not a required distribution, regardless of whether the surviving spouse is the sole beneficiary of the plan. Furthermore, if the spouse is the sole beneficiary of an IRA (not a qualified plan) and has full withdrawal rights, the spouse may elect to treat the entire IRA as her own. The election can be accomplished by (i) registering the IRA in the name of the surviving spouse; (ii) failing to take a required minimum distribution as beneficiary; or (iii) contributing to the IRA. Regardless of how the IRA becomes the spouse’s own, required minimum distributions will thereafter be determined solely by reference to the surviving spouse.

A rollover is not always possible: If the spouse is the beneficiary of a trust that qualifies as a designated beneficiary, she is not permitted to roll over any distributed amount. Even if possible, a rollover is not always advantageous: IRC § 72(t) imposes a 10% tax on withdrawals occurring prior to age 59½ by an account owner. The tax does not, however, apply to distributions made to beneficiaries.

The beneficiaries of a trust which has been named designated beneficiary of an IRA or qualified plan may be considered designated beneficiaries provided (i) the trust is irrevocable or becomes irrevocable upon the owner’s death; and (ii) the trust is valid under state law (or would be valid but for the fact there is no corpus); and (iii) the beneficiaries are easily identifiable. Generally, documentation concerning the trust must be provided to the IRA custodian or plan administrator by October 31 of the year following the participant’s death.

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Supreme Court Declares NY Tax Statute Unconstitutional (July 1998)

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

On certiorari, the Supreme Court, in a 6-3 decision written by Justice O’Connor, voided New York Tax Law § 631(b)(6), which the Court held violated the Privileges and Immunities Clause of the Constitution by effectively denying only nonresidents of New York a state income tax deduction for alimony paid. In annulling the statute, the Court, in a carefully worded decision, reversed and remanded a unanimous decision of the NY Court of Appeals written by Chief Judge Kaye. The decision (in effect) reinstated the unanimous decision of the 3rd Department, which had also found the statute unconstitutional. Justices Rehnquist, Ginsberg and Kennedy dissented in the Supreme Court decision. Lunding et ux. v. New York Tax Appeals Tribunal et al, No. 96-1462 (1998).

New York requires nonresidents to pay tax on net income from New York real or tangible personal property and net income from employment or business, trade, or professional operations in New York. N.Y. Tax Law § 631(a), (b). In computing the income tax nonresidents owe, nonresidents must first compute their tax “as if” they were residents. In computing this “as if” amount, a deduction is allowed for alimony paid, pursuant to IRC  §215.  Nonresidents then apply an “apportionment percentage” to the “as if” tax previously calculated.

The numerator of the apportionment percentage is New York source income which, by operation of Tax Law  § 631(b)(6), did not allow a deduction for alimony paid. The denominator, federal AGI, includes a deduction for alimony paid. Since there is no upper limit on the apportionment percentage, a nonresident could be required to pay more than the “as if” tax if all of the taxpayer’s income was sourced in New York.

In a CPLR Article 78 proceeding which it converted to a declaratory judgment action, the 3rd Department held that although a “disparity in treatment is permitted if valid reasons exist, the [Constitution] proscribes such conduct as discriminatory against nonresidents where there is no substantial reason for the discrimination beyond the mere fact that [taxpayers] are citizens of other states.” 639 N..Y.S.2d 519.

The New York Court of Appeals, however, declared that the Constitution does not mandate “absolute equality in tax treatment,” and upheld the statute, stating that there was a “substantial reason” for the difference in treatment, and that the discrimination bore a substantial relationship to the State’s objective. Applying “well established” principles, the Court concluded that “disparate” treatment was permissible since NY residents were taxed on all income from whatever sources, while nonresidents were taxed only on NY source income.

The Supreme Court disagreed,  observing that the “object of the Privileges and Immunities Clause is to … plac[e] the citizens of each State upon the same footing with the citizens of other States.” While recent cases, according to the Court, did allow States “a considerable amount of leeway in aligning the tax burden of nonresidents to in-state activities,” those decisions could not be held to “categorically deny” personal deductions to a nonresident absent a “substantial justification.”

The Court distinguished the case from earlier cases upholding disparate treatment. Constitutionally, the statute was fatally flawed in that it invariably denied nonresidents the benefit of a deduction allowed to residents. The statute also resulted in a “double-taxation windfall” to New York when a NY resident received alimony from a nonresident New York taxpayer, since the recipient must pay taxes on the alimony but the nonresident could claim no deduction.

In closing, the Supreme Court noted that although the Constitution does not bar States from allocating income and deductions based on in-state activities, States may not disallow nonresident taxpayers “every manner of nonbusiness deductions.”

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IRS Restructuring and Reform Act of 1998

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

By a vote of 402 to 8, the House has overwhelmingly approved the IRS Restructuring and Reform Act of 1998. The proposed legislation follows months of Congressional testimony alleging IRS abuses. The new law would establish an “IRS Oversight Board” within the Treasury Department whose mission would include reviewing operations to ensure the proper treatment of taxpayers. The Board would also review plans for a modernization of operational functions, and approve the Commissioner’s plans for a “major reorganization” of the IRS. A late rider added to the bill would shorten the holding period for long term capital gains property from 18 months to 12 months.

A new Taxpayer Advocate system would replace the present-law problem resolution system with a “system of local Taxpayer Advocates who report directly to the National Taxpayer Advocate.” Unlike under the current system, the Advocate would be “independent from IRS examination, collection, and appeals functions.”

The bill also effects a profound transformation in the procedural rights of taxpayers: Provided the taxpayer complies with the Code and Regulations, maintains records, and cooperates with “reasonable” IRS requests interviews and information, the bill shifts the burden of proof to the IRS in any court proceeding with respect to any factual issue with which the taxpayer provides credible evidence.

The legislation would also:

¶  Expand the authority of courts to award litigation costs to taxpayers prevailing against the IRS. In addition, reasonable attorneys’ fees would no longer contain hourly rate caps; and in determining whether an IRS position was “substantially justified,” courts would be required to take into account whether the IRS had lost in other courts of appeal on substantially similar issues;

¶   Permit taxpayers to recover up to $1 million in civil damages caused by IRS officers or employees who willfully violate provisions of the Bankruptcy Code relating to automatic stays or discharges;

¶ Increase the Tax Court jurisdictional limit for hearing informal “small cases procedures” to $50,000, from $10,000;

¶  Expand the jurisdiction of the Tax Court to hear responsible personal penalty assessments before payment;

¶  Modify the innocent spouse rules by permitting a spouse to elect to limit his or her liability for unpaid taxes on a joint return to that spouse’s separate liability amount. Allocation of items between spouses would follow the rules determining which spouse would report an item if separate returns had been filed;

¶  Equitably toll the statute of limitations for refunds if the taxpayer is unable to manage his or her financial affairs due to severe disability;

¶  Establish a net interest rate of zero on equivalent amounts of overpayment and underpayment existing for the same period;

¶  Bar the IRS from imposing a one-half percent per month failure to pay penalty on taxpayers who have entered into an installment agreement;

¶  Suspend the accrual of interest and penalties after one year (provided the taxpayer timely filed a return) if the IRS has not sent a notice of deficiency within one year from the date of filing, or the due date of the return, if later;

¶  Require each notice containing a penalty to include the name of the penalty, the code section, and a computation of the penalty;

¶  Establish formal procedures to insure that the taxpayer is afforded due process when the IRS seeks to collect taxes by levy or seizure; and

¶ Extend the confidentiality privilege to accountants and enrolled agents furnishing tax advice. The privilege is now applicable only to attorneys.

The IRS has released audit statistics for the 1995 tax year. The overall percentage of individual returns examined was 1.67. More than 4 percent of returns containing a schedule C were examined (primarily due to the number of businesses reporting a net loss). Nonschedule C filers with  incomes up to $100,000 had a 1.16 percent audit rate, while nonschedule C taxpayers with incomes over $100,000 had a 2.85 percent audit rate.

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Self-Employment Tax for LLC Members: New Regs. Proposed

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

LLCs are tax-favored business entities which possess the essential features of limited liability and flow through taxation. Their allure was greatly enhanced by a recent decision of the IRS to withdraw a 1994 NPRM which would have required LLC members to pass a stringent test in order to exclude distributive share amounts from self-employment tax.

Code Sec. 1402 provides that “net earnings from self-employment means the gross income derived by an individual from any trade or business carried on by such individual … plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member.” Sec. 1402(a)(13) excludes from gross income for self-employment taxes the distributive share of any item of income or loss of a limited partner other than guaranteed payments for services actually rendered to the partnership.

Seeking to impose restrictions on the application of Sec. 1402(a)(13) to LLC members, the IRS proposed in 1994 to treat an LLC member as a limited partner for self-employment tax purposes only if (1) the member lacked the authority to make management decisions; (2) the LLC could have been formed as a limited partnership in the same jurisdiction; and (3) the LLC member could have qualified as a limited partner under state law.

The IRS agreed to withdraw the proposed regulations when they were harshly criticized for making an LLC member’s federal tax liability dependent upon state law characterization. For example, some states allow a limited partner to participate in a partnership’s business, while others do not.

Thus, an LLC non-manager member who participated in business decisions would qualify as a limited partner for tax purposes only in the state in which a limited partner could participate in the partnership’s business. In the state in which limited partners were barred from participating in business decisions, self-employment tax would be imposed on the non-manager member since the LLC member could not have qualified as a limited partner under state law.

Under the new proposed regulations, state law characterization of the entity is irrelevant for purposes of determining whether LLC members are limited partners for purposes of Code Sec. 1402(a)(3). Moreover, for purposes of determining the tax status of an individual, the same standards apply both to limited partners in a state law limited partnership, and to LLC members in an LLC formed under state law.

The new proposed regulations provide that an individual will be treated as a limited partner unless the person (1) has personal liability for the debts or claims made against the partnership (or LLC); (2) has the authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or (3) participates in the partnership’s trade or business for more than 500 hours during the taxable year. The objective of the new rules is to exclude from an individual’s net earnings from self-employment amounts that are shown to be returns of invested capital, rather than compensation for services performed.

Limited partner status for self-employment tax purposes will be unavailable to any individual — even one meeting the 500 hour participation test — if that individual performs any services to a partnership or LLC substantially all of the activities of which are in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting.

The proposed regulations also allow an individual who is not a limited partner for purposes of Sec. 1402(a)(3) to exclude from net earnings from self-employment a fraction of that individual’s distributive share if more than one class of interests are held. In such a case, however, the individual may exclude no more of his distributive share on a proportional basis than could other partners who qualify as limited partners but who hold only a single interest in the partnership or LLC.

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Businesses Cope with 1997 Tax Act

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

Many of the tax cuts granted to individuals by the 1997 Tax Act will be fueled by corresponding increases in taxes paid by businesses. Those increases will result primary from (1) the imposition of significant limitations on NOLs and on tax credit carrybacks; (2) the extension of the federal unemployment surtax; (3) the imposition of new taxes on financial instruments; and (4) the restructuring of tax provisions governing corporate reorganizations. Other important changes:

¶ Under new IRC §1045, taxpayers selling qualified small business stock may elect to roll over the gain if the proceeds are reinvested within 60 days in other such stock.

¶ Rules governing home office deductions have been liberalized;

¶  For tax years beginning after 1997, the AMT will be repealed with respect to small corporations (i.e., not more than $5 million in gross receipts for 3-year period beginning Dec. 31, 1994).

¶ The carryback period for NOLs will be reduced from three years to two years, but the carryforward period will be increased from 15 years to 20 years;

¶ Not all sales and exchanges of capital assets in business transactions qualify for the new lower rates. Thus, the new tax rates do not apply to (1) long-term capital gains attributable to most depreciable real property (i.e., “section 1250” property) to the extent of all depreciation claimed. Those gains will be taxed at 25 percent; (2) any property held for 18 months or less; (3) gain from “collectibles” (i.e., works of art, stamps, and coins); and (4) gain from the sale of qualified small business stock which already benefitted from the 50% exclusion from gain provided for by IRC § 1202.

¶ Self-employed individuals will be allowed to deduct a greater percentage of health insurance costs. The current 40% deduction will increase to 60% by 2002 and to 100% by 2007. Note that the adjustment is to AGI and does operate to reduce self-employment tax.

¶  Tax laws affecting partnerships have been changed: first, basis adjustments among distributed assets must now be allocated first to unrealized receivables and inventory; second, upon the sale or exchange of a partnership interest, amounts received that are attributable to unrealized receivables or inventory will generate ordinary income. Under prior law, inventory that had not substantially appreciated generated capital gain; and third, the partnership tax year will now close on the death of a partner. Income accruing until date of death will be reported on the decedent’s final return, rather than the return of the estate.

¶ Corporate tax laws affecting exchanges and reorganizations have been changed. Effective for transactions after June 8, 1997, nonqualified preferred stock received by a taxpayer in a § 351 exchange will be treated as boot, rather than stock, and the taxpayer must recognize gain to the extent of boot received. Nonqualified preferred stock is any stock that (1) is limited and preferred as to dividends; (2) does not participate in corporate growth to any significant extent; and (3) is either required to be redeemed, or is likely to be redeemed within 20 years from issue date.

¶ Effective for leases entered into after Aug. 5, 1997, new IRC § 110 provides that amounts received in cash (or treated as a rent reduction) by a tenant under a lease involving “retail space” of 15 years or less, for the purpose of constructing  improvements in the tenant’s business, will be excluded from income.

¶ Beginning in 1998, family-owned businesses will benefit from a $1.3 million exclusion from estate tax. This amount, which includes the unified credit, will remain constant as the unified credit increases. To qualify, the value of the business must exceed 50% of the estate, and material participation requirements must be met.

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Perspectives in Estate Planning

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

Effective estate planning actually encompasses many objectives, the most obvious of which is to implement a legally effective method of transferring wealth to loved ones. Estate planning should also reduce the incidence of gift and estate taxes, through full use of available tax credits and their leverage where possible. Estate planning should seek to maximize the value of the estate through use of tax-favored investment vehicles. Finally, estate planning should also seek to preserve and protect estate assets.

A well-drafted Will is perhaps the most important single step that can be taken to ensure that assets are distributed effectively at death. Sometimes it is useful to execute a “durable” power of attorney or a “springing” power of attorney when a Will is executed. The existence of these powers may avoid the necessity of court intervention in the event of the incapacity of the person granting these powers. Although these powers are inherently less flexible than similar provisions which could be found in a revocable living trust, in most instances they are acceptable substitutes. The revocable living trust is now also an attractive Will substitute, although avoidance of probate alone is for most persons probably not a sufficient reason to forego the use of a Will.

A Will may also contain testamentary trust provisions within it. These trust provisions greatly enhance the effectiveness and versatility of the Will by enabling the testator to ensure that (1) full use is made of the unified credit; (2) assets are not squandered by trust beneficiaries or seized by creditors; and (3) the surviving spouse is provided with yearly income.

The unified credit will currently shield $600,000, but will eventually shield $1 million by 2006. A “credit shelter” trust which typically resides in the Will makes full use of the unified credit by ensuring that at least $600,000 is transferred to persons other than the testator’s spouse. (A transfer in trust to the testator’s spouse may qualify for the unlimited marital deduction; therefore the unified credit must be applied elsewhere.) However, the credit shelter trust may provide the surviving spouse with a limited income interest without risking inclusion in her estate.

The general power of appointment marital trust and the QTIP trust are both effective in providing an income interest to the surviving spouse while providing the estate with a full marital deduction. Both trusts must provide that all income be distributed to the surviving spouse. A general power of appointment marital trust must provide that the surviving spouse has the right to dispose of trust assets either during life or at death. A QTIP trust, by contrast, may provide the surviving spouse with a very limited power of appointment. The QTIP trust may be preferable where the testator wishes to provide for his first or second spouse, but also wants to insure that assets will ultimately pass to children from a prior marriage. A QTIP election must be made by the executor of the testator’s Will. Failure to elect will result in forfeiture of the marital deduction to the estate.

Often a testator does not know exactly how much his spouse will require when the Will is drafted, or at the time of his death. Including a “qualified disclaimer” provision in the Will permits the surviving spouse to disclaim to residuary legatees, e.g., children, that portion of her legacy which she does not want. This “post mortem” estate planning can be effective in making maximum use of the unified credit, as well as in minimizing the estate taxes.

The incidence of estate and gift taxes can be minimized by leveraging the available tax credits. Effective techniques exist which can leverage both the unified credit and the $10,000 annual exclusion. A simple method of leveraging the annual exclusion is for a married couple to split a gift to a relative. This permits $20,000 to be transferred yearly to that person.

The $10,000 annual exclusion can be further leveraged by other techniques. A common technique is to use “Crummey” powers in conjunction with a life insurance trust. A life insurance trust is an excellent estate planning vehicle, since the proceeds can be used to pay estate taxes. Funding the trust with gifts that qualify for the annual exclusion through the use of “Crummey” powers further enhances the attractiveness of this vehicle. If properly set up, the entire proceeds of the policy will be excluded from the decedent’s estate. In addition, no income tax is imposed on the appreciation of investment within the insurance policy.

Another extremely effective method of leveraging the unified credit and the annual exclusion is by using LLCs or family limited partnerships. These vehicles are also imbued with formidable asset protection features. They may also be effective in shifting income tax liability to lower bracket family members.

The IRS recognizes three types of “discounts” applicable to the transfer of an LLC interest. The discounts are recognized based upon the lack of marketability of the LLC interest, the minority interest discount, and the discount for illiquidity. Each of these discounts, if present, may be taken. They typically may result in a valuation discount of up to 30% or 40%. The types of assets that may be transferred to an LLC for which a discount may be claimed include an interest in a closely held business or income-producing real property. Marketable securities may also qualify for a discount.

The asset protection features of the LLC are also attractive. Creditors attempting to reach LLC assets will at best obtain a “charging order” against the member’s interest. The creditor “stands in the shoes” of the LLC member against whose interest he holds a charging order. Since the operating agreement will provide that the managing member has the power to determine when and how much to distribute from the LLC, a creditor holding a charging order will be faced with the possibility of receiving “phantom” income. That is, although the creditor will not receive any distributions from the LLC, he will be forced to report income based on his distributive share of the income earned by the LLC.

Typically, the managing member, who initially owns the asset or business transferred to the LLC, makes yearly gifts of a portion of his interest to family members. If the gift qualifies for a 40% discount, then the amount qualifying for the annual exclusion is effectively raised from $10,000 to $16,666.

With the recent reduction in capital gains tax rates, intrafamily sales are more attractive. Assume, for example, that an unmarried testator with two children owns a house worth $500,000, with an adjusted basis of $100,000, and also has $1 million in liquid assets. Upon death, the estate tax liability would be $363,000 at current rates. If the testator were instead to sell the house to a child, taking back a mortgage, then $200,000 of the capital gain will be excluded (assuming the testator lived in the house for 2 of the past 5 years) and $200,000 would be taxed at 20%, for a total income tax liability of $40,000.

The parent could even continue to live in the house, making rental payments pursuant to a lease. Those payments could enable the child to pay the mortgage and real estate taxes. Note, however, that if the home were nominally “sold” but the parent continued to pay real estate taxes and neither received mortgage payments nor paid rent, the IRS would seek to include the value of the home in his estate on the theory that he had retained a life estate.

Split-interest trusts, which were developed for estate planning, also have significant asset protection value. In these trusts, the grantor transfers property in trust with a remainder interest passing to beneficiaries. The remainder interest is asset protected. Moreover, since the gift is composed only of the remainder interest, the value of the gift for gift tax purposes is reduced, thereby leveraging the unified credit. One essential requirement of split-interest trusts is that the grantor outlive the trust term; if not, the transaction will be estate tax neutral. Typically, the trust provides that the grantor receives yearly income, based upon an interest rate percentage provided for in the trust instrument. If a high interest rate is used, then the value of the remainder interest is lower, and the amount of the gift is reduced.

There are four types of split-interest trusts: (1) Grantor Retained Annuity Trusts (GRAT); (2) Grantor Retained Uni-Trust (GRUT); (3) Grantor Retained Income Trusts (GRIT); and (4) Qualified Personal Residence Trusts  (QPRT). GRATs and GRUTS are useful for income-producing property. In both, the grantor’s interest is in the form of an annuity for a term of years. While GRUTs require revaluation each year, GRATs do not. GRITs are useful for nonincome-producing property, such as works of art or raw land, in which the grantor retains use. Where the grantor’s interest is in a personal residence or vacation home, a QPRT is effective.

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Estate Tax Reform: New York Joins Sunbelt States (Janaury 1998)

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

New York State has long imposed the highest gift and estate taxes in the nation. New legislation signed by Governor Pataki in August, however, will bring New York into line with other states which impose a much lower rate of transfer tax. After the new law has been phased-in, New Yorkers who maintain a residence both in the south and in New York will no longer need to be concerned that spending more than six months in New York could cause deleterious estate tax consequences.

While the federal unified credit shelters up to $600,000 of lifetime transfers, New York currently imposes transfer taxes of up to 21% on transfers greater than $115,000. Although a federal credit against federal estate tax is available for state estate taxes paid, no federal tax is owed on estate worth less than $600,000. Thus, for estates worth less than $600,000, the federal credit against state estate tax has no application.

For decedent’s dying on or after October 1, 1998, New York’s unified credit will shelter $300,000 in transfers. That amount will gradually increase until reaching the federal unified credit amount by February 1, 2000. The current state estate tax will then be repealed and be replaced by a “sop” tax, which is currently imposed by states such as Florida, South Carolina, Arizona and California. Under this tax regime, states impose an estate tax equal to the maximum federal credit. In this way, no additional estate tax liability is imposed on the estate. The state simply receives a larger share of the tentative federal estate tax. (New York State’s gift tax, for which no federal credit was ever available, will also be repealed in phases over the next two and one-half years.)

Because of these changes in estate tax, existing Wills should be reviewed to ensure that “credit shelter” or “bypass” trusts contain a formulation which results in the largest tax-free gift possible. Rather than utilizing a numerical amount, the Will might contain language providing that the gift over should be the maximum amount which can fully utilize the existing federal unified credit.

The new law will also occasion some quirks. For example, since New York currently imposes tax on estates worth more than $115,000, many credit shelter trusts contain a provision which allows an additional $42,424 beyond the $600,000 to be placed in the trust. Taking into account the federal credit for state estate taxes, this results in an additional $42,424 being removed from the estate at a cost of only $2,545 in additional New York State estate taxes.

Under a “sop” tax, there would be no New York estate tax on an estate of $600,000. However, an estate worth $642,424 would be entitled to a maximum credit against state death taxes of $15,697. New York would quickly proceed to impose this “sop” tax. The cost of shifting the additional $42,424 would rise to $15,697. Therefore, it will generally no longer be desirable to fund a credit shelter trust with more than $600,000, or the actual exemption amount, if higher.

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Planning for Family-Owned Business (QFOBI — November 1999)

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

Until 1997, no special estate tax rules existed for family-owned businesses. Limited relief was available under §2010, (unified credit), the special use valuation of qualified real estate under IRC §2032A,  and the deferral of estate taxes under §6166. In 1997, Congress granted further relief by enacting §2057, which provides for a “qualified family-owned business deduction” (QFOB). Requiring an election by the estate, the deduction augments benefits provided by §§ 2010, 2032A and 6166.

§2057 establishes a maximum QFOB deduction of $675,000. The statute is also closely coordinated with the unified credit (now applicable exclusion amount or AEA): The combined QFOB deduction and AEA limit is $1.3 million. Therefore, if a decedent dies in the year 2006 with a gross estate worth $2 million entirely comprised of a family-owned business, the QFOB deduction would be $675,000. However, since the maximum QFOB and AEA is $1.3 million, the AEA would be limited to $625,000 (despite an AEA of $1 million in 2006).

If a family-owned business is worth less than $675,000, then the QFOB deduction is that amount. However, a preadjusted AEA of $625,000 is adjusted upward by the difference between $675,000 and the value of the family owned business, with one proviso:  The “adjusted” AEA cannot exceed the AEA as provided by §2010 for the year of the decedent’s death. To illustrate, assume the decedent dies in 2006 with a family-owned business worth $500,000. The QFOB deduction would in that case be $500,000.  The difference between $675,000 and $500,000 is $175,000. The “adjusted” AEA would be $625,000 plus $175,000, which is $800,000. Since $800,000 does not exceed $1,000,000, i.e., the AEA for 2006, the full adjustment is taken. However, if the same decedent died in the year 2000, then the “adjusted” AEA, still $800,000, would exceed the AEA for the year 2000, which is $675,000. This is where the proviso applies: The “adjusted” AEA would be limited to $675,000.

To qualify under §2057, each of the following three requirements must be met: (a) the “50% Liquidity Test”; (b) the “Material Participation Test” and (c) the “Business Control Test”:

¶ First, the adjusted value of the decedent’s (a U.S. citizen or resident) QFOB interests must equal at least 50% of the decedent’s adjusted gross estate. In calculating this fraction, the numerator is determined by aggregating (i) the adjusted value of all family-owned business interests passing to qualified heirs and (ii) the total adjusted taxable gifts of QFOB interests made by the decedent to family members; and then by subtracting (i) all indebtedness of the decedent’s estate, except qualified personal residence indebtedness or indebtedness incurred for medical or educational expenses.

The denominator of the fraction is the decedent’s gross estate, decreased by (i) §2053(a)(3) claims against the estate and §2053(a)(4) indebtedness of the estate; and increased by: (i) lifetime transfers to family members of continuously held QFOB interests; (ii) transfers by the decedent to his spouse within 10 years of death; and (iii) any other transfers by decedent within 3 years of his death (except annual exclusion transfers to family members).

Maximizing the value of the fraction entails (i) increasing the size of the active QFOB; (ii) eliminating QFOB gifts to nonfamily members and to the spouse; (iii) ensuring that QFOB gifts to children are retained; (iv) eliminating taxable gifts (other than §2503(b) gifts) within 3 years of death; (v) decreasing value of gifts to the spouse within 10 years of death; (vi) decreasing the value of the estate’s non-QFOB assets, cash, marketable securities, passive assets; and (vii) reducing general indebtedness but increasing indebtedness for a qualified residence, for medical or educational expenses, or to acquire a business.

¶ Second, during 8-year period ending on the decedent’s death, there must have been periods aggregating 5 years or more during which the decedent (or family members) owned and materially participated in the QFOB. Material participation is defined by reference to §1402(a), i.e., net earnings from self-employment. Since the decedent or family member who materially participates must pay self-employment taxes, this may occasion the relinquishment of social security benefits.

§2057 imposes a recapture penalty in the form of an additional estate tax (equal to the 100% of estate tax saved) if a “recapture event” occurs within 10 years following the decedent’s death. The proscribed events include (i) lack of material participation by a family member of the decedent and (ii)  disposal of the QFOB by a family member to a person other than a family member. The recapture percentage is 100% in years 1 through 6, 80% in year seven, 60% in year eight, etc. Thus, the QFOB election is only sensible where it is probable that the decedent’s family will actively manage and own the family business for at least 10 years after the decedent’s death. Note further that the qualified heir is personally liable for the payment of recapture tax unless a bond has been furnished, and §6324B imposes a special lien for estate taxes on the QFOB.

Under the regulations, material participation must occur pursuant to a formal arrangement, although it need not be memorialized. The owner or family member must regularly participate in a substantial number of management decisions and must have a financial interest in the business (whether ownership is direct or indirect through an entity). The business owner should also (i) pay self-employment taxes on income; (ii) hold an office commensurate with material involvement; (iii) be at risk with respect to the investment; and (iv) execute an agreement requiring the decedent or family member to materially participate.

[Note: In addition to the material participation requirement imposed upon family members during the decedent’s life, the qualified heir must materially participate in the family-owned business for 3 out of 8 years after the decedent’s death in order to avoid the recapture tax. However, minor heirs as well as the surviving spouse need only “actively” participate in order to satisfy the recapture tax participation requirement. This requires managerial decisionmaking, but not daily involvement in operations.]

Third, the business must be owned predominantly by three or fewer families, and must pass to members of the decedent’s family or long-term employees. §2057(e) defines the term “qualified family-owned business” as (i) an interest as a proprietor in a trade or business; or (ii) an interest in an entity carrying on a trade or business if (a) at least 50% of the business is owned by the decedent’s family; (b) at least 70% is owned by two families; or (c) at least 90% is owned by three families. The term QFOB excludes businesses (i) whose principal place of business is not in the U.S.; (ii) whose stock or debt was readily tradeable within 3 years of the decedent’s death; or (iii) more than 35% of whose AGI in the year of the decedent’s death constituted personal holding company income. (Nor does the QFOB include that portion of the trade or business attributable to cash or marketable securities in excess of the amounts reasonably required by the QFOB, or assets which produce personal holding company income.)

To maximize the likelihood of satisfying the Business Control test, the that a family business will be a QFOB, the owner should (1) avoid ownership with unrelated parties; (2) ensure that the business is active; and (3) distribute excess cash from the entity to avoid the excess cash rule.

*          *          *

The QFOB deduction may have a significant impact on marital deduction planning, and on particular formulas. For example, assume the decedent dies in 2000 with an estate valued at $2 million, all of which qualifies for the QFOB. If the applicable exclusion amount of $675,000, as well as the QFOB deduction of $625,000 are both claimed, the taxable estate will be reduced to $700,000. If the Will called for the marital trust to be allocated the minimum amount necessary required to eliminate the estate tax, then the marital trust would be allocated $700,000.

If, on the other hand, the Will called for the credit shelter trust to be funded with the largest pecuniary amount necessary which would result in no federal estate tax, then only $675,000 might be required to fund the credit shelter trust, leaving $1,325,000 to fund the marital deduction trust, a result which might not be intended or desirable. Therefore, if the QFOB deduction is likely to be elected by the Executor, all estate planning documents, especially trust provisions in the Will, must be reviewed and revised. [§2057 property will be subject to the GST, and allocation of GST exemption to QFOB property is necessary.]

After death, QFOB interests receive a basis step-up to FMV, despite the fact that QFOB property is excluded from the gross estate. Another odd twist in post-mortem planning: In order to pass the 50% liquidity test, the estate may claim less of a valuation discount for the QFOB than does the IRS.

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Tax Court Finds Premium for 76 Voting Shares is Percent of Equity of Entire Corporation (November 1999)

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

Finding that 76 shares of voting stock of a closely held corporation were each worth $215,539, rather than $2,650 as had been reported, the Tax Court upheld most of a $17,643,886 deficiency asserted against the Estate of Richard R. Simplot, but finding reasonable reliance on tax professionals, abated all penalties. CCH Dec. 53,296

[J.R. Simplot Co. had been founded by the decedent’s father, who transferred all of the company’s stock to his children. His philosophy had been to reinvest the company’s cash-flows into long-term assets, operate privately, and pass ownership to his decedents. As of the valuation date, the company (which had never paid a dividend), was comprised of five operating groups, the largest of which, the food products group, accounted for 60% of McDonald’s domestic potato product purchases. J.R. Simplot Co. also owned 13.36% of the shares of Micron Technology.  The capital structure of J.R. Simplot Co. consisted of two classes of authorized stock: 76 shares of Class A voting common, and 141,289 shares of Class B nonvoting common. Richard Simplot had owned 18 shares of Class A stock, or 23.55%; his three siblings owned the remainder. The decedent had also owned 2.79% of all Class B stock.]

The estate argued that the FMV of class A voting and class B nonvoting shares were identical since the decedent’s class A shares did not represent voting control and there was no reasonable expectation that disproportionate benefits would accrue to the class A shareholders in the immediate future. The taxpayer also argued that an existing 360-day restriction on transferability which applied solely to class A shares, in combination with a liquidation preference accorded to class B nonvoting stock, actually made the class B stock more valuable. However, the IRS argued, and the Tax Court agreed, that a voting privilege premium should be accorded to the class A stock and, more ominously for the estate, that by reason of the disparate ratio between the number of voting and nonvoting shares, the premium should be expressed as a percentage of the equity value of the corporation rather than merely as a percentage premium applied to the 76 shares of class A voting common.

In determining the equity value of J.R. Simplot, both sides’ experts used (a) income (i.e., discounted projected future operating cash-flows) and (b) market (i.e., historical and projected earnings applying market-related pricing ratios of comparable publicly traded companies) approaches and averaged the two values. Rejecting the taxpayer’s contention that equity value should be reduced for short-term debt, the Court accepted the value calculated by the government’s experts, which was (after the adjustment for short-term debt) only 1% higher than the taxpayer’s figure. (A discrepancy which the Court attributed to the taxpayer having taken two minority discounts for Micron Technology stock.)

Both sides’ experts testified that a lack of marketability discount of 35% should attach to the class A voting stock. Ironically, the government’s expert testified, and the Court agreed, that a 40% discount should attach to the class B shares due to their lack of voting rights. The Court observed that “common sense” dictated that since only four persons held all class A voting stock, those shares were, on a per-share basis, “far more valuable than the Class B shares” because of the potential for influence and control of the company (even though they did not represent a controlling block). The Court accepted the government’s lower range figure of 3% of the company’s equity value as “the fair premium” for the voting privileges of the class A stock.

Having found that the taxpayer acted reasonably and in good faith in relying on the advice of tax professionals and appraisers in valuing the voting stock for estate tax purposes, the Court abated $7,057,554 in penalties. Bearing in mind that the Court ultimately allowed a lack of marketability discount for the class B nonvoting stock of 40% (which was even higher than the taxpayer’s valuation experts had calculated), one wonders whether a more aggressive stance with respect to discounts for closely held businesses may be more than justified. The Court’s reluctance to impose penalties reflected its observation that “[d]etermining the fair market value of unlisted stock (such as J.R. Simplot Co. stock) is, to say the least, difficult.”

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Planning for Capital Asset Status

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

The maximum effective marginal tax rate for individuals can now reach 41.4 percent (after limitations on itemized deductions and phase-out personal exemptions). By contrast, the long-term capital gains tax rate for noncorporate taxpayers is 20 percent (25 percent on unrecaptured § 1250 gain). For corporate taxpayers, ordinary income and long-term capital gains are taxed at 35 percent.  From a rate perspective, it is therefore desirable, where possible, to structure individual business transactions so that capital asset status will be accorded.

Long-term capital gains are gains derived from the sale or exchange of a capital asset held for more than one year. The sale of property is a transfer in exchange for cash or a promise to pay. An exchange is a transfer of property for other property. The holding period of a capital asset must exceed one year in order to qualify as “long-term” capital gain.  The foregoing two requirements may be difficult to achieve, but they are not difficult to understand. Defining the term “capital asset” has, by contrast, perplexed Courts.

Sec. 1221(1) defines the term “capital asset” as property (whether or not connected with a trade or business) other than “stock in trade . . . or other [inventory] property . . . or other property held by the taxpayer primarily for sale to customers in the ordinary course of trade or business,” commonly referred to as “dealer property”. [Sec. 1231 provides that to the extent Sec. 1231 gains exceed Sec. 1231 losses for any taxable year, such gains are treated as long-term capital gains. Sec. 1231 property consists of property used in a trade or business that is real property or depreciable property held more than one year.]

In achieving capital asset status, it is therefore important that property be characterized either as a capital asset or Section 1231 property, and not as “dealer property”. This is often a difficult inquiry.

The Corn Products doctrine, (SCt 1955), stood for the proposition that sales of futures contracts related to the purchase of raw materials resulted in ordinary income because the transactions represented an integral part of part of the business. This case illustrates that even assets which would literally fit the Sec. 1221 definition may be excluded from capital asset status.

Whether real estate, for example, qualifies as a capital asset depends upon the particular factual circumstances. To be excluded from capital asset status, Sec. 1221(1) provides that the property must be held “primarily for sale to customers in the ordinary course of a trade or business”. However, the taxpayer may hold real estate for both rental and sale purposes. The Supreme Court has held that exclusion from capital asset status will result only if the sale intent is predominant over the rental intent. Malat (1966).

The phrase “to customers in the ordinary course of a trade or business” has also been imparted with judicial gloss. The Supreme Court has held that Sec. 1221(1) is intended to distinguish between everyday profits and losses (ordinary income) and appreciation in value over a substantial period of time (capital asset).  While this is a factual inquiry, Courts have held that frequent sales, substantive improvements, and active advertising efforts tend to indicate the existence of “dealer property” rather than investment (i.e., capital asset) property. Biedenharn Realty Co., 5th Cir. 1976.

Courts tend to allow capital gain treatment for real property acquired by gift or inheritance — even if the taxpayer engages in substantial improvement — provided the taxpayer liquidates the holdings in an “orderly and businesslike manner”.  Yunker v. CIR, 6th Cir., 1958.

Partial conversation to capital gain may at times be all that is possible. For example, the sale after development of appreciated real estate will result in ordinary income. To convert pre-development appreciation to capital gain, the taxpayer could sell the undeveloped property to a controlled corporation on an installment basis, with the corporation taking a cost basis. Courts have tended to respect these transactions where there is a demonstrated likelihood of early repayment, and the corporation is not thinly capitalized.

Given the enormous rate differential between long-term capital gains and ordinary income, it may significantly benefit taxpayers to structure transactions in advance in order to maximize the likelihood of successfully claiming capital asset status.

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