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

The Tax Court, in a Regular Opinion, held that taxpayer, who was the subject of collection activity through notices of levy, had been deprived of neither his right to (i) meaningful judicial review, despite the fact that no written or audio record of the CDP conference was made; nor his right to (ii) an impartial administrative adjudication, despite the fact that the Appeals Officer had prior involvement in his case. Cox v. Com’r, 126 T.C. No. 13 (May 3).

[The taxpayer was a consultant and software developer who operated a sole proprietorship. He failed to pay any portion of his 1999 and 2000 reported tax liability of approximately $252,000. In December of 2002, the IRS issued a Final Notice of Intent to Levy. A Collection Due Process (CDP) hearing was held in August of 2003. A Notice of Determination denying penalty abatement and release of the levy was issued. An appeal followed. The Appeals Officer was later assigned to a new case involving tax liabilities for 2001 and 2002. Following a CDP hearing, a Determination was issued stating that the taxpayer’s assertion of an inability to pay had not been established and relief from levy was denied. The cases were consolidated for appeal.]

The Tax Court, first addressing the adequacy of the administrative record, stated that hearings conducted under sections 6320 and 6330 are “informal proceedings, not formal adjudications,” with no right to subpoena witnesses or documents. Katz v. Com’r, 115 T.C. 329. Although taxpayers are entitled to record 6330 hearings, the court had “never held or implied that any particular type of record is a necessary prerequisite for meaningful review.” The Appeals Office administrative file contained “extensive contemporaneous notes” which provided a “singularly clear portrayal of administrative developments as they occurred.” Therefore, the administrative record was held to be sufficient to support judicial review.

The court then addressed the taxpayer’s concerns regarding the impartiality of the Appeals Officer. Section 6330(b)(3) requires that a CDP conference be held by an officer who has “no prior involvement with respect to the unpaid tax.” In interpreting the term “prior involvement,” the court quoted from the legislative history, which provides: “[i]f multiple hearings are held . . . the same appellate officer will hear the taxpayer with regard to the lien and levy issues.” Noting the lack of case law authority, the court stated that since multiple CDP hearings with respect to one period may be conducted by the same Appeals Officer, “[l]ogically, it is difficult to argue that an appreciably greater or different harm could ensue where a period is first considered informally and then becomes the direct subject of a subsequent proceeding.”

Having found no statutory bar to the same Appeals Officer conducting all CDP conferences, the court next considered whether section 6330(b)(3) incorporates a “general requirement of impartiality.” The court found it unnecessary to answer this question, as the taxpayer’s allegations of bias “were not borne out by the totality of the record.”

Although the court’s interpretation of “prior involvement” may be a reasonable reading of “Question and Answer 4” of Treas. Regs. § 301.6330-1(d)(2), which addresses “prior involvement,” it is not a reasonable reading of the statute itself, which unambiguously provides that the hearing shall be conducted by an hearing officer “with no prior involvement.” In the end, the Tax Court’s decision may have been informed by what it referred to as the “practical realities” that “Appeals Offices are small with limited staff, [and that] a construction that would progressively disqualify an entire office . . . would be unworkable.” Whether or not this observation is true is irrelevant, since the statutory language is clear. Moreover, meaningful judicial review without a written or audio record of the CDP hearing appears impossible where judicial review is entirely predicated on contemporaneous notes of an Appeals Officer who has adversely decided the taxpayer’s case. The decision appears flawed.

The Tax Court, in a Regular Opinion, held that taxpayer, who was the subject of collection activity through notices of levy, had been deprived of neither his right to (i) meaningful judicial review, despite the fact that no written or audio record of the CDP conference was made; nor his right to (ii) an impartial administrative adjudication, despite the fact that the Appeals Officer had prior involvement in his case. Cox v. Com’r, 126 T.C. No. 13 (May 3).

[The taxpayer was a consultant and software developer who operated a sole proprietorship. He failed to pay any portion of his 1999 and 2000 reported tax liability of approximately $252,000. In December of 2002, the IRS issued a Final Notice of Intent to Levy. A Collection Due Process (CDP) hearing was held in August of 2003. A Notice of Determination denying penalty abatement and release of the levy was issued. An appeal followed. The Appeals Officer was later assigned to a new case involving tax liabilities for 2001 and 2002. Following a CDP hearing, a Determination was issued stating that the taxpayer’s assertion of an inability to pay had not been established and relief from levy was denied. The cases were consolidated for appeal.]

The Tax Court, first addressing the adequacy of the administrative record, stated that hearings conducted under sections 6320 and 6330 are “informal proceedings, not formal adjudications,” with no right to subpoena witnesses or documents. Katz v. Com’r, 115 T.C. 329. Although taxpayers are entitled to record 6330 hearings, the court had “never held or implied that any particular type of record is a necessary prerequisite for meaningful review.” The Appeals Office administrative file contained “extensive contemporaneous notes” which provided a “singularly clear portrayal of administrative developments as they occurred.” Therefore, the administrative record was held to be sufficient to support judicial review.

The court then addressed the taxpayer’s concerns regarding the impartiality of the Appeals Officer. Section 6330(b)(3) requires that a CDP conference be held by an officer who has “no prior involvement with respect to the unpaid tax.” In interpreting the term “prior involvement,” the court quoted from the legislative history, which provides: “[i]f multiple hearings are held . . . the same appellate officer will hear the taxpayer with regard to the lien and levy issues.” Noting the lack of case law authority, the court stated that since multiple CDP hearings with respect to one period may be conducted by the same Appeals Officer, “[l]ogically, it is difficult to argue that an appreciably greater or different harm could ensue where a period is first considered informally and then becomes the direct subject of a subsequent proceeding.”

Having found no statutory bar to the same Appeals Officer conducting all CDP conferences, the court next considered whether section 6330(b)(3) incorporates a “general requirement of impartiality.” The court found it unnecessary to answer this question, as the taxpayer’s allegations of bias “were not borne out by the totality of the record.”

Although the court’s interpretation of “prior involvement” may be a reasonable reading of “Question and Answer 4” of Treas. Regs. § 301.6330-1(d)(2), which addresses “prior involvement,” it is not a reasonable reading of the statute itself, which unambiguously provides that the hearing shall be conducted by an hearing officer “with no prior involvement.” In the end, the Tax Court’s decision may have been informed by what it referred to as the “practical realities” that “Appeals Offices are small with limited staff, [and that] a construction that would progressively disqualify an entire office . . . would be unworkable.” Whether or not this observation is true is irrelevant, since the statutory language is clear. Moreover, meaningful judicial review without a written or audio record of the CDP hearing appears impossible where judicial review is entirely predicated on contemporaneous notes of an Appeals Officer who has adversely decided the taxpayer’s case. The decision appears flawed.

Many wills drafted prior to EGTRRA employ “formula” clauses eliminating estate tax on the death of the first spouse by creating a “credit shelter” trust funded with assets equal to the unused applicable exclusion amount (AEA), and then distributing the remainder of the residuary estate to the surviving spouse outright or in a marital deduction trust, such as a QTIP. The combination of the unified credit and marital deduction result in no tax at the first death.

Anyone, including the surviving spouse, may be a beneficiary of the credit shelter trust, but to qualify for the QTIP marital deduction, only the surviving spouse may possess rights to income or principal. In fact, the surviving spouse must alone have the right to receive all income from the QTIP trust, paid at least annually, and no other person may be a beneficiary of that trust during the surviving spouse’s life.

With the AEA reaching new levels far exceeding previous amounts, and with many states, including New York, “decoupling” their own estate tax and retaining lower threshold levels for the imposition of estate tax, older formula clauses may produce unintended results.

The AEA rose to $2 million on January 1, 2006, and will increase to $3.5 million in 2009. The danger exists that by funding the nonmarital (credit shelter) trust with the maximum amount that can be shielded by the AEA, the surviving spouse might be unintentionally disinherited. Particularly in cases where the estate is less than $4 million and the surviving spouse is not granted distribution rights to the nonmarital trust, consideration should be given to capping the formula clause allocation to the nonmarital trust at a level substantially below the AEA, perhaps at an amount no greater than the amount that can pass free of New York estate tax.

Nevertheless, by capping the nonmarital share and increasing the marital share, a new problem arises: The estate of the surviving spouse might become subject to estate taxes. Fortunately, this problem can be avoided by funding a second nonmarital trust with the excess of the applicable exclusion amount over the cap placed on the first nonmarital trust. The surviving spouse could even be the sole beneficiary of this trust, the assets of which would remain outside of her taxable estate since no QTIP election will have been made.

To illustrate, assume decedent dies in 2009 with a taxable estate of $5 million at a time when the AEA is $3.5 million. Nonmarital Trust #1 is funded with $1 million, the maximum amount that can pass free of New York estate tax. Nonmarital Trust #2 with $2.5 million, and the QTIP Trust with $1.5 million. Nonmarital Trust #1 and Nonmarital Trust #2 make full use of the AEA. The surviving spouse is granted the same distribution rights to Nonmarital Trust #2 as she is to the QTIP. Nonmarital Trust #2 will not, however, be included in her taxable estate because no QTIP election will have been made.

Now consider New York estate tax consequences: New York’s AEA is $1 million, frozen at pre-EGTRRA levels. Nonmarital Trust #1 therefore makes full use of New York’s excludible amount. Does this mean that Nonmarital Trust #2 will attract New York estate tax?  Not necessarily. Even though no federal QTIP election will be made for Nonmarital Trust #2, since New York has “decoupled” its estate tax from the federal estate tax regime, that trust might still qualify for the unlimited marital deduction for New York state estate tax purposes. If this strategy succeeds, Nonmarital Trust #2 would be includible in the surviving spouse’s estate for New York, but not for federal, estate tax purposes.

This plan would (i) eliminate New York (and federal) estate tax completely on the death of the first spouse without overfunding the federal QTIP which will be subject to federal estate tax at the death of the surviving spouse; while (ii) providing maximum benefits to the surviving spouse. Even if no New York marital deduction is allowed for estate tax purposes, the assets in Nonmarital Trust #2 — a trust over which the surviving spouse will have substantial rights — will not be included in her federal taxable estate, because no QTIP election will have been made with respect to it.

New basis rules to take effect in 2010 eliminate basis step-up in favor of a transferred basis regime. However, a $3 million basis increase will be allowed for property passing to a surviving spouse outright or in a QTIP trust; and a $1.3 million basis increase will be allowed for assets passing to any beneficiary, including the surviving spouse. Once these two permitted basis increases are exhausted, beneficiaries will receive assets without any basis increase. To avoid conflict among beneficiaries, the will could provide that assets should be allocated to the nonmarital share in a manner fairly reflecting the appreciation and depreciation in all assets available for allocation.

Property passing to the surviving spouse in a general power of appointment trust will not be treated as an asset of that spouse  for purposes of her estate’s own $1.3 million aggregate basis increase. Therefore, if such a trust is used, the surviving spouse should be given $1.3 million in appreciated assets outright, or the trustee should distribute sufficient principal so that her estate can make full use of her own aggregate basis increase.

The Tucker Act, 28 U.S.C. §1491 (1887), granted the U.S. Claims Court jurisdiction to “render judgment upon any claim against the United States founded . . . upon the Constitution,” waiving sovereign immunity with respect to lawsuits arising out of express or implied contracts to which the government was a party. Suits may be brought for Constitutional claims seeking a refund of taxes.

In Clinton Elkhorn Mining Co.,
SCt. 2008-1 USTC ¶50,281, the taxpayer sought a refund for Coal Tax collected in violation of the Export Clause of the Constitution. IRC §7422(a) provides that “no suit or proceeding shall be maintained in any cout for the recovery of any internal revenue tax . . . until a claim for refund or credit has been duly filed.” Under IRC §6511(a), a refund claim must be filed within three years of the date of filing of the return, or within two years of when the tax was paid, if later.

The taxpayer argued that the Code’s refund scheme was “constitutionally dubious” and that the refund rules did not apply to taxes are unconstitutional on their face. The Court rejected both arguments. The appearance of the word “any” five times: “any court,” “any internal revenue tax,” “any sum,” “in any manner,” indicated that Congress intended the state to be expansive. Furthermore, the language “any manner wrongfully collected” applied provision subsequently held unconstitutional.

IRC § 2036 emerged as a potent IRS weapon against FLP valuation discounts. The 5th Circuit in Estate of Strangi, 417 F.3d 468 affirmed the Tax Court’s decision that partnership assets over which the decedent had retained beneficial enjoyment were includible in the estate pursuant to §2036(a)(1). Further, while the transfer of FLP interests to his children may have been for full and adequate consideration, no “substantial business or other non-tax purpose” existed and no bona fide sale occurred. Since the decedent also controlled beneficial enjoyment by others, inclusion also resulted pursuant to §2036(a)(2).

Sec. 2036(a)(1) also resulted in inclusion in Estate of Abraham, 408 F.3d 26 (1st Cir.), where the the Tax Court found an implied agreement that the decedent’s needs were actually treated as a partnership obligation. The 1st Circuit, affirming, also found that (i) the children’s purchase of partnership units were not bona fide sales since the decedent’s guardian could divert partnership income to the decedent; and (ii) the estate had not established that the children paid adequate consideration for their interests.

Estate of Bongard, 124 T.C. 95, found an implied agreement to retain a lifetime benefit from the partnership, thus precluding the possibility of a bona fide sale for adequate consideration. The opinion emphasized that the nontax reason for the family partnership must be a significant factor and not merely a theoretical justification. Similarly, in Estate of Bigelow, T.C. Memo 2005-65, the Tax Court, noting that the decedent had transferred so much of her property to the partnership that she was unable to support herself, found an implied agreement that the decedent would retain beneficial enjoyment of partnership assets. The decedent was trustee of a trust which was the sole general partner of an FLP of which the children were limited partners.

However, in Estate of Schutt, T.C. Memo 2005-13, the Tax Court found that neither § 2036(a)(1) nor § 2038 applied to a decedent’s transfer of substantial assets to business trusts. His desire to perpetuate investment philosophy was a legitimate purpose of the transaction, intending to protect the family’s wealth by providing for centralized management of the family’s holdings in duPont stock.

To reduce the risk of challenge under § 2036(a)(1) or (a)(2), the following points should be considered:

¶ Avoid commingling of partnership and personal assets;

¶  Retain sufficient assets so that no agreement granting the donor enjoyment rights over the transferred assets may be reasonably implied;

¶   Report management fees paid to the donor or children and pay self-employment taxes associated therewith;

¶ Ensure that limited partnership interests are acquired by cash or property transfers and that such purchases are documented;

¶  Allow a reasonable period of time to elapse before gifted cash is used to purchase limited partnership interests;

¶ Commence planning when the donor is in reasonably good health if possible, since testamentary transfers are more likely to fall prey to an IRS claim of a lack of a bona fide sale;

¶ Avoid permitting the donor to be the sole general partner or the sole managing member; and

¶ Prohibit non-prorata distributions.

Taxpayers fared better in cases where only the size of the discount was in issue. In Estate of Baird, 416 F.3d 442, the Estate claimed a 60% discount for lack of marketability. The IRS argued that only a 5% discount attributable to the cost of partitioning the timberland property, was appropriate. The 5th Circuit affirmed a Tax Court decision allowing a 60% discount, and further, finding the government’s position not substantially justified, allowed an award of attorney’s fees.

In Estate of Kelly, T.C. Memo 2005 235, a 32.24% valuation discount was allowed for an FLP holding only cash and certificates of deposit. The court allowed a 12% minority discount, reflecting the members’ lack of control, and a 23% marketability discount, reflecting the lack of a market for the closely held limited partnership interests. The case seems to refute the notion that FLPs holding only marketable securities cannot produce substantial discounts.

In Estate of Jelke, T.C. Memo, 2005-131, the discount for unrecognized capital gains recognized in Eisenberg (2nd Cir., 1998), Jameson (5th Cir. 2001) and Dunn (5th Cir. 2002) was reduced to reflect the likelihood that the company would not be liquidated for many years. The decision seems questionable, since it is appears to be settled law that in valuing assets for estate tax purposes, only those factors existing on the date of death should be considered. An appeal has been filed with the 11th Circuit.

Estate of Kahn, 125 T.C. No. 11, held that the estate tax value of IRAs may not be discounted for income taxes. The court noted that the issue of double taxation is adequately addressed by §691(c), which provides an income tax deduction for estate tax imposed on items of income in respect of a decedent (IRD).

In Estate of Senda, 88 TCM 8 (2004), the Tax Court refused to allow valuation discounts for gifts of FLP interests where the formation of the FLP and the gifts were contemporaneous. The Tax Court found that the transfer of stock to the FLP and the immediate gift of FLP interests were part of an integrated transaction to which the step transaction doctrine applied.

While acknowledging that a buy-sell agreement was a bona fide business arrangement, Estate of True, 390 F.3d 1210, nevertheless held that the agreement was not binding for estate tax purposes, since its testamentary intent was to transfer business interests to natural objects of the decedent’s bounty for less than adequate and full consideration. Similarly, Smith v. U.S., 2005-2 USTC ¶60,508 (W.D. Pa.) held that restrictions in the partnership buy-sell agreement should be disregarded in determining the value of gifted interests, since the taxpayer-donor had retained the unilateral ability to amend or modify the partnership agreement.

Estate of Tehan, T.C. Memo 2005-128 illustrates that business agreements among family members may be subject to close IRS scrutiny. The Tax Court held that the value of decedent’s condominium was includible in his estate where his children permitted him to live rent-free in exchange for his payment of real estate taxes, mortgage and maintenance. Since fair market value of rent substantially exceeded the costs being borne by the decedent, the court had little difficulty distinguishing Estate of Barrow, 55 T.C. 666 (1971), a case in which the decedent gave property to his children but rented it back at fair rental value.

Estate of Davies, 394 F.3d 1294 (9th Cir.), aff’g, T.C. Memo 2003-55 denied both a QTIP and general power of appointment marital deduction to a trust which failed to grant the surviving spouse the required lifetime income interest. The 9th Circuit rejected the argument that the trust’s failure was cured by California law, which construes a trust in light of a testator’s intent that the gift qualify for the marital deduction. Here, the trust failed to state an intent that the gift qualify for the marital deduction.

A different result was reached in  Sowder v. U.S., __F. Supp.2d __, No. CV-02-0136-WFN (E.D. Wash), where the IRS also denied a marital deduction. Washington state law requires that a bequest intended to qualify for the marital deduction be so construed. In this case, the decedent’s intent that the gift qualify for the marital deduction was established through contemporaneous estate planning documents. The foregoing cases demonstrate the importance of including in the will or trust document an explicit statement to the effect that the testator (or grantor) intends that the marital share qualify for the federal estate tax marital deduction.

In Matter of Goetz, 793 N.Y.S.2d 318, the court held that the taxpayer’s agent, who held a power of attorney, could not amend a revocable trust created by the principal. To eliminate this problem, the trust should explicitly permit an amendment by exercise of power of attorney provided the power of attorney itself specifically refers to amending the trust.

Under Tax Court procedure, a special trial judge often writes an opinion that is adopted by the trial judge, who may modify the opinion without disclosing this to the taxpayer. The taxpayer does not have access to the special trial judge’s opinion. The Supreme Court, in Ballard, 95 AFTR2d 2005-1302, held that the Tax Court may not exclude from the record on appeal reports submitted by the special trial judge, noting that no statute authorized such concealment, and the Tax Court’s own rules did not warrant such concealment. In response to the Supreme Court’s admonishment, the Tax Court has proposed that under Proposed Rule 183, the special trial judge’s recommended findings of fact and conclusion of law be filed and served on the parties, with a reasonable opportunity provided to file exceptions to such findings.

In TAM 9842003, the IRS rejected a 60% valuation discount claimed with respect to the transfer of $1.8 million of securities and real estate to a NY FLP created six weeks before the decedent’s death, claiming that (i) the partnership should be ignored for estate tax purposes because the transfers constituted a single testamentary transaction lacking substance; and (ii) the restrictions in the operating agreement were not the result of a bona fide business arrangement pursuant to §2703, and were more restrictive than applicable state law under §2704.

The qualified family owned business deduction (QFOB) provided by IRC §2057 is claimed on Schedule T of the Form 706. Double deductions with respect to the same decedent are prohibited by §2056(b)(9). The question arises how can an estate establish that QFOB property did not impermissibly pass to the surviving spouse or to a marital deduction trust? Estate of Reeves, 100 T.C. 427 (1993) suggests that a specific bequest of the §2057 shares into the credit shelter trust or a prohibition against the funding of the marital deduction trust with any §2057 shares would solve the problem. (Schedules M, i.e., for marital deduction, and T should not contain cumulative deductions.)

Codifying the position taken by the IRS in previous PLRs, Prop. Reg. §25.2702-3 provides that GRAT and GRUT annuity payments may not be paid with notes, since debt instruments cannot qualify as payment of the required annuity or unitrust amount. Therefore, a trust cannot qualify under §2702 unless the trust instrument prohibits the trustee from making payment by note. (It may be possible, however, for the grantor of an IDGT to take back notes after selling assets to the trust. See From Washington.)

§6501(c)(9) provides a 3-year limitation period for the IRS to challenge the value of taxable gifts “adequately disclosed” on the return. Although annual exclusion gifts do not require the filing of gift tax returns, Prop. Regs. §§20.2001-1 and 25.2504-2 provide that filing a gift tax return — even where not required — begins the limitation period. It may therefore be prudent to file for some §2503(b) gifts. Adequate disclosure (Prop. Reg. §301.6501(c)-1(f)(2)) comprehends a description of the relationship of the parties, a detailed description of the method used to determine FMV, including any relevant financial data, and any discounts claimed. Restrictions on the transferred property affecting value must also be articulated. Although failure to adequately disclose gifts empowers the IRS to challenge the value after three years, this should not (in theory) be considered probative of an unreasonable position.

1999 New York Legislation

New York repealed its gift tax with respect to transfers made after Dec. 31, 1999. On Feb. 1, 2000, New York’s unified credit for estate tax will rise to $1 million from $115,000. This change necessitates review of existing wills, since many wills allocate to the credit shelter amount the full federal AEA (§2010) plus an additional amount to account for the §2011 credit for state death taxes. Funding the credit shelter with an additional $48,485 currently results in no additional federal tax (i.e., §2011), and only $2,909 in additional NYS tax. As of Feb. 1, 2000, this analysis will change: No NYS tax will be owed on $675,000 (and no ET-90 will need to be filed). Allocating $52,174 more to the credit shelter amount will still result in no additional federal tax (§2011), but will cause the imposition of $19,304 in NYS tax (i.e., §2011). Existing wills should be revised to limit the credit shelter to the §2010 amount.

EPTL § 7-1.1 abolished the merger doctrine, which had invalidated trusts in which the sole grantor was also the sole beneficiary. This change facilitates the use of revocable living trusts, and also credit shelter trusts where the surviving spouse is the sole beneficiary. EPTL § 10-10.1, which prevents a trustee from exercising a discretionary power in his or her favor, was amended to exclude revocable trusts but not credit shelter trusts. Consequently, a surviving spouse named as sole trustee of a credit shelter trust should not be granted discretionary powers.

NY revised its LLC statute effective August 31. Since §701 governing dissolutions, now explicitly references the terms of the operating agreement, it may be possible to avoid the unwanted application of §2704(b).

PLR 200540004 illustrates the importance of carefully drafted marital trusts. The federal estate tax return incorrectly claimed a deduction for only the actuarial value of the spouse’s income interest, rather than for the entire interest, including the remainder interest. The IRS would not grant an extension of time to make a correct QTIP election, reasoning that an election to deduct the actuarial value of the spouse’s income interest constituted a partial QTIP election which could not be amended.

Proposed Regs (NPRM REG 147775-06) provide guidance with respect to circumstances in which a transferor may request an extension of time in which to allocatino a generation-skipping transfer (GST) exemption to a transfer pursuant to IRC §2642(g)(1).

Proposed Regs have been issued which provide that in any state which requires a deed to be recorded in a public index before being valid, a notice of federal tax lien (NFTL) will not meet the filing requirements until it is both filed and indexed in the appropriate office. (NPRM REG-141998-06).

Notice 2008-46 provides additional guidance concerning return preparer penalty provisions of IRC §6694. The guidance adds certain returns to which preparer penalties may apply, including Form 1040NR, Form 1040-SS, various Forms 1120 and various information returns relating to foreign persons and entities.