High Court Holds IRAs Exempt from Bankruptcy Creditors

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

A unanimous Supreme Court, reversing a decision of the Bankruptcy Court, the Bankruptcy Appellate Panel, and the 8th Circuit Court of Appeals, and in so doing resolving a conflict among the circuits, ruled that debtors in bankruptcy may properly exclude assets in their IRA account pursuant to § 522(d)(10)(E) of the Bankruptcy Code.

[The debtors, former employees of Northrup Grumman, at the termination of employment, were required to take lump-sum distributions from their employer-sponsored pension plans. Pursuant to IRC § 408(d), the distributions were rolled over into separate IRAs. Several years later, the debtors filed a joint Chapter 7 bankruptcy petition, and sought to shield portions of their IRAs from creditors by claiming them as exempt from the bankruptcy estate pursuant to § 522(d)(10)(E).]

Justice Thomas, writing for the Court, agreed with the debtors’ contention that the requirements for exemption had been satisfied: First, the right to receive payment was from “a stock bonus, pension, profitsharing, annuity, or similar plan or contract;” and second, that right was “on account of illness, disability, death, age, or length of service.”

The Court dismissed the argument of the trustee in bankruptcy that the debtors’ right to receive payment was not “on account of illness, disability, death, age, or length of service,” since the debtors could withdraw funds from their IRA at any time. Noting a “causal[] connection to their age,” the Court found that the 10 percent early withdrawal penalty effectively limited the petitioners’ right to “payment” of their IRAs.  Further, because the condition was “removed” upon the petitioners’ attaining the age of 59½, the right to receive IRA payments was indeed “on account of age.”

Next, the Court found that the  “similar plan or contracts” requirement was also met, since the IRA, like profitsharing, pension or annuity plans, bore the “common feature” of providing income which was a substitute for wages. The minimum distribution requirements, which commence when the account holder turns 70½, as well as the likelihood, due to the early withdrawal penalty, that money would be held in accounts until retirement, convinced the Court that the IRA was an income substitute rather than a mere “savings account,” as had been urged by the Trustee.

Similarly, the Court found unpersuasive the Trustees’ contention that the availability of penalty-free distributions in limited circumstances rendered the IRAs as mere savings accounts, remarking that the exceptions were “limited in amount an scope [and] [e]ven with these carveouts, an early withdrawal without penalty remains the exception, rather than the rule.”

Finally, the Court noted that certain clauses expressly exclude from the exemption from the bankruptcy estate certain “rights to payment” that would otherwise benefit from the general exemption. It would make “little sense” to specifically cite elaborate upon certain plans that did not enjoy the exemption, unless other plans, such as IRAs, were generally within the exemption.

Posted in News, Pension & Retirement Accounts, Tax Decisions | Leave a comment

2004 REGS, IRS RULINGS & PRONOUNCEMENTS

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

Many property owners seek to swap management-intensive property for property requiring no active management. However, triple net leased properties – the primary candidates for passive ownership – are generally unavailable for less than $1 million. Rev. Proc. 2002-22 ameliorated this problem by permitting a group of small investors to obtain an advance ruling with respect to the acquisition of larger replacement property in a § 1031 like-kind exchange. In appropriate circumstances, the IRS will regard undivided interests in real estate not as interests in a partnership, which interests cannot be acquired in a § 1031 exchange, but as Tenancy-in-Common interests (TICs) or Undivided Fractional Interests (UFIs).

The objective of the Rev. Proc. was to prevent the owners of TICs from avoiding the requirements of section 1031 by operating a business as a de facto partnership. Thus, the Ruling provides that co-owners may not file a partnership return or hold themselves out as being a partnership. Nor could there be any restrictions on alienability as might typically be found in a partnership agreement. The business activities among the co-owners were required to be limited to those customarily performed in connection with the “maintenance and repair” of rental real estate. The guidance provided the basis for a private letter ruling; it was not a substantive rule of law nor did it provide a “safe harbor” for such transactions.

Until recently, the IRS had issued little guidance with respect to how the taxpayer could meet the seemingly endless requirements imposed by Rev. Proc. 2002-22. After relinquishing property in a like-kind exchange, the taxpayer has only 45 days in which to identify a replacement property.  Accordingly, as a practical matter the taxpayer has had to rely on tax opinions of counsel. On December 4, 2004, however, the IRS issued a Private Letter Ruling involving a multi-tenant net leased property with a blanket mortgage owned by no more than 35 co-owners, which sheds some light on the issue. The Ruling has not yet been officially published.

The Ruling implies that (i) the IRS will not view the multi-tenant aspect of the building as creating a partnership; (ii) a blanket mortgage will not violate the guidelines of Rev. Proc. 2002-22; and (iii) the power of the Manager to exercise discretion when leasing without obtaining the express consent of the owners will not cause the undivided fractional interest to fail to be eligible “replacement” property.  The Ruling also implies that a Sponsor could retain an ownership interest for up to six months without causing the Sponsor’s activities in selling the Undivided Fractional Interests (UFIs) to the other co-owners to be attributed to those co-owners

In another recent ruling, the IRS expanded the scope of like-kind replacement property by equating interests in a Delaware Statutory Trust (DST) – the income from which, as a “grantor trust”, is considered earned by the owners of the DST interests –  with actual ownership of real property.  Thus, Revenue Ruling 2004-33 provides that the exchange of real property for interests in a Delaware statutory trust (DST) which owns real estate qualifies for exchange treatment under § 1031.

In the facts of the Ruling, an A borrows money on a note and purchases Blackacre.  The note is secured by Blackacre.  The individual then enters into a 10-year net lease, the terms of which require the tenant to pay all taxes, insurance, repairs and utilities.  A then forms a Delaware statutory trust (DST), and contributes Blackacre to that trust.  Upon contribution, the DST assumes A’s rights and obligations under the note and the lease to tenant.  B and C then exchange Greenacre and Whiteacre for all of A’s interest in the DST through a qualified intermediary.  A does not engage in a § 1031 exchange.  Whiteacre and Greenacre were held for investment and are of like kind to Blackacre, within the meaning of § 1031.

The DST agreement provides that  interests in the DST are freely transferable, but are not publicly traded on an established securities market.  The trustee’s activities are limited to the collection and distribution of income, and the trustee may not exchange real estate or purchase assets (other than short-term investments), and is required to distribute all available cash (less reserves) quarterly to each beneficial owner in proportion to his respective interest in the DST.

Under Subchapter J of the Code (§§ 671 et seq.), i.e., the grantor trust provisions, each certificate holder is treated as the owner of an undivided fractional interest (UFI) in the DST, and is considered to own the trust assets attributable to that UFI of the DST for federal income tax

A Delaware statutory trust (DST) is an unincorporated association recognized as an entity separate from its owners.  The trust may sue or be sued, and property within the trust is subject to attachment or execution as if the trust were a corporation.  Beneficial owners of a DST are entitled to the same limitation on personal liability that is extended to stockholders of a Delaware corporation.

While § 1031(a)(2) provides that § 1031(a) does not apply to an exchange of interests in a partnership, exchanges of interests in a DST do not violate this rule, since the DST is not a business or commercial trust created by the beneficiaries simply as a device to carry on a profit, and is thus not subject to reclassification for federal income tax purposes as a partnership under Regs. § 301.7701-3.  The DST provides that the trustee’s activities are limited to the collection and distribution of income.  Accordingly, the DST would also not be subject to reclassification under Regs. § 301.7701-4(c)(1), which provides for such reclassication by reason of the authority vested in the Manager to enable a trust to take advantage of variations in the market to improve the investment of the investors.  Comm’r v. North American Bond Trust, F.2d at 546.  Since the trustee has no power to vary the investment of the certificate holders, the DST is an investment trust that will be classified as a trust for federal income tax purposes.

Persons receiving DST interests in exchange for real property are considered grantors of the DST when they acquire these interests (i.e., the replacement property) from the party acquiring their real estate (i.e., the relinquished property), and they are considered to own an undivided fractional interest in the real estate owned by the DST for federal income tax purposes.89 The Ruling, in blessing this type of exchange, concludes: Accordingly, the exchange of real property . . . for an interest in DST through a qualified intermediary is the exchange of real property for an interest in Blackacre, and not the exchange of real property for a certificate of trust or beneficial interest under § 1031(a)(2)(E).  Because [the relinquished real property] is of like kind to Blackacre, and provided the other requirements of § 1031 are satisfied, the exchange of real property for an interest in DST . . . will qualify for nonrecognition of gain or loss under § 1031.

The trustee is required to distribute all available cash (less reserves for expenses associated with holding the real estate) to each beneficial owner in proportion to their respective interests in DST. Section 671 provides that where a grantor is considered the owner of any portion of a trust, the grantor must report on his own tax return items of income, deduction and credits attributable to that portion of the trust considered owned by the grantor.  Under § 677(a), the grantor is treated as owner of any portion of a trust whose income without the approval or consent of any adverse party is, or in the discretion of the grantor or a nonadverse party, or both, may be distributed, or held or accumulated for future distribution, to the grantor or the grantor’s spouse.  Regs. § 1.671-2(e)(1) provides that a person who is considered as the owner of an undivided fractional interest of a trust is considered to own the trust assets attributable to that undivided fractional interest of the trust for federal income tax purposes.

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Congress Fails in Bid to Repeal Estate Tax (October 2000)

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

By modest but not slim margins, the House failed to override President Clinton’s veto of two bills, one providing $252 billion in marriage tax relief over 10 years, the other phasing out the estate tax over 10 years at a cost of $100 billion.

The House also voted overwhelmingly in favor of two recent bills; the first would increase the IRA contribution limit from $2,000 to $5,000, the §401(k) contribution limit from $10,500 to $15,000, and would also allow individuals age 50 and older to make additional “catch up” contributions to IRAs and §401(k)s. The second bill, having the support of Mr. Clinton and House Republicans, approved nearly $6 billion in tax incentives to encourage private investment in 40 “renewal zones” in inner cities.

In other tax matters:

¶  Beginning Jan. 1, 2000, capital assets purchased after that date and held for at least 5 years will be taxed at only 18%. Postponing large investments until January could make sense. IRC § 1(h)(2) will also permit a “deemed-sale-and-repurchase” election to qualify previously held capital assets for the lower rate. Since the election avoids transaction costs, it may be sensible for unappreciated assets. However, since the election also results in immediate tax on any appreciation and begins a new holding period, its benefit is reduced. No guidance has been issued.

¶  Final regulations have been issued relating to the sale or exchange of a partnership, trust or S corporation interest. Effective for transactions on or after Sept. 20, 2000, the regulations implement 1997 changes in the capital gains rate.

¶ Amendments to Reg. §25.270203 provide that a trust using a note or other debt instrument to satisfy the annual payment obligation of a GRAT to the grantor does not meet the requirements of §2702(b). Trusts created after 9/20/99 should therefore contain a provision expressly prohibiting the use of notes. Notes obtained from unrelated parties, in contrast, are not prohibited.

¶   Rev. Proc. 2000-34 warns that in order to commence the limitations period for a prior gift that was not adequately disclosed, an amended return must be filed which apprises the IRS of the nature of the gift and the basis for the value reported, as required by Reg. §301.6501(c)-1(f)(2).

¶   Rev. Proc. 2000-37 provides a safe harbor under which the qualification of property as either “replacement property” or “relinquished property” in §1031 “reverse exchanges” will not be challenged. The ABA Tax Committee had lobbied in support of such rules. (See discussion, Tax News, 10/99)

¶  Nine members of the IRS oversight board created by TRA 1997 were recently sworn in. Members include Treasury Secretary Summers and IRS Commissioner Rossotti.

¶ Commissioner Rossotti has requested an $8.8 billion budget for fiscal 2001 which would permit the IRS to hire new compliance employees. Tax audits, he notes, have decreased by fifty percent since the mid-1990’s because of a shift in resources aimed at improving customer service and implementing congressionally mandated reforms. The Senate recently rejected an IRS funding bill that the White House considered inadequate.

¶  The IRS Appeals Division has been redesigned into four operating units, which offer new services designed to accelerate appeals cases. Mediation and arbitration processes have also been implemented.

¶    The Tax Appeals Tribunal held that an automobile lessee is not entitled to a prorated tax refund on early termination arising from a vehicle’s total loss, noting that the legislature was not unaware of the failure of the statute to provide for such a refund. In re Miehle (citation unavailable).

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Tax Court Bars Late Alternate Valuation Election

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

The Tax Court held that estates of spouses who were presumed to die in a private airplane crash could not use actuarial tables to value the testamentary life estates because the interests created by reciprocal will had no value. Estate of Harrison v. CIR, 115 T.C. 13 (8/22/2000). The will of each spouse presumed survival by the other in circumstances where the order of death was unknown and transferred a life estate to that spouse.

For estate tax purposes, the transferred life estates were valued on the basis of actuarial tables, and each estate took a credit for tax on prior transfers pursuant to IRC § 2013.  [§ 2013 provides an estate tax credit with respect to the “transfer of property . . .  to the decedent by or from a person who died within 10 years before, or within 2 years after, the decedent’s death.” The credit is the product of a fraction, determined by calculating the value of property transferred over the taxable estate, multiplied by the estate tax paid.]

The estates argued that the language of § 7520 was clear in providing that “the value of any annuity . . . shall be determined under tables prescribed by the Secretary” and cited to McClendon, which in reversing an earlier Tax Court decision, held that “[w]here the Commissioner has specifically approved a valuation methodology, like the actuarial tables, in his own revenue ruling, he will not be heard to fault a taxpayer for taking advantage of the tax minimization opportunities inherent therein.” McLendon v. CIR, 135 F.3d 1017 (5th Cir. 1998), revg. and remanding T.C. Memo. 1996-307.

The Tax Court, finding McLendon inapposite, ruled that the life estates must be accorded no value. The court reasoned that §7520(b) by its own terms “shall not apply” where otherwise provided in the regulations, and that Estate Tax Reg. §20.7520-3 provides that § 7520 shall not apply “to the extent provided by the IRS in revenue rulings or revenue procedures.” Rev. Rul. 96-3 in turn provides that departure from actuarial tables is warranted in instances of (1) terminal illness, where there is at least a 50% probability of death within one year; and (2) deaths resulting from a common accident.

Noting Estate of Carter v. U.S., 921 F.2d 63 (5th Cir. 1991), which held that an interest which “passed between persons dying in a common disaster has no value,” the Tax Court concluded that although Notice 89-24 provides that new tables are to be used to value an annuity, the notice does not determine the “substantive” question of whether actuarial tables are properly applied in the first instance. In a simultaneous death situation the court found that the life estates had no value. Therefore, actuarial tables could not be used in valuing the reciprocal life estates.

*          *          *

The Tax Court in Estate of Eddy v. CIR, 115 T.C. 10 (8/16/00), held that an alternate valuation election must be made within 1 year after the time prescribed by law (including extensions) for filing the estate tax return.

The due date for the estate tax return in question was January 13, 1994, nine months after the decedent’s date of death. A timely extension was filed, requiring the estate tax return to be filed by July 13, 1994. The estate tax return was not filed until January 19, 1996, 33 months after the decedent’s death and more than 18 months after the extended due date for filing the return. The return reported the alternate value of the estate assets as $5.99 million and the date-of-death value as $6.60 million.

Under IRC § 2032(d), which was amended in 1984, an alternate election may be made on a late-filed return if the return is filed within one year of the due date. The estate argued that Rev. Proc. 92-85 accords the Commissioner discretion to allow an untimely election to use the alternate valuation date. Rev. Proc. 92-85 permits “extensions of time when a statute provides that an election may be made by the due date of the taxpayer’s return or the due date of the taxpayer’s return including extensions.”

In rejecting the estate’s argument, the court held that no election could be made after the 1-year period of “legislative grace” provided by § 2032(d), since the due date of the taxpayer’s return, including extensions, ended after the 1-year period. Since Rev. Proc. 92-85 applied only to the 1-year grace period, the executor’s failure to file a return within that period precluded the election.

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HURRICANE AID AND NEW TAX EXPENDITURES THREATEN PROPOSED TAX CUTS; DEFICIT MAY INCREASE

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

President Bush urged Congress to provide tax incentives to invigorate areas destroyed by Katrina and to pay for relief initiatives, already over $70 billion, by reducing nondefense spending. Bush administration’s proposals for defense and homeland security may portend a $400 billion deficit in fiscal year 2006.

Revenue shortfalls may force Congress to eliminate preferential rates for capital gains and most corporate dividends scheduled to expire in 2008. Senate Finance Chair Chuck Grassley (R-Iowa) accused the Bush Administration of stalling a bipartisan healthcare bill, and warned of a “domino effect” that would doom the investment tax cuts.

The House narrowly passed a bill intended to increase oil-refining capacity by easing regulatory constraints, and also to avert a projected home heating-oil crisis in New England this winter by enlarging a federal oil reserve in New York harbor. The bill also proposed federal penalties (up to $11,000 per incident) for price gouging by oil companies or retailers of petroleum products. Although Republican House leaders refused to allow debate concerning increased fuel efficiency standards, the Senate may revisit that issue and may also endorse a proposal allowing states to waive a federal moratorium banning drilling for natural gas on federal land off their coastlines.

The Energy Policy Act of 2005 provides new tax credits for the purchase of (i) hybrid, fuel cell, advanced diesel and other alternative power vehicles placed in service after 2005, and (ii) qualifying residential solar water heating, photovoltaic equipment and fuel cell property (up to a maximum credit of $2,000). The Act also provides for (i) a new $2,000 business tax credit for the construction of new energy efficient homes, and (ii) a new deduction for energy efficient commercial buildings.

The President’s Advisory Panel on Tax Reform is due to report November 1. Many Eastern European countries have recently adopted a flat tax. Romania’s S&P credit rating is now investment grade; tax revenues in Russia have increased dramatically since adopting a 13% flat tax. The Wall Street Journal, citing Code “complexity,” urged the Panel to reject fairness arguments and “endorse a simple, broad-based,  single-rate tax system. (“The World is Flat,” 10/7/05).

However, Congress is unlikely to abandon progressive tax rates. Americans and Western Europeans view the flat tax with contempt. German Chancellor Schröder seized upon his opponent’s named choice of a flat-tax advocate for finance minister, warning that Germany should not host an “unjust tax experiment.” His opponent’s lead in the polls evaporated. Contrary perhaps to popular view, new IRS data show that the top 1% of taxpayers paid more than a third, and the top half of taxpayers paid for all but 4%, of total personal income tax in 2003, demonstrating the “steeply progressive nature of the federal income tax,” according to Joint Economic Committee Chair Rep. Jim Saxton (R-N.J.).

Thus far in 2005, 91 U.S. companies have announced plans to repatriate about $206 billion in foreign profits under a one-year tax break enacted as part of the American Jobs Creation Act of 2004. While U.S. companies generally pay U.S. income tax on foreign source income, profits permanently reinvested overseas are generally excepted. During 2005, companies may repatriate profits from overseas operations at a special rate of 5.25%, rather than the typical effective rate of 25%. Although job growth cannot be tied directly to the tax provision, employment growth has been moderate in 2005, and unemployment fell to 4.9% in August, a four-year low. Companies are required to file board-approved plans to the Treasury Department for “approved uses,” although they are not required either to isolate funds or to show that spending on approved uses exceeds that which would have otherwise occurred.

Mutual funds invested in Latin American funds and funds specializing in natural resources are expected to make large capital gains payouts in December. Under federal law, mutual funds are required to pay out any net realized capital gains to their shareholders each year. These gains, which derive from stock trades or other investment income, may be either short-term or long-term. The type of gain — and therefore its tax treatment to investors — is based upon how long the fund held the particular security, and not how long the investor owned the mutual fund. Since short-term capital gains are taxed at the taxpayer’s regular income tax rate, investors should be careful about investing in these funds in the final weeks of 2005. Note that funds held in a tax-favored retirement account such as an IRA are not subject to current tax on capital gains. Accordingly, capital gains distributions to these accounts do not pose a similar concern.

As U.S. Treasury Secretary John Snow  embarks on a trip to China, central-bank head Zhou Ziaochuan said that China must reexamine the value of its currency in light of its soaring trade surplus. Chief Asia economist for Credit Suisse First Boston, Don Tao, said China will address currency reform “at its own pace.”

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2nd Circuit Dismisses EU Suit to Recover Lost Tax Revenue

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

Citing the common law doctrine known as the “revenue rule,” the 2nd Circuit, on remand from the Supreme Court, dismissed a civil suit brought by the European Union under the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. §§ 1961-1968 (“RICO”) against RJR Nabisco, Inc., which suit sought to recover lost tax revenues due to alleged smuggling. European Community v. RJR Nabisco, Inc., Dcket Nos. 02-7325 (L); 9/13/05.

[The EU alleged RJR had participated in a smuggling enterprise within the meaning of RICO and had committed various predicate acts of racketeering, including mail and wire fraud, and money laundering. The complaint sought to recover treble damages pursuant to RICO for duties and taxes not paid on cigarettes; and injunctive relief to end smuggling and to ensure future compliance.]

The appeals court initially observed that under the “revenue rule”  courts of one nation will not enforce final tax judgments or unadjudicated tax claims of other nations. The rationale for the rule is predicated in the belief that the judiciary should not evaluate enactments of a foreign sovereign. The EU asserted, however, that the the revenue rule had been abrogated by amendments to RICO embodied in the Patriot Act.

The court acknowledged that various provisions in the Patriot Act did address the conduct alleged. However, it found that neither the amendments nor legislative history evidenced a Congressional intent to abrogate the doctrine, which was necessary for two reasons: First, serious policy implications and “embarrassment” might follow if one nation’s courts analyzed the validity of another’s laws; and second, the executive, rather than the judicial branch, should decide when one nation should enforce another nation’s tax laws.

The EU cited Pasquantino v. U.S., 125 S.Ct. 1766 (2005) for the proposition that the revenue rule had not barred prosecution under 18 U.S.C. § 1343 where Canada had been fraudulently deprived of its right to collect tax money. Although prosecution did in a sense “enforce” Canadian law, the court found the connection was nevertheless “too attenuated” to be significant, since the U.S., rather than a foreign sovereign, had commenced the prosecution.

The court concluded that where a domestic sovereign enforces its own penal law, there is little risk of causing the evil against which the revenue rule was traditionally thought to guard: judicial evaluation of “policy-laden” enactments of foreign sovereigns. However, where the executive branch does not expressly consent to the litigation, separation of powers militates against the judiciary being drawn into foreign relations issues better handled by the political branches of government.

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EXTRACTING TAX-FREE CASH IN A TAX-FREE EXCHANGE

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

Refinancing before or after a like-kind exchange may enable the taxpayer to extract tax-free cash in addition to reporting no gain on the exchange. Depending on the size of the mortgage encumbering the property to be replaced, refinancing may actually be necessary to avoid boot gain caused by debt relief. However, since refinancing during a like-kind exchange transforms what would otherwise be taxable boot or taxable debt relief into tax-free loan proceeds, the IRS may argue that the transaction is taxable unless an independent business purpose justifies the refinancing.

To illustrate preexchange refinancing, assume the relinquished property is heavily mortgaged but the replacement property is unencumbered or subject to only a small mortgage. Regs. §1.1031(d)(2) treats debt relief as cash received in the exchange. However, the Regs. also permit the “netting” of mortgages, suggesting that boot gain may be avoided by “evening up” the mortgages prior to the exchange. Encumbering the replacement property by an amount equal to the existing mortgage on the relinquished property would accomplish this equilization.  Will this strategy work?

The taxpayer in Wittig v. Comr., T.C. Memo, 1995-461 equalized the mortgages by encumbering the replacement property prior to the exchange, extracting cash from the new mortgage in the process. Since the assumption of the taxpayer’s liabilities with respect to the relinquished property equaled the new liabilities assumed by the taxpayer, the taxpayer reported no gain. PLR 9853028 concurred, stating that a new mortgage placed to acquire the replacement property could be netted against the existing mortgage on the relinquished property.

What if the loan is obtained shortly before the exchange? Although Regs. §1.1031(b)-1(c) would treat such as bona fide debt, Garcia v. Comr 80 T.C. 491 (1983) held that a loan obtained shortly prior to the exchange would be as cash received on disposition of the relinquished property unless the new debt had “independent economic significance.” Fredericks v. Comr, T.C. Memo, 1994-27 blessed pre-exchange financing where it was not conditioned on closing of title and was dependent on the taxpayer’s creditworthiness. Even here, the step-transaction doctrine could be invoked by the IRS if pre-exchange financing was in integral part of the exchange. See, e.g., Behrens v. Comr., T.C. Memo 1985-195. Ideally, refinancing should be entirely unrelated to the exchange.

In contrast to preexchange financing, no judicial or legislative authority appears to place restrictions on encumbering replacement property following an exchange. The ease of post-exchange financing might be explained by the fact that here the taxpayer remain economically answerable for the new debt. (In preexchange refinancing, the newly encumbered property is relinquished.)

Nevertheless, to avoid the step-transaction doctrine, title in the replacement property should be acquired before  engaging in post-exchange financing. Post-exchange financing proceeds should not be paid at the closing or appear on the closing statement. If additional construction draws will be made following acquisition of the replacement property, only the advance made by the construction lender (and not the draws) should appear on the closing statement.

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Irrevocable Life Insurance Trusts (ILITs)

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

Life insurance proceeds are excludible from beneficiaries’ income under §101, provided the policy had not been transferred for valuable consideration. Proceeds from policies transferred in trust will also be excluded from the insured’s gross estate provided the insured (i) retained no incidents of ownership in the policy and (ii) survived three years after making the transfer. To ensure favorable estate tax consequences, the trust must also be both irrevocable and not amendable. It is therefore crucial that the insured understand the finality of decisions made when executing the trust.

Even though the policy in trust may be excluded from the gross estate, proceeds can nevertheless be used to satisfy estate tax liabilities. However, the trust agreement must not obligate the trustee to assist in the payment of estate taxes. Thus, even though a major objective of an irrevocable life insurance trust may be to satisfy estate tax liabilities, the trust language must not mandatorily direct such payments. Language appearing to require the trust to pay estate taxes could result in estate tax inclusion under §2042 — regardless of whether the proceeds are so used.

In order to accomplish the desired objective, the trust could authorize the trustee to purchase assets from, or make commercially reasonable loans to, the estate. Alternatively, the insurance proceeds might simply be distributable to beneficiaries who would ultimately bear the burden of estate taxes, as determined by the insured’s Will. The Will must be carefully coordinated with the Trust to accomplish that objective. Inconsistent language in the two instruments could result in harsh estate tax consequences.

Life insurance trusts are flexible post-mortem vehicles for distributing income and principal to beneficiaries: If broad discretionary powers are granted to the trustee, principal may be distributed estate tax-free to children either when they reach a particular age, or earlier, if the trustee is given such discretion. The trust may also permit “sprinkling” income distributions to the surviving spouse, who may or may not require trust income or principal.

To ameliorate the harsh estate tax consequences occasioned by the application the three-year inclusion rule, the trust might might direct that in such event insurance proceeds instead be payable to the insured’s estate. While this would negate provisions benefiting children, it would allow the Will (if so drafted) to claim a marital deduction which would at least keep the wolf at bay and result in exclusion from the gross estate.

Premiums paid by the insured may qualify as annual exclusion gifts under the Crummey doctrine. The IRS has attempted to defeat Crummey powers where a contingent beneficiary had “no interest other than the withdrawal power”. However, the Tax Court in Kohlsatt (T.C. Memo 1997-212) rejected that position where “credible” reasons were offered by trust beneficiaries not to exercise withdrawal rights. Where the Crummey withdrawal right exceeds $5,000, the use of a “hanging” power may avoid the lapse which would cause a gift back into the trust by the Crummey beneficiary.

For those estates potentially subject to GST tax, if trust beneficiaries include grandchildren, the transfer must be a direct skip, and the trust must provide that if the beneficiary dies before the trust terminates, trust property must be included in his estate. Alternatively, the insured could fail to include GST provisions and simply allocate part of the GST exemption to the transfer.

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Tax Cuts Likely; Democrats Urge Debt Reduction (June 2000)

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

In an era of budget surpluses not seen in 30 years, President Clinton has proposed tax reductions, marriage penalty relief, increased charitable contribution deductions, and the following credits: (i) a new college credit, (ii) a long-term health care credit, (iii) an increase in the child-care credit, and (iv) an expanded earned income tax credit.

The House in March approved a fiscal 2001 budget calling for up to $240 billion in tax cuts over five years. The Senate in April approved a more modest $150 billion tax reduction. Budget proposals of both the Congress and the President were dwarfed by the five-year $483 billion package of tax cuts proposed by Governor Bush, who favors lowering marginal tax rates for individuals, phasing out gift and estate taxes, reducing the marriage penalty, doubling the child credit to $1,000 per child, vetoing any increase in corporate taxes, and expanding education savings accounts.

Vice President Gore, an advocate of national debt reduction, favors more modest tax cuts. Mr. Gore also supports marriage penalty relief, a permanent  research and development tax credit, and the creation of (i) tax-favored accounts for education expenses, and (ii) Universal Savings Accounts (USAs), which are tax-favored retirement accounts funded by low and middle income families with matching government contributions.

In other tax developments:

¶ A bill sponsored by Senate majority leader Trent Lott (R-Miss.) proposing sharp increases in the standard deduction for married couples and expansion of the 15% and 28% tax brackets was defeated in April, perhaps due to its projected cost of $248 billion over ten years. Mr. Clinton had earlier vowed to veto a similar House bill costing $182 billion;

¶ The Senate in April also rejected Mr. Lott’s proposal to temporarily suspend the 4.3 cents per gallon federal gasoline tax. Republicans were said to express concern over the potential loss of road construction subsidies;

¶  House and Senate Conferees are currently negotiating a package of health-related tax bills that would increase deductions for health insurance premiums and long-term care expenses, and facilitate the use of medical savings accounts;

¶ Federal Reserve Chairman Greenspan, who also favors reducing the national debt, urged the Senate Committee on Aging in May not to divert income tax surpluses to Social Security;

¶ The House Judiciary Committee voted in May to extend for another five years the current moratorium on new state and local taxation of the Internet imposed by the Internet Tax Freedom Act of 1998.

¶ The House approved a five-year, $46 billion tax reduction for small businesses over five years, which would provide greater deductions for (i) business equipment purchases, (ii) self-employed health insurance premiums, and (iii) meal and entertainment expenses. Mr. Clinton has vowed to veto the bill;

¶ The House voted unanimously in April to approve new taxpayer rights legislation protecting against illegal disclosure of taxpayer information. The bill would also simplify estimated tax rules, and reduce IRS penalty and interest charges for individuals;

¶ In response to last year’s unpopular repeal of accrual basis taxpayers’ right to use the installment method, the IRS has issued guidance (Rev. Proc. 2000-22) permitting taxpayers with annual gross receipts of $1 million or less to use the cash method of accounting, and therefore, the installment method. The guidance would be retroactive to the date of repeal, December 17, 1999; and

¶ Treasury Secretary Summers characterized the growth in corporate tax shelters as the “most serious compliance issue threatening the American tax system today,” and outlined the administration’s strategy to curb their use.

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Tax Court Applies IRC §2036(a) in FLP Context

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

Finding the existence of an “implied agreement” whereby the decedent was to retain the possession and enjoyment of, and the right to income from, property transferred to a family limited partnership (FLP), the Tax Court has held that the FLP assets were includible in the estate pursuant to §2036(a).  Estate of Reichardt et al. v. CIR, 114 T.C. No. 9, (2000).

[The decedent, after being diagnosed with terminal illness, formed a revocable living trust and an FLP in 1993, and shortly thereafter transferred nearly all partnership interests to his children. He then transferred all of his property (except for his car and a small amount of cash), and deeded real property of his deceased wife’s estate over which he held a general power, into the trust, and then from the trust into the FLP. The decedent continued to live in the residence which had been transferred to the partnership, withdrew funds from the partnership bank account, and continued to manage real estate and investment accounts of the partnership.]

The Court first determined, based upon the “facts and circumstances surrounding the transfer and subsequent use of the property” that there was an implied agreement that the decedent would retain the present economic benefits of the property, even if the retained right were not enforceable at law. In attempting to bear its burden of proof which the Court termed “especially onerous for transactions involving family members,” the estate argued, inter alia, that the FLP was formed (i) to prevent the decedent from taking imprudent actions with respect to the property (the decedent had a paramour), and (ii) to give his children more control over the assets. The Court rejected the argument, finding that the decedent did not curtail his enjoyment of the property, since he continued to manage the trust which managed the FLP. Moreover, the Court found the decedent had “commingled” partnership and personal funds, and had “used the partnership’s checking account as his personal account.” Citing Schauerhamer, T.C. Memo. 1997-242, Judge Colvin concluded that inclusion under §2036(a) was required since the decedent’s relationship to the assets “remained the same after he transferred them.”

The Estate, in attempting to distinguish Schauerhamer, argued family members had testified that the decedent’s relationship with the transferred assets was intended to remain the same after the transfer. The Court however, rejected the distinction, remarking that “[t]he decedents in both Schauerhamer and the instant case commingled funds.” The Court also noted that  the decedent was left with virtually no income or assets after the FLP transfers.

The holding in the case is not surprising; nor does it appear erroneous. The case is nevertheless of concern to estate planners since §2036(a) had not found routine application in the context of FLPs; the fiduciary duty of the Manager was thought to preclude its relevance. Here §2036(a) was applied based on an implied agreement at variance with the formalities of the legal transfers. In combating what it perceives as abusive FLPs, the IRS strategy has been to argue that the transactions lacked substance, or that inclusion should result under §2704(b). §2036(a) represents a new potent potential weapon. One almost regrets the poor planning and execution which caused this case to be decided.

In any event, if §2036(a) is to be avoided, the fiduciary duties of the managing member of the FLP must be taken seriously. A mere recital in the operating agreement of the Manager’s fiduciary duties may be insufficient. Implied agreements are difficult to disprove; to defeat the assertion the taxpayer should be armed with demonstrable facts negating its existence during the lifetime of the agreement.

Retaining sufficient assets so as to avoid dependence on the FLP for income would undermine the argument that the transferor was intended to continue to benefit from the assets or income of the FLP. Frequent (and substantial) distributions to family members would also be probative of the absence of an implied agreement. If the parent continues to live in the residence, a lease agreement with monthly payments to the FLP is crucial. Finally, and perhaps most importantly, partnership and personal funds must never be commingled.

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Asset Sales to Grantor Trusts Discussed at ABA (June 2000)

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

[Louis A. Mezzullo, Esq., of Mezzullo & McCandlish, Richmond, Va., presented a paper discussing installment sales to grantor trusts at the ABA Tax Section’s midyear meeting in San Diego.]

Generally, the grantor of a trust who retains the right to enjoy or to control the enjoyment of the income or principal is treated as owning the assets for income tax purposes. The objective of the grantor trust rules found in IRC §§ 671 – 679 is to prevent income-shifting by the grantor. Asset sales to grantor trusts exploit this income tax attribute.

When the grantor of a grantor trust sells assets to the trust, no taxable event occurs — the sale is considered a sale to the grantor himself, provided the sale is made for full and adequate consideration, and the note bears interest at a rate at least equal to the AFR determined under §1274. (Rev. Rul. 85-13, 1985-1)

For transfer tax purposes, if the grantor takes back an installment note and does not retain incidents of ownership, the sale could remove appreciating assets from the estate without the imposition of any gift or estate taxes ever. Moreover, the grantor’s estate would be reduced by the yearly income taxes which the grantor must pay on trust income. In effect, this would accomplish a gift tax-free transfer of income tax payments to beneficiaries of the trust. It is true that the trust would take a transferred, rather than a cost, basis in the trust assets, since the grantor and trust are the same income tax entities. However, the flip side of this is that neither the trust nor the grantor would be required to recognize gain if appreciated assets were later used to satisfy the outstanding note.

If grantor trust status terminates before the note is repaid, Mr. Mezzullo concludes that the grantor would “presumably” recognize taxable income equal to the amount of the gain represented by the unpaid portion of the note. However, unlike the situation with a GRAT, the early death of the grantor would not result in a tax fiasco: Whereas the early death of the grantor of a GRAT results in gross estate inclusion of the trust assets, no inclusion would result where the grantor-noteholder died before the repayment of the note (although the estate may have been augmented by principal and interest payments made on the note).

Another advantage an asset sale to a grantor trust possesses over the GRAT reflects the interests rates which must be employed: The GRAT must use an annuity rate equal to 120 percent of the AFR. The note securing the assets sold to the grantor trust need only bear interest at AFR rate itself. In the GRAT context, the IRS has also threatened in rulings to contest the gift tax-free transfer of income tax payments by the grantor by requiring the grantor to pick up gift tax on these payments. Mr. Mezzullo believes that the IRS could not make the same argument with respect to asset sales to grantor trusts since the grantor is obligated under the Code to pay the tax.

The grantor trust asset sale can also achieve non-tax objectives, as note proceeds can be used to provide income for family members who do not wish to participate in the business which is sold to the trust. The installment sale to a grantor trust may also constitute an effective way of transferring assets to younger family members at their current value without incurring any gift tax.  The only real cost to the beneficiaries would be the loss of the carryover basis. The importance of this drawback diminishes if the if the grantor expects the family members to continue the business.

Mr. Mezzullo concludes that “if the installment-sale-to-a-grantor trust technique is used, the formalities should be followed to the letter, including a properly drafted trust agreement, installment note, and any other documents required under state law to transfer ownership of the assets to the trust and to support the grantor’s status as bona fide creditor of the trust.” He adds that the “safest” means of achieving grantor trust status while still effectuating a transfer for gift tax purposes would be to permit an independent party to add beneficiaries.

*          *          *

Mr. Mezzullo also discussed the perplexing Simplot case (112 T.C. 190; see Tax News, Oct. 1999), which held that the premium for voting rights on only a few shares owned by the decedent should be based on the entity’s equity value, rather than merely as a percentage of the voting shares, resulting in a premium of $325,724 per share. He concluded that Simplot was simply a reaction to a situation where the total number of voting shares was extremely small, and was therefore an anomaly.

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Qualified Personal Residence Trusts (QPRTs)

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

IRC §2702 provides that an interest transferred in trust to or for the benefit of a family member is treated as a gift of the entire interest, even if the transferor retains a partial interest. In such case, the taxable gift is equal to the entire value of the property.  The GRAT, an exception for retained “qualified interests” which pays an annuity for a term of years based on a fixed percentage of the initial value of trust assets, permits a reduction in the taxable gift to reflect the retained interest. Thus, the taxable gift may be small, especially if a long trust term is chosen and the assumed rate of growth of the assets is high.

Some appreciating assets, such as personal residences, produce no income stream which could fund a GRAT. §2702 thus provides for the QPRT,  in which the grantor retains the right to live in a personal residence for a term of years. Like its close cousin, the GRAT, the QPRT results in a taxable gift of only the remainder interest. If the grantor, age 60, retains the right to live in a $1 million personal residence for 20 years, gifting  the remainder interest to children, the taxable gift would be only approximately $150,000, versus $1 million for an outright gift. For estates whose assets may exceed the credit provided by §2010, the QPRT becomes attractive.

The QPRT may hold assets other than a residence, but they are strictly circumscribed: the trust may hold appurtenant structures, a reasonable amount of adjacent land, and cash for the immediate payment of trust expenses reasonably expected to be paid within six months, such as mortgage expenses. The trust may also permit improvements to the residence. QPRTs may hold a principal residence or vacation home, or both.

Regs prohibit the grantor from repurchasing the residence from the trust during the trust term. This rule is intended to prevent the grantor from repurchasing the appreciated residence near the end of the trust term, depleting the estate of those funds, and permitting the residence to pass to family members with a stepped-up basis. The grantor may, however, execute a lease at the end of the trust term and continuing to live in the residence. If the residence is sold during the trust term, the QPRT must require distribution of trust assets or conversion to a GRAT.

The QPRTs greatest limitation, one shared with GRATs, is that if the grantor does not survive the trust term, the entire value of the appreciated residence is included in the grantor’s estate pursuant to IRC § 2036. It is said that this result is estate tax neutral, in that the grantor is no worse off than if no QPRT transfer had been made. This holds true only if no other estate planning alternatives would have been considered.

To hedge against the possibility of the grantor’s not surviving the trust term, an irrevocable life insurance trust could purchase a term life insurance policy. If the grantor then died during the trust term, insurance proceeds could pay estate taxes occasioned by inclusion of the residence in the grantor’s estate.

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Tenancies in Common & Like Kind Exchanges

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

Tenancy in common (TIC) interests have become extremely popular as replacement properties in like kind exchanges. A TIC interest represents an ownership slice of a larger fee interest, which is evidenced by an individual deed. A TIC owner possesses the same rights as would an owner in fee simple absolute.

Given their recent popularity, the most desirable TIC investments also command substantial premiums. However, costs associated with the TIC properties also reflect economies of scale. Since multiple owners may pool their resources, a TIC interest in high quality commercial property may be acquired for as little as $200,000. A smaller initial investment translates into an opportunity to diversify.  TIC properties generally consist of high quality triple net leased buildings or office buildings whose cost may range from $1 million to more than $10 million. A TIC sponsor will generally analyze leases, conduct demographic studies, and determine desirable investment property. The sponsor may enter into a master lease with the TIC interest holders, and then lease the property to subtenants. Secure monthly cash flow can be anticipated, since most tenants would be creditworthy and would sign multi-year leases. The TIC sponsor will typically provide quarterly updates and annual reports to investors, who will have little if any day-to-day management responsibility. The investment is particularly appealing for taxpayers who wish to minimize their involvement in replacement property.

A TIC property marketed through a Private Placement Memorandum (PPM) can often be identified and closed within the 45-day identification period. A second TIC property owned by the sponsor can also be identified as backup replacement property. Before TIC property is acquired, a business plan of 3 to 7 years, as well as an exit strategy, may already be in place. As mortgage loans are paid down, and as the market value of the property increases, the taxpayer’s equity will increase, making it possible to “trade up” with sequential Section 1031 exchanges.

To illustrate, assume the taxpayer relinquishes property and identifies the following TIC properties: (i) a Class A 300,000 square foot distribution center in Chicago; (ii) a new 265 unit apartment community in Las Vegas; (iii) a shopping center in New Orleans; and (iv) an oil and gas interest in Alaska. Not only has the taxpayer diversified his investment, but he has chosen a mix of properties with differing cash flows and investment potential. The distribution center in Chicago may have a high cash flow (i.e., capitalization); the New Orleans shopping center may offer unique federal, state and local tax advantages; the Las Vegas apartments may possess enhanced growth potential; and the Alaska oil and gas lease may offer attractive current write-offs.

In response to increased taxpayer interest in TICs as replacement property, the IRS issued Revenue Procedure 2002-22, which permits acquisition of TIC interests by a group of owners, but prevents TIC owners from operating as a de facto partnership. The ruling states the circumstances in which a group of small investors acquiring undivided interests in a larger single-tenant replacement property will be viewed as acquiring TIC interests or undivided fractional interests (UFIs), rather than as partnership interests.

Until recently, the IRS had issued little guidance with respect to how the taxpayer could meet the prolific requirements of Revenue Procedure 2002-22. Since replacement property must be identified within 45 days, the taxpayer has had to rely on tax opinions of counsel as to whether the requirements of Revenue Procedure 2002-22 were satisfied. PLR 200513010 ruled favorably on a multi-tenant net leased property with a blanket mortgage. The ruling suggests that (i) the IRS will not view the multi-tenant aspect of the building as creating a partnership; (ii) a blanket mortgage will not violate the guidelines of Revenue Procedure 2002-22; and (iii) the power of the manager to exercise discretion when leasing, without obtaining the express consent of the owners, will not cause the UFI to fail to constitute eligible replacement  property.

To obtain a favorable ruling under Revenue Procedure 2002-22, tenants in common must each possess a right to participate in management decisions. Certain decisions, such as leases to new tenants, require the approval of all co-owners. However, a prospective tenant might not agree to wait a month for approval by all co-owners. PLR 200513010 implies that certain business decisions requiring expeditious action may be put to co-owners for their approval within a fairly short period of time without violating Revenue Procedure 2002-22. Therefore, a notice might be sent to tenants providing that their implied consent will be assumed unless they respond within 15 or 30 days.

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PRESIDENT BUSH SIGNS $70 BILLION TAX BILL

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

On May 17th, President Bush signed into law the “Tax Increase Prevention and Reconciliation Act of 2005,” which provides $70 billion in tax incentives, extends the 15% capital gains and dividend rates through December 31, 2010, and increases the AMT exemption amount for married taxpayers to $62,550. The Section 179 expense allowance ($108,000 in 2006), scheduled to revert to $25,000 in 2008, will instead remain in effect for two additional taxable years, 2008 and 2009. (P.L. 109-222; H.R. 4297).

To finance these tax incentives, Congress (i) imposed a new estimated tax regime on corporations; (ii) made the kiddie tax applicable to children up to 18 years; (iii) eliminated the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs; (iv) imposed information reporting for tax-exempt interest on tax-exempt bonds beginning in 2006 (which, although unlikely to affect federal income tax liability, could affect state income tax liability); (v) imposed new earnings stripping rules on corporations and partnerships; (vi) increased the amortization period for geological costs from 2 years to 5 years; (vii) imposed a new rules requiring taxpayers who submit offers in compromise to make partial payments pending consideration of their offer (the new rule requires taxpayers to make a down payment of 20% on a lump sum offer); and (viii) imposed tax increases of approximately 6% on Americans living overseas.

With respect to item (viii), while many taxpayers working abroad will see no increase, others’ tax liabilities will quadruple. For example, Americans working in high-tax European countries, will not be substantially affected. However, Americans working in low-tax jurisdictions with high housing costs, such as the Middle East, Singapore and Hong Kong, will have sharply increased tax liability, since the law changes taxation on subsidies.

The Senate on June 8th, voting mainly along party lines, rejected legislation permanently repealing the estate tax. Although Iraq and Katrina, as well as Mr. Bush’s own political troubles, could be factors which reversed the momentum for estate tax repeal, the issue seems to have become ideological. Senator Voinovich of Ohio, one of two Republicans voting against repeal, opposed further tax cuts given the current deficit. The Joint Committee on Taxation estimates that full repeal would cost $600 billion over 10 years. If Congress takes no action, the present exemption of $2 million will increase to $3.5 million in 2009, the estate tax will be eliminated for one year in 2010, and the pre-EGTRRA exemption amount of $1 million, with tax rates between 41% to 55%, will return in 2011.

Since Republicans fell only 3 votes short of full repeal, compromise could occur. Senator Baucus (D-Mont.), senior Democrat on the Senate Finance Committee, and one of four Democrats who voted for repeal, favors a $5 million exemption and an estate tax rate of 15%. Senator Clinton has in the past mentioned a $5 million exemption, but at a time when full repeal seemed more likely. Senator McCain has switched course, now voting for full repeal. He had previously voted against repeal in 2005, and had opposed even partial repeal.

Senate Majority Leader Frist (R-Tenn), a vocal advocate of repeal, had until recently refused to discuss compromise. However, he recently held meetings with several Democrats to discuss a compromise. The House, which has approved repeal several times, would likely take up compromise legislation if it clears the Senate.

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