IRS & NYS DTF MATTERS: Recent Developments & 2015 Regs. & Rulings of Note

May 2016 FD

Tax News & Comment — May 2016 View or Print

IRS Issues Final Regulations on Portability

The Treasury and the IRS have released the final regulations on portability of a Deceased Spouse’s Unused Exclusion Amount (“DSUE amount”).  These regulations modify the Temporary Regulations issued on June 18, 2012. The final regulations became effective June 12, 2015. Several issues in connection with extensions of the deadline to elect portability are addressed.  First, no extension of time to elect portability will be granted under Reg. §301.9100-3 because the portability requirement is statutory and not regulatory. However, under circumstances addressed in Rev. Proc. 2014-18, in some cases a taxpayer may obtain a discretionary extension of time in which to file an estate tax return for the purpose of electing portability without the need to obtain a Private Letter Ruling. One such case would be the situation in which the taxpayer is not required to file an estate tax return by reason of the value of the gross estate and adjusted taxable gifts, without regard to portability.

The final regulations also clarify which individuals may elect portability.  The Internal Revenue Code requires that the election be made by the decedent’s “executor.” The final regulations clarify that although an individual may be deemed to be an executor if in possession of estate assets, an appointed executor has the right to make the portability election. The final regulations do not address whether a surviving spouse who is not an executor to make the portability election. Treasury affirmed its position that the IRS has broad authority under IRC § 2010(c) to examine the correctness of any estate return to determine the allowable DSUE amount without regard to the period of limitations on the return of the decedent. Whether an estate tax return is complete and properly prepared would be determined on a case-by-case basis by applying standards as prescribed in current law. Applicability of portability to a surviving spouse that becomes a U.S. citizen subsequent to the death of a spouse is addressed by the final regulations in favorable manner. The final regulations allow a surviving spouse to take into account the DSUE amount of the deceased spouse as of the date he or she becomes a U.S. citizen. Thus, the spouse would benefit from the DSUE for any subsequent lifetime transfers made. Of course, the estate of the deceased spouse must have made a portability election.

The Surface Transportation and Veterans Health Care Improvement Act of 2015

 The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (enacted July 31, 2015) created new Code §§ 6035 and 1014(f). IRC § 6035 provides that an executor required to file an estate tax return file a valuation statement with the IRS and with beneficiaries within thirty days of the earlier of (i) the date on which the estate tax return was required to be filed, or (ii) the date on which the estate tax return was actually filed. Only those estates that are required to file an estate tax return must file valuation statements. Executors that file an estate tax return to elect portability are not required to file valuation statements.

Valuation statements must identify the value reported on the decedent’s estate tax return for each property interest. A supplemental statement reporting any later adjustment in the value of the property must be filed no later than thirty days after the adjustment. For the purpose of penalties, the statement filed with the IRS is an information return, while the statement filed with beneficiaries is a “payee statement.” IRC § 1014(f) introduces the “consistent valuation rule.” Subsection (f) states that the basis of property acquired from a decedent shall not exceed the value determined for estate tax purposes or, for property the value of which has not been determined for federal estate tax purposes, the value identified in a valuation statement filed pursuant to IRC § 6035.

The purpose of Section 1014(f) is to prevent taxpayers from using a lower value for an asset in order to reduce estate tax while at the same time using a higher value to reduce gain for income tax purposes. The IRS made proposals similar to the consistent basis rule in its General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals. The Joint Committee on Taxation estimated that Section 2014(f) will raise $1.54 billion in revenues for the ten year period 2015 through 2025.

New Rulings and Procedures

The IRS made additions to the “no-rulings” list in Rev. Proc. 2015-37. With respect to all ruling requests received after June 15, 2015, the IRS will no longer rule on whether the assets in a grantor trust will receive a Section 1014 basis adjustment if they are not includible in the gross estate of the owner at death. This is an issue which has elicited a fair amount of commentary by tax attorneys. The prevailing and preferred view is that assets in a grantor trust not includible in the gross estate would not receive a basis step up.

In PLR 201544005, the IRS agreed with the taxpayer, and found that amending an irrevocable trust to correct scrivener’s error retroactively created a completed gift, which resulted in the avoidance estate taxation. Here, a husband and wife created an irrevocable trust for the benefit of their two children. They intended that transfers to the trust be completed gifts that would not be included in their gross estates. Gift tax returns were filed reporting the transfers as gifts. The settlors later discovered that transfers to the trust were not completed gifts, because they had retained the power to amend the trust to change the beneficial interests. At the request of the settlors, a local court amended the trust language to correct the error. The IRS respected the amendment because it effectuated the intent of the settlors.

Two recent rulings, PLRs 201507008 and 201516056 address the time at which contributions to a trust will be deemed as completed gifts subject to federal gift tax. In PLR 201507008, the IRS examined an irrevocable trust and the effect of settlor’s powers over distributions. The Service concluded that the settlor’s contributions were not completed gifts, reasoning that the settlor had retained lifetime and testamentary powers of appointment, as well as the power to veto distributions.  The IRS further determined that a distribution of income or principal by a “distribution adviser” to a beneficiary that was not the settlor was a completed gift. Upon the settlor’s death, the fair market value of the property remaining in the trust (less distributions made to beneficiaries) would be included in the settlor’s gross estate for estate tax purposes.

In PLR 201516056, the taxpayer’s proposed disclaimers of securities gifted by his wife prior to her death constituted qualified disclaimers. The disclaimers involved securities held in two accounts. With respect to the first account, securities transferred by the wife were a completed gift at the time of transfer. With respect to the second account, the wife added her husband as a joint owner with right of survivorship. That transfer became complete only upon the death of the wife. The disclaimers would be qualified with respect to the completed gift in the first account since the disclaimer occurred within nine months of the date of transfer of securities; and would be qualified with respect to the second account because the disclaimer was made within nine months of the date of death.

Treasury General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals

Treasury proposed changes in connection with estate tax procedures. The first involves broadening the term “executor,” thereby giving that person the authority to act on behalf of the decedent with respect to all tax matters, rather than only estate tax matters. The second would be that the special lien imposed under IRC § 6324(a)(1) for taxes deferred under IRC § 6166 be extended from ten years to fifteen years. Treasury General Explanations of the Administration’s Fiscal Year 2016 (the “Green Book”) proposed various changes involving capital gains: First, the capital gains tax would increase to 24.2 percent; second, the basis step up upon death would be eliminated; and third, gratuitous transfers of appreciated property (either by gift or at death) would be treated as a sale for income tax purposes, with the donor or decedent realizing capital gain at the time of the gift or death.

The following exceptions would apply to the somewhat draconian proposed third change:

(i) Taxes imposed on gains deemed realized at death would be deductible on any estate tax return of the decedent’s estate;

(ii) Capital gains on a gift or bequest to a spouse would not be realized until the spouse disposes of the asset or dies;

(iii) Each decedent would have a $100,000 exclusion for capital gains recognized by reason of death, portable to the decedent’s surviving spouse;

 (iv) Gifts or bequests to a spouse or charity would carry out the basis of the donor or decedent;

 (v) Appreciated property given or bequeathed to charity would be exempt from capital gains tax;

 (vi) The final income tax return of a decedent may utilize unlimited capital losses and carry-forwards against ordinary income;

 (vii) There would be no capital gain tax imposed on tangible personal property;

 (viii) The $250,000 per person exclusion for capital gain on a principal residence would apply to all residences, portable to the decedent’s surviving spouse; and

 (ix) A deduction would be available for the full cost of appraisals of appreciated assets.

Sales of assets to grantor trusts have also attracted the attention of Treasury, which proposed that the gross estate of a decedent deemed to own a trust under the grantor trust rules would include that portion of the trust attributable to a sale, exchange, or “comparable transaction” between the grantor and the trust, if that transaction was disregarded for income tax purposes. The gross estate would include any income, appreciation and reinvestments (net the amount of consideration received by the grantor) therefrom. These amounts would also be subject to gift tax at any time during the life of the deemed owner if grantor trust treatment terminated, or to the extent any distribution were made to another person.

New York State Matters

Determining Residency for Income Tax Purposes Where Property Straddles a Boundary Line

The NYS Department of Taxation and Finance (“DTF”) recently advised whether married taxpayers were residents of New York City for income tax purposes where their residence was located on both sides of the border separating the Bronx (a borough of New York City) and Yonkers. The taxpayers do not work in New York City or hold any other property located in New York City. New York (Tax Law § 605(b)), New York City (N.Y.C. Administrative Code § 11-1705(b)(1)(A)) and Yonkers (Yonkers Income Tax surcharge § 15-99) all define residence as the place where an individual is domiciled and maintains a permanent place of abode. The tax law defines “domicile” as “the place which an individual intends to be such individual’s permanent home.” (20 NYCRR 105.20(d)(1)). “Permanent place of abode” is defined as “a dwelling place of a permanent nature maintained by the taxpayer.” (20 NYCRR § 105.20(e)(1)).

TSB-A(15(8)I advised that a house meets the definition of “permanent place of abode” and that its location determines the residency of the taxpayers. Since the portion of the property located in the Bronx consisted entirely of vacant land, while the house itself was located in Yonkers, the taxpayers were domiciled in Yonkers rather than New York City. Although the TSB provides some clarity in this particular situation, questions still remain. DTF did not opine as to whether taxpayers would be treated as residents of either or both locations where a house straddles two different jurisdictions.

Interests in Disregarded Single Member LLCs are Tangible Property for New York Estate Tax Purposes

 A recent advisory opinion (TSB-A-15(1)M) stated that a membership interest in a single-member LLC disregarded for income tax purposes is not intangible property for New York State estate tax purposes. However, this result would not obtain if a single member LLC elected to be treated as a corporation. The New York resident  intended to transfer real property with a situs in New York to a non-New York LLC prior to moving permanently to another state. New York imposes estate tax on real property and tangible personal property that is physically located in New York. However, New York imposes no estate tax on a nonresident’s intangible property since such property is considered to be located at the domicile of the owner. New York regulations state that a single member LLC disregarded for Federal income tax purposes is treated as owned by the individual owner. Activities of the LLC are treated as activities of the owner. Thus, the New York real property held by a single member LLC that is disregarded for income tax purposes would be treated as real property held by the taxpayer for New York estate tax purposes.

There is a question as to the Constitutionality of the conclusion reached in this TSB since the New York Constitution prohibits the imposition of an estate tax on the intangible property of a nonresident, even if such property is located within New York State. While it is true that single member LLCs are ignored for federal income tax purposes, they are not ignored for other federal (or state) legal purposes. Therefore, it arguably an unjustified logistical jump to conclude that because the entity is ignored for federal income tax purposes, it should also be ignored for purposes of the New York State Constitution.

DTF Explains 2015 Legislative Amendments to Estate Tax Provisions Enacted in 2014

The year 2015 saw significant changes in New York estate tax. On April 13, 2015, the legislature enacted technical amendments which provided some clarity. DTF then issued a technical memorandum on July 24, 2015 explaining the amendments. (TSB-M-15(3)M). Some amendments clarify certain issues relating to the new three year “add-back” rule. The add-back rule provides that any gifts made within three years of death that are taxable for federal gift tax purposes will be added back to the New York taxable estate. The first amendment to the add-back rule provides that the rule will not apply to estates of decedents dying on or after January 1, 2019. A second specifically excludes from the scope of the rule any gifts of real or tangible personal property located outside of New York at the time the gift was made.Estate Tax § 960(b) was amended to disallow deductions related to intangible personal property for non-resident decedents otherwise available for federal estate tax purposes. The amendment is logical since intangible personal property is excluded from the taxable estate of a non-resident.

Another amendment made to the estate tax law in 2015 corrects a drafting error which would have resulted in the estate tax expiring on March 31, 2015. There was no tax rate schedule applicable after that date.  The tax tables have now been made permanent.

Neither the amendments nor the technical memo address a significant change to New York estate tax made effective in 2014. That change related to the exemption amount. Prior to 2014, an estate was only subject to estate tax to the extent that it exceeded the exemption amount. For the first time, estates considered too large could not benefit from the tax exemption at all. Under current law, if an estate exceeds 105 percent of the basic exclusion amount, the entire estate becomes subject to New York estate tax, rather than just the amount which exceeds the exemption amount. Those estates between 100 percent and 105 percent of the exemption amount are subject to a phase-out of the estate tax exemption. With the law remaining unchanged, marginal changes in the size of the New York estate may cause disproportionate differences in the amount of estate tax imposed. One means of easing the resulting burden would be to extend the phase-out of the exemption to apply to larger estates. A Senate budget proposal would have extended the phase-out of the exemption to those estates between 100 percent and 110 percent of the exemption amount. The proposal was not enacted.

Decanting Bill Passes Both Houses

 EPTL §10-6.6 allows trustees  to decant or transfer trust property from an existing irrevocable trust to another existing irrevocable trust or a new irrevocable trust. The statute provides that a trust decanting becomes effective within thirty days of notifying interested persons. Although current law allows interested parties to object to a decanting, it does not provide any mechanism for a trustee amendable to the objection from preventing the decanting from becoming effective by operation of law after thirty days. A bill passed by both houses would allow a trustee to void a proposed decanting in response to objections by interested persons. However, the bill would not grant interested parties any power to compel the trustee to void the decanting. Governor Cuomo has not signed the bill.

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Creating and Maintaining Flexibility in Wills and Trusts

May 2016 FD

Tax News & Comment — May 2016 View or Print

The principal objective when drafting wills or trust agreements is to best effectuate the intent of the settlor or testator, while at the same time ensuring that the most advantageous tax and legal objectives are met. Since the will may be revised only infrequently, and irrevocable trusts are difficult and some even impossible to amend, competently drafted instruments are at a premium. To ensure present and future viability, many legal and tax issues, some rather complex and others not intuitive, should be considered in drafting. Some are discussed below.

I. Decanting

“Decanting” describes the transfer of trust res from an existing irrevocable trust (the “invaded” trust) to a new or existing irrevocable trust (the “appointed” trust). EPTL § 10-6.6 allows the trustee to amend the terms of an irrevocable trust to accomplish any of the following desirable objectives: (i) to extend the termination date of the trust; (ii) to add or modify spendthrift provisions; (iii) to create a supplemental needs trust for a beneficiary who is or has become disabled; (iv) to consolidate multiple trusts; (v) to modify trustee provisions; (vi) to change trust situs; (vii) to correct drafting errors; (viii) to modify trust provisions to reflect new law; (ix) to reduce state income tax imposed on trust assets; (x) to vary investment strategies for beneficiaries; or (xi) to create marital and non-marital trusts. Decanting is becoming increasingly common in New York and other states. Although EPTL §10-6.6 applies by default, the trust should still define circumstances in which it should be utilized. If the settlor is opposed to decanting, the trust should also so state. As statutes go, this one is still relatively new; caution is therefore advisable when drafting. Following the precise statutory procedure is important.

II. Scope of Trustee Discretion

No Discretion

Eliminating trustee discretion with respect to distributions provides certainty to beneficiaries, and reduces the chance of conflict. Nevertheless, the trustee will also be unable to increase or decrease the amount distributed in the event of changed circumstances. If the trustee is given no discretion, the trust could also never be decanted, as a requirement of the New York decanting statute (as well as other states which have decanting statutes) is that the trustee have at least some discretion with respect to trust distributions.

Absolute Discretion

At the opposite end of the spectrum lie trusts which grant the trustee unlimited discretion with respect to distributions. If the settlor were the trustee of this trust, estate inclusion would result under IRC §2036 — even if the settlor could make no distributions to himself — because he would have retained the proscribed power in IRC §2036(a)(2) to “designate the persons who shall possess or enjoy the property or the income therefrom.” Disputes among beneficiaries (or between beneficiaries and the trustee) could occur if the trustee possesses absolute discretion with respect to trust distributions. By adding the term “unreviewable” to “absolute discretion,” the occasion for court intervention would appear to be limited to those circumstances where the trustee has acted unreasonably or acted with misfeasance. Another disadvantage of giving the trustee absolute discretion is that it diminishes asset protection, since the creditor will argue that the trustee should exercise absolute discretion to satisfy creditor claims. A beneficiary’s power to make discretionary distributions to himself without an ascertainable standard limitation would constitute a general power of appointment under Code Sec. 2041 and would result in inclusion of trust assets in the beneficiary’s estate, and would also decimate creditor protection. Still, a trustee vested with absolute discretion will find decanting easier to accomplish under the statute. And finally, it may also be the settlor’s desire that the trustee be accorded absolute discretion.

Ascertainable Standard

In the middle of the spectrum lie trusts which grant the trustee discretion limited to an ““ascertainable standard.” If the trustee’s discretion is limited by such an ascertainable standard, no adverse estate tax consequences should result if the settlor is named trustee. Since this degree of discretion affords the trustee some flexibility regarding distributions without adverse estate tax consequences, and now qualifies under the New York decanting statute, many settlors find this model attractive. The most common ascertainable distribution standard is that of “health, education, maintenance and support” (“HEMS”). In practice, the HEMS standard allows for considerable trustee discretion. Despite this flexibility, issues may arise as to what exactly is meant by the standard. Is the trustee permitted to allow the beneficiary to continue to enjoy his or her accustomed standard of living? Or is the trustee required to do that? Should other resources of the beneficiary be taken into account or not? To illustrate, a beneficiary living an extravagant lifestyle may request a distribution of $1 million to be among those to first travel into space. While the distribution could conceivably fall within the ambit of distributions allowing the beneficiary to continue to enjoy an accustomed standard of living, it would also likely raise the ire of remainder beneficiaries. Even a trustee granted absolute discretion to maintain a beneficiary in an accustomed standard of living might have a problem with such a request.
The trustee should be informed by the trust with respect to discretionary distributions. A clear and well drafted trust provision is the most effective way to convey the settlor’s intent. While some might object to the technical legal language required to effectively implement the settlor’s intent, there is unfortunately no simple way for a drafter attempting to create a lasting trust to best address unforeseeable circumstances without some complexity. Each possible future occurrence necessarily adds to trust complexity.

Asset Protection

The HEMS standard itself provides a fair amount of asset protection. In practice, it may be helpful to include another provision whose exclusive purpose is to further asset protection objectives. That provision is termed a “hold back” provision. Basically, when the terms of the provision are triggered (e.g., the beneficiary gets divorced or has a health problem occasioning astronomical costs) the trust would go into a “lockdown” mode unless and until the creditor threat ceases to exist. Although not a failsafe, the holdback provision is another arrow in the settlor’s quiver to protect the trust property from unforeseen creditor threats. Even though implied in law, most trusts also contain a “spendthrift”” provision, which bars alienation or transfer of trust assets. A holdback provision is a specific use of the concept of a spendthrift limitation.

III. Annual Accounting

The Uniform Trust Code (“UTC”) is a model code that has been adopted by a majority of states. UTC § 813(c) requires that trustees provide annual accountings to beneficiaries unless that requirement is waived within the trust instrument. Some settlors may believe this requirement places an excessive burden on trustees and may be economically unnecessary, particularly if the trust will last for decades. New York has not adopted the UTC. SCPA §2306 requires trustees to provide annual accountings to any beneficiary receiving income or any person interested in the principal of the trust if a request for an annual accounting is made. It may be desirable for the trust to waive the requirement of annual accountings. Although the SCPA does give the beneficiary the right to demand an annual accounting, trust language stating that the trustee is under no obligation to furnish an annual accounting might tend to minimize the frequency of unwanted requests.
Obviously, in some cases — such as where there is a corporate or bank trustee — the settlor might not want to condition annual accountings to situations where the beneficiary requests it, but might want to impose upon the trustee the obligation to furnish an annual account without any request by the beneficiary. If this is the case, the trust should so state. Bear in mind however that (barring misfeasance) accountings are paid for by the trust, and a bank will spare no expense in engaging legal counsel to ensure that the account is complete and accurate.

IV. Non-Beneficiaries’ Right to Information

New York has no statutory requirement that trustees provide information to individuals who are not beneficiaries. Thus, even the settlor might not be entitled to information concerning the trust. This could be problematic if the settlor retained the right to replace the trustee or trust protector. Therefore, if the trust grants the settlor or other non-fiduciary the power to remove a trustee, the trustee should be required to furnish such information (unless a compelling reason exists not to do so). Frequently, banks also require copies of trust instruments. Simply providing the first and signature pages of the trust may satisfy the banking institution. If not, the document should be redacted to exclude information not reasonably necessary for the bank in performing its due diligence. Although it is possible for a trust to be “silent,” meaning that the beneficiary does not even know of the existence of the trust, these cases are unusual. It is good practice to provide an inquisitive beneficiary with a copy of a trust (which may be redacted where appropriate). It is unclear whether the trustee is under such a legal requirement in New York. A beneficiary is not represented by counsel to the trustee, and communications between counsel for the trustee and the beneficiary are best kept to an minimum. This is true even though the interests of the beneficiaries are not adverse to that of the trustee. It is justified by the fact that it is the trustee who engages the attorney. As a corollary to this, the confidentiality privilege would likely not extend to communications between counsel to the trustee, and trust beneficiaries.

V. Disclaimers

EPTL § 2-1.11(d) provides that a disclaimant is treated as predeceasing the donor (or testator), or having died before the date on which the transfer creating the interest was made. Since the disclaimant is treated as never having received the property, a disclaimer qualified under federal law occasions no gift or estate tax consequences. To qualify under IRC §2518, property must pass to someone other than the disclaimant without any direction on the part of the disclaimant. However, with respect to a surviving spouse, the rule is more lenient. Estate of Lassiter, 80 T.C.M. (CCH) 541 (2000) held that Treas. Reg. §25.2518-2(e)(2) does not prohibit a surviving spouse from retaining a power to direct the beneficial enjoyment of disclaimed property, even if the power is not limited by an ascertainable standard, provided the surviving spouse will ultimately be subject to estate or gift tax with respect to the disclaimed property. The disclaimant may not have the power, either alone or in conjunction with another, to determine who will receive the disclaimed property, unless the power is subject to an ascertainable standard. Accordingly, it is important that the trust specify what happens to the disclaimed property if a disposition other than that which would occur under the existing will provisions is desired. To illustrate, assume John disclaims. The effect of John disclaiming would result in Jane receiving the property under the will. However, the will may be drafted to provide that if John disclaims, Susan will receive the property. The will cannot provide that if John disclaims, then either he or the executor may decide who receives the property. It would be permissible however to provide that if John disclaims, he may still receive a benefit under a marital trust in which he is a beneficiary.

VI. Dispositions Per Stirpes or By Representation

Most wills and trusts provide for a “per stirpes” distribution standard. This means that the decedent’s property is divided into as many equal shares as there are (i) surviving issue in the generation nearest to the deceased ancestor which contains one or more surviving issue and (ii) deceased issue in the same generation who left surviving issue. If the decedent had three children, each would take a third provided they all survive the decedent. Should one predecease, the predeceasing child’s children would share equally in their parent’s third.
If two children predeceased, each leaving differing numbers of children, there are generally two means of disposing of the grandchildren’s shares. Either each grandchild could take a proportionate share of his predeceasing parent’s third; or each grandchild could take a proportionate share of the sum of the two predeceasing children’s respective one third shares. If one predeceasing child had a single child and the other, nine children, the difference in the chosen standard becomes apparent. To illustrate, if the will provides for a per stirpital standard (which is not the default but is more common) then the grandchild (in the case described in the preceding paragraph) with no siblings would take 1/3(i.e., his parent’s), and the other 9 grandchildren would each take 1/27th (i.e., 1/9 of 1/3).  Conversely, if the will provides for distribution by representation (which is the default standard in New York but less common) then each of the 10 grandchildren would be treated equally, and each would take 1/15 (i.e., 1/10 of 2/3). New York has modified its statute in a novel way. Under New York law, the number of “branches” is determined by reference to the generation nearest the testator that has a surviving descendant. Therefore, if the will provides for a per stirpes distribution standard, and all of the children predecease the testator, then each grandchild is treated as a separate “branch.”

VII. Personal Liability for Actions of Co-Trustees

Trustees may be held personally liable for breach of fiduciary duty by a co-trustee. In Matter of Rothko, 401 N.Y.S.2d 449, 372 N.E. 291 (N.Y. 1977), The Court of Appeals found that an executor was liable for failing to challenge actions taken by co-executors. Rothko found that all three executors of an estate had breached their fiduciary duties where a contract was entered into which served the self-interest of two of the executors. Although one executor had not engaged in conduct benefitting himself (as had the other two) his failure to challenge actions taken by two other executors was itself a breach of fiduciary duty. The Court remarked:

[a]n executor who knows that his co-executor is committing breaches of trust and not only fails to exert efforts directed towards prevention but accedes to them is legally accountable even though he was acting on advice of counsel.

To diminish the possibility of a co-trustee being held accountable for the misfeasance of a co-trustee, the trust could contain a provision either requiring that a majority of trustees approve a major decision, with no liability to the dissenting trustee; or the trust could require unanimity. Requiring unanimity could also elevate the significance of trustee discord in situations not involving self-interest. Therefore, it might not be desirable. Simply inserting exculpatory language would probably be ineffective under Rothko. A trust instrument cannot absolve the trustee from failing to act in a fiduciary capacity.

VIII. Prudent Person Standard

The New York Prudent Investor Act (EPTL § 11-2.3) is effective for all trust investments made on or after January 1, 1995. It imposes an affirmative duty on trustees to “invest and manage property held in a fiduciary capacity in accordance with the prudent investor standard defined in this section.” The prudent investor standard (EPTL § 11-2.3(b)) provides that a trustee shall exercise reasonable care, skill and caution to make and implement investment and management decisions as a prudent investor would for the entire portfolio, taking into account the purposes, terms and provisions of the governing instrument. The statute further requires that trustees diversify assets unless they ““reasonably determined that it is in the interest of the beneficiaries not to diversify taking into account the purposes and terms and provisions of the governing instrument.” Compliance with the Prudent Investor Act is determined not by outcome or performance, but rather in light of facts and circumstances prevailing at the time of the decision or action of the trustee. Some factors that court will consider where a trustee fails to diversify are liquidity of assets, tax consequences, and settlor intentions (as demonstrated by the trust instrument). Although the Prudent Investor Act generally requires diversification, courts do not always find trustees liable for failures to diversify. Thus, it may be desirable to include a provision in trust instruments requiring diversification of assets.

IX. Exculpatory and Indemnification Clauses

A trusteeship imposes fiduciary obligations upon the person or company which assumes that office. By reason of the high standards of fealty to which a trustee is held, the trust may contain an exculpatory clause which exonerates the trustee for liability which might not otherwise be forgiven. Exculpatory clauses protect a trustee from personal liability arising from acts or omissions that do not amount to willful wrongdoing. Trusts may attempt to limit liability to the malfeasance of the trustee himself, but not of a co-trustee. However, as was the case in Rothko, the co-trustee cannot with impunity cast a blind eye to actions taken by another trustee acting with misfeasance. Without an exculpatory clause excusing some actions short of misfeasance, many persons would be reluctant to assume a trusteeship. Even so, both the Uniform Trust Code (§ 1008(b)) and the Restatement (Third) of Trusts (§ 96 cmt. d) provide a presumption of unenforceability for exculpatory clauses. To overcome that presumption, the clause must be fair and adequately communicated to the settlor. Obviously, a trust clause cannot exculpate bad faith, reckless indifference, or intentional or willful neglect.

Notably, New York has not adopted the UTC, and has no presumption against the enforcement of exculpatory clauses. Nevertheless, EPTL § 11-1.7(a)(1) does bar testamentary instruments from exonerating trustees from liability for failure to exercise reasonable care, diligence and prudence. However, New York statutory law is silent with respect to exculpatory clauses appearing in inter vivos trusts. New York case law has provided conflicting determinations in connection with the enforceability of exculpatory clauses appearing in inter vivos trust instruments. Although an exculpatory clause might not be enforced by a New York court, it may nevertheless be desirable to include such a clause, especially if the trustee is a family member, relative, or friend. There is less of a reason to include an exculpatory clause where the trustee is a bank or trust company. (In all likelihood, a bank or trust company would insist upon such a clause.) Indemnification clauses may be drafted in such as manner as to appear to entitle trustees (e.g., a bank) to indemnification for costs and legal fees incurred in actions concerning breach of fiduciary duty, unless it is proven that the trustees engaged in willful wrongdoing or were grossly negligence. Such clauses are presumptively unenforceable.  The First Department held unanimously in Gotham Partners, L.P. v. High Riv. Ltd. Partnership (2010 NY Slip Op 06149) that unless an indemnification clause of a contract is “unmistakably clear” and meets the “exacting”” test set forth twenty years previously in Hooper Associates v. AGS Computers (74 N.Y.2d 487), the victorious party in a contractual dispute will not be awarded attorney’s fees, regardless of the parties’ intent. This is consistent with the general proposition in most U.S. jurisdictions that the prevailing party may not generally recover legal fees from the defeated party in litigation. This promotes litigation but also encourages meritorious claims by persons with few resources. The U.S. view emphasizes one’s right to his “day in court.” The U.S. rule is in distinct contrast with the English Rule, where attorney’s fees are typically awarded.

X. Survivorship and GST Tax

The Generation-Skipping Transfer (GST) tax thwarts multigenerational transfers of wealth by imposing a transfer tax “toll” at each generational level. Prior to its enactment, beneficiaries of multigenerational trusts were granted lifetime interests of income or principal, or use of trust assets, but those lifetime interests never rose to the level of ownership. Thus, it was possible for the trust to avoid imposition of gift or estate tax indefinitely. The GST tax, imposed at rates comparable to the estate tax, operates for the most part independently of the gift and estate tax. Therefore, a bequest (i.e., transfer) subject to both estate and GST tax could conceivably require nearly three dollars for each dollar of bequest. The importance of GST planning becomes evident. The GST tax operates by imposing tax on (i) outright transfers to “skip persons” (“direct skips”); (ii) transfers which terminate a beneficiary’s interest in a trust (“taxable terminations”), unless (a) estate or gift tax is imposed or unless (b) immediately after the termination, a “non-skip” person has a present interest in the property; and (iii) transfers consisting of a distribution to a “skip person,” unless the distribution is either a taxable termination or a direct skip (“taxable distributions”).

IRC § 2651(e) provides an exception which allows a lineal descendant to “move up” a generational level where that decedent’s parent (who is also a lineal descendant of the transferor) is deceased at the time of the original transfer by the transferor. For example, where a gift is made to a grandchild whose parent predeceased the transferor, the grandchild will be deemed to be at the same generational level as his deceased parent and the GST tax will be inapplicable. With respect to trusts, an original transfer is deemed to occur on the date the trust is funded, and not on the date that a beneficial interest vests.
Treas. Reg. § 26.2651-1(a)(2)(iii) will treat the parent as predeceasing the transferor — thus falling within the exception which allows avoidance of the GST tax — if the descendant’s parent dies within 90 days of the transfer. The regulation would only apply if the trust actually provides that the descendant’s parent is deemed to have predeceased the transferor if the descendant’s parent dies within 90 days.  Thus, the inclusion of a “survivorship provision” in a will containing a testamentary trust could well achieve the result of avoiding the GST tax in some situations, such as where a simultaneous death occurs. The survivorship provision typically states that no person be deemed to have survived the decedent for purposes of inheriting under the will unless that person is living on the date 90 days after the decedent’s date of death. Since the applicable exclusion amount is now well over $5 million, the GST tax applies to relatively few people today. However, there may be other reasons for including a survivorship provision. Many testators would not want their entire estate to pass to their spouse if the spouse died within a very short period of time. Thus, survivorship provisions requiring survival for more than three months may be chosen. Longer survivorship provisions would also be consistent with the requirement for qualifying for the GST exception.

XI. Governing Law

If privacy is important, the settlor might choose Delaware as the situs of the trust. Delaware, as well as Nevada, also provide a greater degree of asset protection than would New York. States’ perpetuities periods also vary. It might be desirable for a trust to state that the laws of another state would control disputes arising under the trust, especially if the beneficiaries and trustees reside in another jurisdiction. There are limits to what choosing the governing law may achieve. While the trust may provide that another state’s governing law will control in many situations, it would not be possible — and would be against public policy — for a New York resident to deprive New York of its right to tax New York source income by stating that another jurisdiction’s law will control. In fact, in direct response to a tax planning technique explicitly permitted by the IRS, New York now treats income of a New York resident as New York source income and thus subject to tax in New York, in a manner different from how the income is treated for federal tax purposes. Therefore, defeating the ability of New York to impose tax on a trust having a nexus with New York would likely be impossible.

XII. Trustee Incapacity

The incapacity of a trustee would render the trustee incapable of fulfilling fiduciary obligations and in that sense would defeat the purpose of the trust. New York does not specifically refer to incapacity as a basis for removing a trustee. SCPA § 711 does provide a mechanism that permits co-trustees, creditors, and beneficiaries to commence trustee removal proceedings in Surrogates Court. However, Section 711 provides specific grounds for removal which at best only vaguely apply to incapacity. For example, SCPA §§ 711 (2) and (8) both authorize removal of a trustee that is unfit by reason of “want of understanding.” SCPA §711(10) permits removal where a trustee is an “unsuitable person to execute the trust.” Given the limited guidance provided by New York statute, trusts should define incapacity and provide a procedure for removing trustees believed to be incapacitated. Such provisions would be particularly helpful in the case of inter vivos trusts, which may generally be administered without court intervention.

Including clear language in an inter vivos trust could avoid the necessity of litigation, or reduce litigation costs if they are still necessary. One means of resolving the troublesome issue of removing an incapacitated trustee is to specifically provide within the trust that any trustee who is or becomes incapacitated shall be deemed to have resigned. A clear definition of incapacity should then be drafted.  Incapacity may be defined in a number of ways. Someone who is a minor, or who is legally disabled, or who has been incarcerated is considered “incapacitated” in a legal sense, and would clearly be unsuitable trustees. Perhaps the most common definition of incapacity of an acting or appointed trustee references a licensed physician who has examined the person within the preceding six months, and makes a written statement to the effect that the person is no longer competent to (or in the case of an appointed trustee, is not competent to) manage the business and legal affairs in a manner consistent with the manner in which persons of prudence, discretion and intelligence would, due to illness or physical, mental or emotional disability.

The trust may include procedures permitting a co-trustee (or, in the case were there is no trustee, a beneficiary) to compel a person suspected to be incapacitated to prove capacity as a condition to continue serving as trustee (or be appointed as trustee).
However, no trustee will appreciate being summoned by a beneficiary or co-trustee to prove competence, and the possible abuse of such a provision is evident. The settlor’s choice of trustee is paramount and beneficiaries should not have the power to remove trustees except as explicitly permitted in the trust or by commencing appropriate proceedings in Surrogates Court. Therefore, the use of such a provision should be carefully circumscribed to where deemed absolutely necessary.

XIII. Single Signatory

Where a trust has more than trustee, there may be a question as to whether all co-trustees need participate in actions taken on behalf of the trust. Such action could include the signing of a check, agreement or other legal document. For enhanced administrative efficiency, a trust could provide that the approval of only one trustee is required to evidence trustee approval of a legal action taken on behalf of a trust. Note that this type of provision would not conflict with a trust provision requiring that a majority of trustees approve a particular substantive decision; only that the approval may be evidenced by a single signature.

XIV. Portability and Marital Deduction Election

The concept of “portability” allows the estate of the surviving spouse to increase the available lifetime exclusion by the unused portion of the predeceasing spouse’s lifetime exclusion. Thus, the applicable exclusion of the surviving spouse is augmented by that of the predeceasing spouse. In technical terms, IRC § 2010 provides that the Deceased Spouse Unused Exclusion Amount (“DSUE,” pronounced “dee-sue”) equals the lesser of (A) the basic exclusion amount, or (B) the excess of (i) the applicable exclusion amount of the last such deceased spouse of such surviving spouse, over (ii) the amount of the taxable estate plus adjusted taxable gifts of the predeceased spouse. The basic exclusion amount for 2016 is $5.45 million. As the term “election” implies, portability is not automatic. An abbreviated Federal estate tax return must be filed. This raises the possibility of a Federal estate tax audit. This and other factors may result in a preference by the executor for funding a credit shelter trust instead of electing portability.

If, after funding a credit shelter trust there remains a portion of the applicable exclusion amount, portability may be elected with respect to that portion. If the amount is small, it may not make sense to elect portability, if the chance for an audit would be increased by reason of filing the estate tax return. All of this counsels for allowing the executor considerable discretion with respect to electing the marital deduction and portability, or absorbing as much of the exclusion amount as is available at the death of the first spouse.
The difference between electing portability and utilizing a credit shelter trust involves the weighing of a number of factors. When a credit shelter trust is funded, the trust may be funded with rapidly appreciating assets that will remain out of the estates of both spouses. However, there will be only one basis step up, and that will be at the death of the first spouse. If portability is elected, two basis step up opportunities will occur: the first at the death of the first spouse (since the assets are included in the estate even though the marital deduction will absorb any potential estate tax liability); and the second at the eventual death of the second spouse, which could be many years later.

If one presumes that the estate tax will be abolished by the time the second spouse dies, then the basis step up would be invaluable. However, if the estate tax (which seems to have nine lives) still exists, the benefit of a basis step up must be weighed against the possibility of a large estate tax at the death of the second spouse.  At the present time, the disparity between the capital gains tax and the estate tax is not so great as to be of monumental concern. This would seem to militate in favor of electing portability and foregoing the funding of a credit shelter trust, at least for tax purposes. However, important non-tax reasons might favor funding a credit shelter trust, such as providing for children in a second marriage situation. The following language grants the executor discretion with respect to electing the marital deduction and portability:

Notwithstanding any other provisions in this Will, my Executors are authorized, in their absolute and unreviewable discretion, to determine whether to elect under Section 2056(b)(7) of the Code and the corresponding New York State statute to qualify all or any portion of the residuary estate for the Federal (or New York) estate tax marital deduction and, to the extent that the law permits different elections, whether to elect to qualify any portion of the residuary estate for the New York State estate tax marital deduction only or for the Federal estate tax marital deduction only. I also grant my Executors absolute and unreviewable discretion with respect to whether to elect Federal portability or New York State portability, if the latter is available at that time. Generally, I anticipate that my Executors will endeavor to minimize both Federal and New York State estate tax liability of my estate and to seek the maximum basis step up available at my death and at the death of JOHN SMITH. In accomplishing that objective, I would expect that due consideration be given to the Federal estate tax payable upon the estate of JOHN SMITH, the availability of Federal (and perhaps New York State) portability, and the importance of the basis step up for income tax purposes both at my death and at the death of JOHN SMITH. Nevertheless, the determination of my Executors with respect to the exercise of the portability election shall be absolute, binding, unreviewable and conclusive upon all persons affected (or potentially affected) by the election.

XV. Children Born to Future Spouses

When drafting a trust with children as beneficiaries, one should consider the possibility that the settlor may have issue with another spouse. To prevent an unanticipated benefit to issue not intended to benefit from a particular trust, it might be desirable to be specific with respect to the exact identity of ultimate beneficiaries. The trust might limit the definition of the term “issue” to the issue of the spouses at the time the trust was settled.
It is also important to contemplate the possibility of after-born children. An after-born child has no interest in a trust in which only children recited to in the trust are designated. Including trust language taking into account possibility of after-born children may be prudent, especially if the spouses are young.

XVI. Trusts and S Corporations

Only certain trusts, i.e., (i) grantor trusts; (ii) Qualified Subchapter S Trusts; and (iii) Electing Small Business Trusts, may own S corporation stock. A grantor trust that becomes a nongrantor trust at the death of the grantor will no longer be an eligible S Corporation shareholder. Without some affirmative action, the S corporation election could be lost, with attendant adverse income tax consequences. Two options are available which will prevent the inadvertent termination of a S Corporation election. The first involves the trust making an election to be treated as a “Qualified Subchapter S Trust,” or “QSST.” To qualify as a QSST, IRC §1361(d)(3)(B) requires that trust instruments provide that all income be distributed annually to the sole trust beneficiary. An election must be made by the beneficiary to qualify the trust as a QSST. If the trust cannot qualify as a QSST because the trust instrument does not require all income to be distributed annually (i.e., the trustee is given discretion to distribute income) it cannot qualify as a QSST.

Qualification for a nongrantor trust may also be possible by making an election to be treated as an Electing Small Business Trust, or “ESBT” under IRC §1361(e). While it is somewhat easier for a trust to qualify as an ESBT rather than a QSST, there is a tax trade-off: A flat tax of 35 percent is imposed on the ESBT’s taxable income attributable to S corporation items. Income of a QSST is taxed to the beneficiary’s income tax rate. An ESBT does not require that all income be distributed annually. The ESBT election is made by the trustee, rather than by the beneficiary. The ESBT, rather than the income beneficiary, reports the beneficiary’s share of S Corporation income. Expenses of the trust will be allocated the Subchapter S interest of the Trust and the interest of the Trust consisting of non-S Corporation assets. Treas. Reg. § 1.1361-1(j)(6)(ii)(A).

Testamentary trusts may own S Corporation stock for the two-year period beginning on the date the stock is transferred to the trust. Following that two-year period, the trust must qualify as a QSST, an ESBT, or a grantor trust for the S Corporation election to continue. During the two-year period in which the trust owns S corporation stock, tax must be paid by the trust itself if no other person is deemed to be the owner for Federal income tax purposes. In light of the complexity and importance of making these elections, the will or trust should contain explicit language. The trust may direct the trustee to separate any shares of S Corporation stock into a separate trust intended to qualify as a QSST or ESBT. It may also be desirable to permit the trustees to amend the trust such that it would qualify to hold stock in an S Corporation or it could be converted from a QSST to an ESBT, or vice versa. Allowing the trustee to elect either QSST or ESBT status is particularly significant in light of the 3.8 percent net investment income tax now imposed on trusts. The surtax is only imposed on passive income and is not imposed on income resulting from “material participation” in a business by the taxpayer. The trust beneficiary is deemed to be the taxpayer for purposes of determining material participation in the case of a QSST. Conversely, it is the trustee who is deemed to be the taxpayer for the purpose of determining material participation of an ESBT. This highlights the importance of being able to convert an ESBT to a QSST. It may be beneficial for a trust to convert to a QSST where a beneficiary, and not the trustee, materially participates in the business activities of the corporation in order to avoid the 3.8 percent surtax

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Escaping the Quandary Posed by Unreported Foreign Accounts

May 2016 FD

Tax News & Comment — May 2016 View or Print

 Many U.S. taxpayers have at least one financial account located in a foreign country. Failure to report an offshore account carries with it possible civil and criminal penalties. Foreign account reporting requirements are provided for under the Bank Secrecy Act, enacted in 1970. The legislation was intended to assist U.S. investigators in preventing offshore tax evasion and in tracing funds used for illicit purposes. Actual reporting of foreign accounts and the filing of Foreign Bank and Financial Account Reports (FBARs) has been required since 1972, but the rule had been largely ignored by taxpayers., prompting Congress to amend the requirements.

Amended FBAR regulations became effective in 2011. 31 C.F.R. § 1010.350 now provides that each “United States person” having a financial interest in, or “signature authority” over, a bank, securities, or other financial account in a foreign country must file an FBAR. A United States person includes U.S. citizens and residents, and domestic corporations, partnerships, estates, and trusts. Having signature authority over a foreign financial account means that the person can control the disposition of money in the account by sending a signed document to, or orally communicating with, the institution maintaining the account. The FBAR has proven to be an effective tax compliance tool for the IRS, since penalties may be imposed upon taxpayers maintaining foreign accounts which earned no income. This unfairness led to the inauguration of a “streamlined” disclosure program, discussed below.

31 C.F.R. § 1010.306(c) provides that an FBAR must be filed if the aggregate value of all foreign financial accounts is more than $10,000 at any time during the calendar year.  Therefore, a U.S. person who owns  several small financial accounts in various countries, whose total value  exceeds $10,000 at any time during the calendar year, would be required to file an FBAR.  Some exceptions to the FBAR filing requirement exist. For example, no FBAR is required to be filed by the beneficiary of a foreign trust.   The FBAR must be filed by June 30.  (Form TD F90-22.1).  The existence of foreign financial accounts is reported by checking the appropriate box on Schedule B of Form 1040.  31 C.F.R. § 1010.306(c).  Extensions given by the IRS for income tax returns will not operate to extend the FBAR filing deadline of June 30.

The civil penalty for failure to file the FBAR is $10,000 for each non-willful violation. Where a taxpayer willfully fails to file, civil penalties are the greater of $100,000 or fifty percent of the highest balance of the unreported account per year, for up to six years. Criminal penalties for willful violations run as high as $500,000, with the possible sanction of imprisonment for up to ten years. Those taxpayers required to file FBARs may also be required to file Form 8938 (Statement of Specified Foreign Financial Assets) if the amount of assets exceeds a certain threshold.

Form 8938 is required if the taxpayer has foreign financial accounts (or other specified foreign financial assets) exceeding $50,000 ($100,000, if married filing jointly) on the last day of the tax year or $75,000 ($150,000, if married filing jointly) at any time during the tax year. For  the purpose of Form 8938, specified foreign financial assets include partnership interests in foreign partnerships, notes or bonds issued by a foreign person, and interests in foreign retirement plans. Note that taxpayers are not required to report ownership of foreign real property on Form 8938, as Form 8938, as well as the FBAR, operate exclusively to apprise the Service of the existence of foreign financial accounts. Failure to file Form 8938 may result in a penalty of $10,000, even if the foreign assets were actually reported on the FBAR.

Other information returns that may be required for persons owning foreign assets include (i)  Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts); (ii) Form 3520-A (Annual Information Return of Foreign Trust with a U.S. Owner; (iii) Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations); (iv) Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business); (v)  Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation); and (vi) Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund).

Remedies for Taxpayers Who Have Failed to Report Foreign Assets, Foreign Accounts, or Foreign Source Income

Taxpayers who have failed to report foreign source income or foreign assets may be eligible to participate in a disclosure program. Acceptance into the OVDP program is conditioned upon IRS approval following partial disclosure. Those participating in a disclosure program enjoy the elimination of exposure to criminal sanctions, and may incur fewer tax penalties. Participation in these programs can only occur if the taxpayer has not been subject to audit. The existence of an audit will result in all bets being off for the taxpayer. One downside to electing to apply for the OVDP programs is that if the taxpayer is ultimately not accepted into the program, he may have provided the IRS with a blueprint for audit. Taxpayers not participating in any program may instead choose to make a “soft disclosure” by filing all required returns with the hope that no tax audit occurs within the applicable period of limitations. Currently, the following four disclosure programs exist:

(i) the Offshore Voluntary Disclosure Program (the “OVDP”);

(ii) the Streamlined Filing Compliance Procedures (the “Streamlined


(iii) the Delinquent FBAR Submission Procedures (the “FBAR Procedures”);


(iv) the Delinquent International Information Return Submission Procedures (the

“International Return Procedures”).

The Offshore Voluntary Disclosure Programs

To penalize more sharply taxpayers who have willfully failed to report foreign financial assets and to ease the burden on taxpayers who have non-willfully failed to comply with foreign reporting requirements, the IRS modified the Offshore Voluntary Disclosure Program (OVDP) on July 1, 2014. Subsequent to the modifications, the OVDP has generally remained the best available disclosure option for taxpayers who have acted willfully. Taxpayers falling into the non-willful category may seek to participate in the Streamlined Procedures.


The OVDP permits taxpayers who have willfully failed to disclose foreign accounts to correct past non-compliance. Taxpayers accepted in the OVDP program will avoid criminal prosecution and benefit from fixed, ascertainable penalties. A taxpayer may be accepted into the OVDP program if no audit or investigation has been commenced, or if the IRS has not received information from a third party concerning non-compliance. Understandably, taxpayers maintaining offshore accounts housing illegal sources of funds may not qualify for relief under the program.

To participate in the current OVDP, taxpayers must first make a partial disclosure. The modified OVDP now requires the disclosure of more information at this pre-clearance stage. In addition to taxpayer identifying information, information concerning financial institutions, foreign entities, and domestic entities at issue must also be provided. The IRS will notify taxpayers  within thirty days concerning whether conditional acceptance has been approved. Taxpayers that obtain pre-clearance to enter the OVDP must make the next required submission within 45 days. That submission consists of a narrative identifying the accounts, the location of the accounts, and the source of the income of the offshore accounts. IRS Criminal Investigations will review the submission and issue notification within 45 days.  Taxpayers passing the second submission stage are allowed 90 days in which to make a final disclosure submission, which includes copies of previously filed original tax returns, as well as amended tax returns, for the prior eight tax years. Payment of tax on unreported income, as well as an accuracy-related penalty of twenty percent, and interest, must be paid as part of the final disclosure submission.

Following the IRS review and approval of the final disclosure submission, the taxpayers will be furnished with a closing agreement, setting forth the penalty structure. Taxpayers may make an irrevocable election to forego the closing agreement and instead submit to a standard audit. Taxpayers opting to not execute the closing agreement will not forego protection against criminal prosecution provided the taxpayer continues to cooperate. The “miscellaneous penalty” imposed on taxpayers accepted into the OVDP is equal to a percentage of the highest aggregate value of foreign accounts. That percentage is 27.5, rising to fifty percent if the foreign financial institution holding the account is under investigation by the IRS or the Department of Justice. The IRS publishes an updated list of these “blacklisted” institutions on its website. The number of such institutions has increased steadily, and consisted of ninety-five institutions as of February 5, 2016.

The Streamlined Procedures

Recent modifications to the OVDP created for the first time a separate filing procedure for taxpayers who non-willfully failed to comply with reporting requirements. Unlike the OVDP, the “Streamlined Procedures” provide no assurance that criminal prosecution will be avoided. The Streamlined Procedures are, as its name implies, simpler than the procedures involved in participating in the OVDP. Multiple submissions are not required. Instead, participating taxpayers submit all required documentation in one phase. The Streamlined Procedures also require the submission of fewer tax returns. While the OVDP requires the submission of eight years of amended income tax returns and information returns (e.g., FBARs and Form 8938) , the Streamlined Procedures require only three years of amended income tax returns (and the payments of associated taxes, interest, and penalties), six years of FBARs and three years of any other information returns (e.g., Form 8938). The Streamlined Procedures impose significantly lesser penalties than the OVDP. Eligible taxpayers residing in the United States, in addition to paying tax (and applicable penalties, if any) on unreported income, must pay a miscellaneous offshore penalty equal to five percent (rather than 27.5 or fifty percent, as the case may be) of the highest aggregate year-end value of the unreported foreign financial assets. Non-resident taxpayers are exempt from the miscellaneous offshore penalty.

Only individual taxpayers (including estates of deceased taxpayers) may participate in the Streamlined Procedures. An important part of the submission consists of the Certification: Participating taxpayers must certify that their failure to report all income, pay all tax, and submit all required information returns was due to non-willful conduct. As with the  OVDP, participation is excluded if the IRS has initiated a civil examination of taxpayer’s returns for any taxable year or has commenced a criminal investigation. So too, electing to participate in the Streamlined Procedures precludes participation in the OVDP and vice versa. Although the Streamlined Procedures impose lower penalties than the OVDP, there is less assurance that the taxpayer will be accepted, since he must demonstrate that the failure was non-willful. Again, failing to be accepted into the program will result in the IRS possessing a significant amount of information which it may then use in an audit, be it civil or criminal.

The element of non-willfulness in failing to properly report and pay tax must be shown by means of a detailed narrative. The IRS will reject submissions which it finds lack sufficient detail. As noted, there is also a risk that the IRS will determine that individual taxpayers in fact acted willfully, thus opening up a potential Pandora’s box. According to the IRS (but not necessarily the Courts), “non-willful” conduct is conduct due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law. In determining whether a taxpayer has acted non-willfully, the IRS states that it will consider the facts and circumstances. However, the IRS has provided little guidance as to specific circumstances that will be considered. Further, there is a dearth of case law providing clarity on this issue.

The Fourth Circuit recently determined that a taxpayer acted willfully by failing to disclose the existence of a foreign account by falsely checking the box “no” on Schedule B (which elicits a response concerning the existence of a foreign account.) United States v. Williams, 489 F. App’x 665 (4th Cir. 2012), reasoned that the question instructed taxpayers to refer to the FBAR instructions, putting the taxpayer on notice with respect to  FBAR requirements. The Court remarked that willfulness can be inferred from a conscious effort to avoid learning about reporting  requirements . . . and may be inferred where a defendant was subjectively aware of a high probability of the existence of a tax liability, and purposely avoided learning the facts. The Court dismissed as irrelevant the claim that the taxpayer had not in fact reviewed the return.

In determining willfulness, the IRS may also consider the source of funds held in foreign account. The Service is more likely to find a taxpayer acted willfully if the foreign financial account either produced unreported income or if the source of funds of the foreign financial account derived from unreported foreign source income. The IRS may also consider the financial sophistication and education of the taxpayer, any history of tax compliance (or lack thereof) by the taxpayer, and also whether the taxpayer disclosed the existence of foreign accounts to the return preparer or tax preparer.

III.  Delinquent FBAR Submission Procedures and Delinquent International Information Return Procedures

Delinquent FBAR Submission Procedures

The Delinquent FBAR Submission Procedures (“Delinquent FBAR Procedures”) supersede provisions of the OVDP existing prior to the OVDP modifications. Those terms provided for automatic exemption from penalties where the taxpayer had no unreported income and whose only failure consisted of not filing FBARs (or filing inaccurate FBARs). The FBAR Submission Procedures made no changes to OVDP provisions which it superseded. To qualify for the Delinquent FBAR Procedures, the taxpayer must not be under a civil examination or criminal investigation and must not have been taxpayers must have been contacted by the IRS concerning an audit or delinquent information returns.

Delinquent International Information Return Submission Procedures

The Delinquent International Information Return Submission Procedures (“International Return Procedures”) also supersede provisions of the OVDP existing prior to the OVDP modifications. Those terms also provided for an automatic exemption from penalties where the taxpayer had no unreported income and whose only failure related to the non-filing of international information returns other than FBARs (or the failure to file accurate international information returns that were not FBARs). Applicable international information returns include, but are not limited to, Form 8938, Form 3520, and Form 5471.

As is the case with the Delinquent FBAR Procedures, taxpayers must not be under either a civil examination or criminal investigation, or have been contacted by the IRS concerning an audit or delinquent information returns.  However, Unlike the Delinquent FBAR Procedures described immediately above, the International Return Procedures apply to taxpayers irrespective of whether there was or was not unreported income.  In addition, penalties may now be imposed if the taxpayer cannot demonstrate reasonable cause for the failure to file the required information returns.

The IRS has elaborated that longstanding authorities regarding what constitutes reasonable cause continue to apply, citing as examples Treas. Reg. §§ 301.6679-1(a)(3) and 1.6038A-4(b), and 301.6679-1(a)(3).  § 301.6679-1(a)(3) provides that a taxpayer that exercises ordinary business care and prudence has reasonable cause. § 1.6038A-4(b) provides that the determination of whether a taxpayer acted with reasonable cause is made considering all the facts and circumstances. Circumstances that would qualify as reasonable cause include honest misunderstanding of fact or law, as well as reasonable reliance on the advice of a professional.

Treas. Reg. §301-6724-1 provides a list of factors that may demonstrate reasonable cause. For example, reasonable cause is more likely to be found to exist where the taxpayer has an established history of compliance (Treas. Reg. §301-6724-1(b)(2), where the compliance failure concerned a requirement that was new for a particular taxpayer (Treas. Reg. §301-6724-1(b)(1)), or where the compliance failure was due to events beyond the control of the taxpayer (Treas. Reg.  §301-6724-1 (c)).

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Like Kind Exchanges Alive and Well: An Update

May 2016 FD

Tax News & Comment — May 2016 View or Print

Attempts by the Obama administration to curtail or eliminate IRC § 1031 exchanges were decidedly unsuccessful. Based upon their pronouncements, neither Ms. Clinton nor Mr. Trump would be expected to attempt to curtail the statute. Increased tax rates and increased real properly values have rekindled interest in deferred exchanges. Most of the litigation, and many of the PLRs issues in past two years have involved the (i) related party exchanges under IRC §1031(f); (ii) the qualified use requirement under IRC §1031(a)(1); reverse exchanges under Rev. Proc. 2000-37; and (iv) “LKE programs” pursuant to Rev. Proc. 2003-39.  In North Central Rental & Leasing, LLC v. U.S., No. 13-3411 (8th Cir. 2015), the Court of Appeals upheld a determination that 398 (essentially identical) exchanges made by the taxpayer were invalid under because they were structured to avoid the related-party exchange restrictions under Section 1031(f). The Court found that exchange transactions were unnecessarily structured to involve and provide a cash windfall to an entity related to the taxpayer.

Taxpayer Northern Central Rental & Leasing (““Northern Central”) was a 99 percent subsidiary of Butler Machinery. Both Butler Machinery and Northern Machinery conducted businesses relating to agricultural, mining and construction equipment. Butler Machinery sold equipment, while Northern Machinery rented and leased equipment. The exchange transactions allowed North Central to replace used equipment with new equipment. The structure of each exchange transaction was as follows: Northern Central conveyed relinquished equipment to a qualified intermediary (“QI”), who then sold the equipment to an unrelated third party. Later, Butler Machinery purchased replacement equipment from an equipment manufacturer with whom it had a business relationship. The QI used the proceeds from the sale to purchase the replacement equipment from Butler Machinery before transferring the equipment to North Central.

As a result of this exchange as structured, the QI paid the proceeds derived from the transfer of the relinquished property to an unrelated third party to Butler Machinery instead of directly to the party from whom the eventual replacement property was acquired. At the same time, Butler Machinery benefited from a financing arrangement with the equipment manufacturer which allowed Butler Machinery to make payments six months after purchasing equipment. During that six-month period, Butler Machinery had free use of the relinquished property sales proceeds. Thus, each exchange transaction amounted to a six month zero-interest loan made to Butler Machinery.

The Court questioned the reason for any involvement at all by Butler Machinery, citing cases from the Eleventh and Ninth Circuits which held that transactions were structured to avoid the purposes of § 1031(f) when unnecessary parties participated and when a related party ended up receiving cash proceeds. The Ninth Circuit in Teruya Bros. v. Comm’r, 580 F.3d 1038 (9th Cir. 2009), had found that the taxpayer could have achieved the result through “far simpler means” and that the transactions “took their peculiar structure for no purpose except to avoid § 1031(f)’s restrictions.” Similarly, the Eleventh Circuit in Ocmulgee Fields v. Comm’r, 613 F.3d 1360 (11th Cir. 2010), had found no “persuasive justification” for the complexity of its transaction other than one of “tax avoidance.”

Section 1031(f) was enacted as part of RRA 1989 to eliminate revenue losses associated with “basis shifting” in related party exchanges. Basis shifting occurs when related persons exchange high basis property for low basis property, with the high basis (loss) property being sold thereafter by one of the related persons and gain on the low basis property being deferred. Basis shifting allows the parties to retain desired property but shift tax attributes. Section 1031(f)(1) causes deferred realized gain to be recognized if, within two years, either related party disposes of exchange property, unless the disposition falls within one of three exceptions, the most important of which being that the exchange does not have as “one of the principal purposes” tax avoidance. On the other hand, even if an exchange is outside the literal scope of the statute (i.e., by engaging a QI, but was “structured” to avoid the related party rules, the entire exchange will fail under Section 1031 ab initio.

The Tax Court was recently called upon to ascertain whether a person the son of the exchanger constituted a “disqualified person” in connection with the qualified intermediary (“QI”) deferred exchange regulations. In Blangiardo v. Comm’r, T.C. Memo 2014-1010 (2014), the taxpayer’s son, who was also an attorney, acted as a qualified intermediary, pursuant to Treas. Reg. § 1.1031(k)-1. The regulations define a disqualified person as anyone who has acted as “the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer.” Treas. Reg. § 1.1031(k)-1(k)(2). Disqualified persons include persons related to the taxpayer as defined by IRC § 267(b), which include siblings, spouses, ancestors and lineal descendants. Treas. Reg. § 1.1031(k)-1(k)(3). As a lineal descendant, a son thus appears to be clearly within the definition of a disqualified person. The taxpayer argued that an exception should be made because (i) his son was an attorney; (ii) the funds from the sale of the relinquished property were held in an attorney trust account; and (iii) the real estate documents referred to the transaction as a IRC §1031 exchange. The Court dismissed the arguments as irrelevant since the regulations do not provide for any exceptions.

Although like kind exchanges are most often associated with real property or tangible personal property (e.g., an airplane), exchanges involving intangible personal property, consisting of customer lists, going concern value, assembled work force, and good will may also occur. An exchange of business assets requires that the transaction be separated into exchanges of its component parts. Revenue Ruling 57-365, 1957-2 C.B. 521. Unlike the case involving exchanges of real property or tangible personal property, little regulatory guidance is provided for exchanges of intangible property. Whether such an exchange qualifies under Section 1031 is therefore reduced to an inquiry as to whether the exchanged properties are of “like kind” under the statute itself. In published rulings, the IRS has imported concepts from the regulations dealing with real property exchanges. As might be surmised, exchanges of intangible personal property are at times problematic.
Treas. Reg. §§ 1.1031(a)-2(c) provides that whether intangible personal properties are of like kind depends on the nature and character of (i) the rights involved and (ii) the underlying property to which the intangible personal property relates. PLR 201532021 held that agreements providing intangible rights with respect to the manufacture and distribution of a certain set of products are of like kind since they meet the requirements of the regulation. The nature or character of the agreements are of like kind because the terms of the agreements are substantially similar, despite differences in grade or quality. The underlying property to which the intangible rights relate are of like kind because the products are distributed in a similar manner to a common set of customers.

Section 1031(a)(1) provides that


The phrase ““held for” means the property must be in the possession of the taxpayer for a definite period of time. Exactly how long has been the subject of considerable debate. PLR 8429039 stated that property held for two years satisfies the statute. Some have suggested that, at a minimum, the property should be held for a period comprising at least part of two separate taxable years (e.g., November, 2010 through October, 2011). However, it should be taxpayer’s intent that is actually determinative. Therefore, an exchange of property held for productive use in a trade or business should qualify even if it were held for less than two years provided the taxpayer’s intent when acquiring the property was to hold the property for productive use in a trade or business or for investment, (rather than to hold it just long enough to qualify for exchange treatment). Of course, evidencing the taxpayer’s intent for a short period of time might be difficult, and for this reason guidelines, such as that articulated in PLR 8429039 are useful.

Chief Counsel Advisory (CCA) 201605017 addressed whether an aircraft that is used for both personal and business purposes meets the IRC § 1031(a)(1) requirement that property be “held for productive use in a trade or business or for investment” (i.e., the “qualifying use” requirement). The IRS advised that an aircraft is considered only one type of property that is either held for a qualifying use under Section 1031, or for personal use. Whether the qualifying use (“held for”) requirement has been met involves an all-or-none determination. Property cannot partially meet the held for requirement.
IRS counsel further noted that whether property meets the held for requirement must be determined on a case-by-case basis based upon the particular facts and circumstances. The IRS determined that the fact that more than half of flights made by the relinquished aircraft during the year it was relinquished were for personal purposes suggests that the property was not held for productive use. However, other factors should be considered, such as the number of flight hours. The IRS did not opine, however, as to whether the qualifying use requirement could be met where less than half of the use of the aircraft was for personal purposes.

CCA 01601011 also involved the qualifying use (“held for”) requirement in connection with aircraft. Here, however, the IRS addressed the question of whether the intent to earn a profit is necessary in order to satisfy the qualifying use requirement. The taxpayer exchanged relinquished aircraft for replacement aircraft. The aircraft were the only operating assets of the taxpayer. Both the relinquished and replacement aircraft were leased to a related entity. The lease payments in both cases were not intended to generate economic profit, but rather to cover the carrying costs of the aircraft. The Chief Counsel determined that lack of intent to generate an economic profit from the aircraft rental does not cause a failure to meet the productive use in a trade or business standard of § 1031.

Technical Advice Memorandum (TAM) 201437012 involved an “LKE Program,” as defined in Revenue Procedure 2003-39. An LKE Program is an ongoing program involving multiple exchanges of 100 or more properties conducted by a taxpayer that regularly and routinely enters into agreements to sell and agreements to buy tangible personal property. Rev. Proc. 2003-39 provides that in order to receive nonrecognition treatment under IRC § 1031 in connection with an LKE Program, relinquished properties must be “matched” with replacement properties received. The auditor had determined that replacement property which had been properly identified during the identification period was not of “like kind” to relinquished property with which it had been matched. Consequently, the taxpayer asserted that other property which had been acquired during the 45 day identification period was of like kind and thus the transaction qualified for exchange treatment. (Normally, property acquired during the 45 day identification period need not be formally identified. This is known as the “actual purchase” rule, which is a corollary to the three normal identification requirements.) In this case, even though the actual purchase rule was satisfied, the auditor found that since the taxpayer had previously “matched” other property that failed to satisfy the “like kind”” requirement, that failure could not be later remedied by “matching” other property, even though the later property was of like kind, and was properly identified and acquired.

Sensibly, the TAM found that nonrecognition and rematching was appropriate since the previously unmatched replacement property met the requirements of IRC § 1031. This was true irrespective of the fact that the previously matched replacement property failed to be of like kind. In essence, the TAM correctly concluded that the requirements of an LKE program do not trump the requirements of IRC § 1031 itself, the rationale being that Section 1031 is not (technically) an elective provision. If properties exchanged are of like kind, and the other statutory requirements of Section 1031 are met, the transaction will constitute a like kind exchange, even if the taxpayer does not so desire.
It has been suggested that where the taxpayer desires to recognize a loss in a transaction otherwise qualifying under Section 1031, the taxpayer could purposely fail to identify other replacement property within the 45 day identification period. It is doubtful that this strategy would work; at the very least it would invite litigation.

Although the deferred exchange Regulations apply to simultaneous as well as deferred exchanges, they do not apply to reverse exchanges. In a reverse exchange, the taxpayer acquires replacement property before transferring relinquished property. Perhaps because they are intuitively difficult to reconcile with the literal words of the statute, reverse exchanges were slow to gain juridical acceptance. An early case, Rutherford v. Comm’r, TC Memo (1978) held that purchases followed by sales could not qualify under Section 1031. However, Bezdijian v. Comm’r, 845 F.2d 217 (9th Cir. 1988) held that a good exchange occurred where the taxpayer received heifers in exchange for his promise to deliver calves in the future. Following Bezdijian, taxpayers began engaging in a variety of “parking” transactions in which an accommodator (i) acquired and “parked” replacement property while improvements were made and then exchanged it with the taxpayer (exchange last); or (ii) acquired replacement property, immediately exchanged with the taxpayer, and “parked” the relinquished property until a buyer could be found (“exchange first”). Just as deferred exchanges were recognized by courts, so too, reverse exchanges soon received a judicial imprimatur.

In an Exchange First reverse exchange, the EAT purchases the relinquished property from the taxpayer through the QI. The purchase price may be financed by the taxpayer. Using exchange funds obtained from the EAT, the QI purchases replacement property which is transferred to the taxpayer, completing the exchange. The EAT may continue to hold the relinquished property for up to 180 days after acquiring QIO. During this 180-day period, the taxpayer will arrange for a buyer. At closing, the EAT will use funds derived from the sale of the relinquished property to retire the debt incurred by the EAT in purchasing the relinquished property from the taxpayer at the outset.

In an Exchange Last reverse exchange, the EAT takes title to (i.e., acquires “QIO”) and “parks” replacement property at the outset. Financing for the purchase may be arranged by the taxpayer. The EAT may hold title to the replacement property for no longer than 180 days after it acquires QIO. While parked with the EAT, the property may be improved, net-leased, or managed by the taxpayer. During the period in which the replacement property is parked with the EAT, the taxpayer will arrange to dispose of the relinquished property through a QI. The taxpayer must identify property (or properties) to be relinquished within 45 days of the EAT acquiring title (QIO) to the replacement property, and must dispose of the relinquished property (through the QI) within 180 days of the EAT acquiring title (QIO). Following the sale of the relinquished property to a cash buyer through a QI, the QI will transfers those proceeds to the EAT in exchange for the parked replacement property. The EAT will direct-deed the replacement property to the taxpayer, completing the exchange. The EAT will use the cash received from the QI to retire the debt incurred in purchasing the replacement property.

PLR 201416006 blessed a proposed transaction in which the taxpayer and two related entities intending to complete a Exchange Last reverse like-kind exchange involving the same “parked” replacement property would each simultaneously enter into separate Qualified Exchange Accommodation Arrangements (“QEAAs”) with the same Exchange Accommodation Titleholder (““EAT”). Under this scenario, it would be unclear at the time that the EAT acquires the replacement property which entity (or entities) would ultimately complete the exchange.

Each QEAA would expressly acknowledge the existence of the other two QEAAs. Each QEAA would further reference the right of all three related parties to acquire the replacement property, in whole or in part. The three QEAAs would provide that the right by each party to acquire the replacement property would be accomplished by notifying the EAT of that party’s intent. Once exercised, the right of the other parties would be extinguished (to the extent thereof, in the case of an exercise with respect to only a portion of the replacement property). The taxpayer’s proposed QEAA was valid. The fact that related entities would enter into concurrent QEAAs in connection with the same replacement property, was of no moment since the taxpayer and both related entities had a bona fide intent to acquire the replacement property under the terms of their respective QEAAs. The PLR further noted that the Revenue Procedure providing for safe harbor for reverse exchanges (Rev. Proc. 2000-37) does not prohibit an EAT from acting as such with respect to more than one taxpayer under multiple simultaneous QEAAs for the same parked exchange property.

PLR 201408019 approved a proposed reverse exchange where the EAT would sublease vacant land from an entity related to the taxpayer pursuant to a sublease exceeding 30 years, construct improvements on the land, and then transfer the leasehold interest to the taxpayer as replacement property. The leasehold interest would be purchased with funds held by a qualified intermediary, originating from the sale of relinquished property (a fee simple interest in a retail building) to an unrelated person. The IRS determined that the IRC § 1031 (f) related party rules were inapplicable. Although the related entity provided the leasehold interest, no cash left the related party exchange group. Gain would be recognized however to the extent exchange funds were not applied to improvements upon the earlier of (i) the transfer of the leasehold interest to the taxpayer or (ii) the termination of the 180 day exchange period. Section 1031(f)(4) provides that like kind exchange treatment will not be accorded to any exchange that is a part of a transaction, or series of transactions, structured to avoid the purposes of Section 1031(f). One test used in determining whether the Section 1031(f)(4) “catch all” applies is to determine whether the related persons, as a group, have more cash after the related party transaction than before. If cash “leaves” the group, there is less chance that a tax avoidance motive is present. Conversely, if cash “enters” the group, a tax avoidance purpose is more likely.

PLR 201425016 drew upon IRC § 1031 for determining when a date of sale of property occurs for the purpose of IRC §512(a)(3)(D). IRC §512(a)(3)(D) provides for the nonrecognition of gain from qualifying sales of property made by certain exempt organizations. The IRS applied the IRC § 1031 rule that the date of sale triggering the commencement of the 45-day identification period for a like kind exchange transaction is the date when the taxpayer relinquishes control of the property.

May 2016 FD

Tax News & Comment — May 2016 View or Print

Prior to this PLR, there was some question as to when a taxpayer relinquishes control of the property. Does the identification period begin to run on the closing date? The date the deed is recorded? Or when the exchange funds are transferred if that date is not coincident? The PLR seems to resolve this issue. The IRS ruled that date of sale is the date that local law determines that a taxpayer relinquishes control and title transfers. Thus, if local law states that the date of title transfer is the date of closing, than the date of closing would be the date of sale for purpose of a § 1031 exchange.

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Tax News & Comment — March 2015

Tax News & Comment -- March 2015

Tax News & Comment — March 2015 — View or Print

Posted in News

From Washington & Albany — Income & Estate Tax Planning in 2015

Tax News & Comment -- March 2015 View or Print

Tax News & Comment — March 2015 View or Print

I.    From Washington

Income tax planning in 2015 will seek to reduce the effect of high federal and New York tax rates. Avoidance of unnecessary capital gain realization through basis increases or nonrecognition transactions will remain important. Estate tax planning is simplified by portability at the federal level. The top federal income tax rate is now 39.6 percent, its highest since 2000. Capital gains are taxed at 23.8 percent, which includes the 3.8 percent net investment income tax. The top New York rate levels off at 8.82 percent, while New York City adds another three and a half percent for most residents. Wage earners must pay social security and Medicare tax. All told, ordinary income tax rates in New York for wage earners now top out at 52.26 percent; long-term capital gains rates reach 37.69 percent.

The cost of living in New York is higher than in other states not only because of high tax rates, but also because of high living costs. However, many people who leave New York to avoid northeast winters seem to come back when the weather moderates. The Department of Taxation is well aware of this and keeps a vigil over those persons who seek to enjoy the benefits of New York without paying tax here. Residency audits continue to spark litigation. Income tax planning is now prominent in estate planning, not so much for reasons of the federal estate tax, which has whimpered out, but because of the importance of basis; more particularly, the basis step up at death. While placing assets in a credit shelter trust will remove those assets from the estate of both spouses forever, the cost will be a second basis step up at the death of the surviving spouse. In contrast, if assets are gifted to the surviving spouse in a QTIP, a second basis step up is possible with no loss of the federal estate tax exemption, due to portability.

Trusts other than grantor trusts are taxed at 39.6 percent when fiduciary income reaches only $12,150. This means that trusts should distribute income to beneficiaries in lower tax brackets whenever feasible. Trust losses in excess of income benefit no one until the final year of the trust. Accordingly, it may be prudent to defer the timing of trust operating losses until the final year of the trust when the losses may be taken as itemized deductions by beneficiaries. Grantors who sold assets to grantor trusts to save estate taxes may no longer wish to report the tax of the trust they created, since the income tax liability may exceed 50 percent on the personal level, and reducing estate tax planning may no longer be necessary. One solution to these “burned out” trusts may be to “turn off” grantor trust status. Many trusts will contain language expressly permitting such “toggling.” If the trust does not so expressly provide, the grantor may consider amending the trust or decanting the trust into another trust that does contain express language permitting toggling.

While the IRS has not issued regulations concerning the tax implications of turning off grantor trust status, the situation is somewhat muddled, and Revenue Ruling 85-13 — whose tenets are consistent with permitting such a switch — has assumed such prominence, that the tax risk of turning off grantor trust status may be one well worth assuming. The government may be uninterested in challenging these transactions, since at best the taxpayer achieves small or moderate rate bracket benefit. Someone is going to continue to pay the tax; if not the grantor, then the trust or the trust beneficiaries. However, once grantor trust status is turned off, it may be risky to attempt to turn grantor trust status back on at a later date. This “toggling” might present an opportunity for the IRS to argue that the device was being used for tax-avoidance. Somehow it seems inappropriate for a trust to toggle between being a grantor trust or nongrantor trust at the whim of the grantor on a yearly basis.

Especially with the advent of portability, marriage itself is an extremely effective estate tax plan for more affluent taxpayers with accumulations of wealth. Gifts between spouses occasion no income and except in rare occasions no gift tax. Gifts of low basis property to an ailing spouse who lives one year can accomplish a valuable basis step up if the property is willed back to the donor spouse. If the ailing spouse cannot be expected to live a year, giving property to the ailing spouse and having the ailing spouse will the property to children will also lock in the basis step up with no tax risk. (Although in the latter case the children, rather than the surviving spouse, will end up with the property.)

Predicting which spouse may die first is an unseemly proposition, yet the life expectancy of men is statistically shorter than women. As a general rule it may make sense to title lower basis assets (which would benefit most from a basis step up) in the name of the husband. The basis of assets may also be stepped down at death if the asset has declined in value. Avoiding a step down in basis can best be achieved by selling the asset before death. Familiar nonrecognition transactions, which taxpayers take for granted, such as 1031 exchanges, or 121 exclusions, are gem-like tax provisions that can save vast amounts of capital gains tax when highly appreciated residences or business property is disposed of. If the taxpayer is willing to wait seven years, these twin Code provisions can also be used together, magnifying tax benefits.

For those inclined to retire in sunny locations without income tax, moving to Texas, Arizona, or Florida may preserve retirement capital by eliminating the burden of New York income tax. Again, those making the decision to leave will risk being subject to a residency audit if they return too frequently. Much tax planning over the past fifteen years has focused on reducing the size of one’s estate for estate tax purposes. Ironically, some of that planning may turn out to have been counterproductive, since it may be preferable to have property previously transferred out of the estate brought back into the gross estate to benefit from the basis step up at death. Various strategies can be employed to attempt to reverse tax planning that has now become a liability.

The taxpayer whose earlier estate-planning entities are now a liability may attempt to liquidate the entity or undo discounts that no longer provide any tax benefit. This may be achieved by amending or restating the operating or partnership agreement. Alternatively, the taxpayer may utilize a “swap” power in a grantor trust to substitute a higher basis asset — perhaps even cash — for a lower basis asset, in order to take title to low basis property that can most benefit from a basis step up at death. It is not clear to this writer whether the “swap” power which so many have espoused for so long, actually works. See, Tax News & Comment, February 2014, “Rev. Rul. 85-13: Is There a Limit to Disregarding Disregarded Entities.” If the taxpayer is willing to take the risk and it does work, great.

The taxpayer may be tempted to argue that poorly maintained vehicles previously established with the intention of transfer assets — and the appreciation thereon — out of the grantor or donor’’s estate should be pulled back into the estate by virtue of IRC §2036. However, the IRS — quite understandably — does not like to be “whipsawed,” and one would expect the IRS to fiercely challenge such strategies. In essence, it is possible that the arguments previously made by the IRS may not be made by the taxpayer. The taxpayer might attempt to make these arguments due to the attenuation of the estate tax and the invigoration of the income tax. In the end, the difference between capital gains rates and estate tax rates, which only recently were significant, have now narrowed to the extent that complicated analyses may be required to determine whether or not to rely on portability or whether to use a credit shelter trust. Even such analyses are subject to the vagaries of the market and the economy, but may be probative of the best course of action. When presented with a clean slate, and everything else being equal, most agree that portability and the second basis step up it carries with it, is the best estate planning option in most cases.

To reduce the value of assets in the decedent’s estate that will be entitled to a basis step up, but whose inclusion in the estate would no longer produce estate tax revenue, the IRS may now accept questionable valuation discounts claimed by the taxpayer that the Service might previously have challenged for a multitude of reasons. One reason might have been that the basis for the discount was not adequately disclosed. The doctrine of substance over form, first enunciated by the Supreme Court in 1935 in Gregory v. Helvering, 293 U.S. 465, provides that for federal tax purposes, a taxpayer is bound by the economic substance of a transaction where the economic substance differs from its legal form. However, the taxpayer, once having chosen a form, may not later assert that the form chosen should be ignored.

In seeking to ignore a questionable valuation which would now benefit the government, the IRS might argue that the taxpayer, having chosen the form, must be bound by that form, and that the IRS may accept even a valuation that appears questionable, since it was reported by the taxpayer. However, this would seem to be a distorted view of the doctrine of substance over form. In practice, the IRS might achieve its goal anyway since there appears to be no way that the taxpayer could effectively argue that earlier valuation was incorrect, without inviting other, more serious problems. Moreover, the taxpayer would be placed in the peculiar and unenviable position of essentially requesting that the IRS to audit a previous gift tax return.

Proving basis at death is not generally necessary due to the basis step up occasioned upon death by virtue of IRC §1014, but at times the determination of historical basis may be necessary when capital gains must be calculated with respect to property held for many years. While an old saw provides that if the taxpayer cannot prove basis, basis is zero, this is simply not true. Just as the courts have consistently held that difficulty in valuing property or services will not prevent the calculation of realized gain, the taxpayer may establish basis by the best available means. It is true that the taxpayer may have the initial burden of proof when establishing basis, but under IRC §7491 that burden can change “if the taxpayer comes forward with credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer.”
Portability is now a permanent fixture on the estate tax landscape, and levels the playing field for taxpayers who have been lax in their estate planning. As Howard Zaritsky noted at the University of Miami conference in Orlando, portability is the default means of ensuring best use of the large federal estate exemption. In advising a client to implement estate plans not utilizing portability, Mr. Zaritsky aptly observed that the advisor should be sure that what he or she is counsels, if portability is foregone, will not be worse. Of course in New York some additional estate tax planning is necessary to utilize the increasing New York estate exemption, since New York — like almost all other states — has not adopted the concept portability.

New York has also prevented an obvious end-run around its own estate tax by residents making large gifts before death. Now, gifts made within three years of death will be included in the taxable estate of New Yorkers for state estate tax purposes, and will attract estate tax at rates of between 10 and 16 percent. The “cliff” rule will penalize those estates which dare to exceed the New York exemption amount by between 0 and 5 percent. In fact, once the estate exemption amount is exceeded by 5 percent, New York will grant the estate no exemption; the entire taxable estate will be subject to estate tax.

The use of QTIP trusts in devising property to surviving spouses will continue to ensure a basis step up while accomplishing portability of the federal exemption. QTIP trusts and portability elections are now the magic elixir of most moderate to high net worth individuals who seek to implement an effective estate plan. Portability, still new, does have some issues which need to be resolved by Congress. For example, basing the unused exclusion amount on the last-to-die spouse may produce inequitable results. Some have called upon Treasury to fix this problem. In the interim, especially in second marriage situations, a provision in a prenuptial agreement regarding portability may be a good idea. This will protect the heirs of both spouses against uncertainties in the portability statute.

Asset protection using trusts established in Nevada, Delaware, North Dakota or Alaska have proved to be only marginally superior to asset protection trusts created in, for example, the Cayman Islands. Those trusts have generally been ineffective when challenged in state court. However, implementing trusts in those tax-friendly jurisdictions may be quite effective in saving tax.

New York has implemented new rules which seek to restrict tax benefits to New Yorkers who implement trusts in these jurisdictions. There may still be some benefit to be availed of by a New York grantor who establishes such a trust for beneficiaries who do not reside in New York.

In planning for a possible IRS audit, taxpayers should keep in mind that email exchanges to non-attorneys are not privileged, and the privilege extending to exchanges with attorneys may be lost if other persons are copied. Memoranda of law espousing a particular tax-saving strategy may become discoverable in litigation, and even if marked “confidential,” may find its way into the hands of the IRS. It is best not to explicitly detail the merits of a particular tax-saving strategy even in confidential memoranda.

When implementing a tax planning strategy, courts have been particularly impressed with arguments made by taxpayers which emphasize non-tax motivations for a tax-saving transaction. Where valuations are required for returns, taxpayers should be aware that drafts of appraisals can be used against the taxpayer. The IRS has immense information-gathering power and the taxpayer should assume that at audit the IRS will possess more information than the taxpayer might otherwise assume.

Fiduciaries determining trust distributions may now be required to be more mindful of IRS scrutiny. The trust may provide for a discretionary distribution standard based upon the “health, education, maintenance and support (“HEMS”) of the beneficiary.” The trustee may be inclined to make larger distributions to lower-bracket beneficiaries to reduce the incidence of taxation to the trust which is in a higher tax bracket. However, in the event of a large distribution to a beneficiary which appears unjustified, the IRS may argue that the distribution violated the HEMS standard, and that the trust should pay tax at higher rates on amounts distributed in excess of what is required to satisfy the HEMS standard.

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From Federal Courts, NYS Courts & Tax Tribunals — Recent Developments & 2014 Decisions of Note

I.     Disputes Involving Sales of Assets to Grantor Trusts Reach the Tax Court

Tax News & Comment -- March 2015 View or Print

Tax News & Comment — March 2015 View or Print

In Estate of Woelbing v. Com’r, Docket No. 30261-13, filed on December 26, 2013, the IRS made several arguments seeking to negate the tax benefit sales of stock to grantor trusts based upon Rev. Rul. 85-13. That ruling stated that no realization event for federal income tax purposes occurs when a taxpayer sells an asset to a grantor trust. While the sale is invisible for income tax purposes, practitioners had concluded that the same was not the case for gift and estate tax purposes. Thus, sales to grantor trusts were made which were presumptively complete for transfer but not for income tax purposes. These sales shifted appreciation out of the grantor’s estate, while at the same time resulted in the income tax for the grantor trust being attracted like a magnet to the grantor. This permitted trust assets to appreciate without the imposition of yearly tax. An added bonus of this planning technique was that the payment of the income tax of the trust by the grantor was not deemed to constitute a gift to the trust.

Risks associated with this estate planning transaction had always been presumed to exist. However, it appeared that careful tax planning could minimize those risks. The IRS in Estate of Woelbing has fired the first salvo in contesting the sale of assets to “defective” grantor trusts, as has been their sobriquet.The IRS first argued that the promissory note received in exchange for the sale of stock was undervalued, and that the difference between the value of the Note and the actual value of the stock transferred constituted a taxable gift. The IRS then argued that that the stock should be included in the decedent’s estate under IRC §§ 2036 and 2038 as “retained” interests. Finally, the Service asserted that a 20 percent underpayment penalties amounting to more than $25 million should be imposed.

The principal hurdle that the taxpayer in Woelbing — as in other cases — must surmount, aside from ensuring that the formalities of the transfer are well documented, and that the transaction is bona fide, is that the promissory note received in exchange for the assets (i) constitutes debt rather than equity and (ii) is fairly valued. One way of ensuring that the Note is bona fide debt is transfer to trust sufficient assets such that there are sufficient assets to satisfy the Note even if the trust has an income deficit.In practice, the requirement of the promissory note comprising debt has been accomplished by making a gift of “seed” money into the trust prior to the sale. If the trust produces just enough income such that the Note is satisfied, it begins to look as if the transferor has retained an interest in the transferred assets such that Section 2036 comes into play. If ample trust assets assure that the terms of the Note will indeed be repaid without incident, the Note will more likely have independent significance. It will be interesting to see how Woelbing is decided. As insurance against a successful IRS argument that the promissory note is undervalued, trusts have been drafted to contain formula clauses shifting any excess value that could be deemed a taxable gift, to an entity for which a deduction was available.

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Until Woelbing is decided, some have suggested that GRATs be used frequently, at least for extremely wealthy individuals. However, GRATs are like the Model T of estate planning — their time has passed. GRATs are much less effective as estate planning vehicles than are sales to trusts, and are generally inferior to other estate-planning strategies. While one well-known tax practitioner has suggested that GRATs be rehabilitated at least until one gets a sense of how disputes involving sales to grantor trusts will be resolved, this approach has little to commend it. The sensible approach, suggested by Dennis Belcher at the University of Miami tax conference in Orlando in January is that clients should be advised of the current litigation involving sales to grantor trusts, but having been made aware of the risk, are competent to make their own decision as to whether or not to fly into the turbulence hoping, as most do, that sales to grantor trusts will end up being vindicated for tax purposes.

Interestingly, other speakers at the Orlando conference noted that for all but fewer than one percent of taxpayers, sophisticated tax planning involving sales to grantor trusts (or GRATs for that matter) is no longer even necessary, given the combined spousal exemption amount which is now more than $10.86 million. Since 2012, 87 percent fewer federal estate tax returns have been filed. Although it may be a slight overstatement, it is clear that income tax planning has now taken center stage, and federal estate tax planning has been relegated in importance. New York state estate tax planning is still important, however, at least until 2019, when New York’s exemption reaches parity with the Federal exemption amount.

Despite efforts to abolish it, the federal estate tax appears to have a considerable life expectancy since it generates considerable revenues even though the tax reaches only a fraction of a percent of all taxpayers. Abolishing the estate tax appears to be an excellent “talking point” for Republicans, but no one seems to care very much about eliminating the estate tax. In fact. President Obama indicated that he favored reducing the federal exemption amount. Given the current makeup of Congress, Mr. Obama’s position appears to have scant likelihood for success. In the end, Congress appears unlikely likely to forego this source of revenue which is imposed on only a few thousand taxpayers, regardless of who next occupies the White House.

II. Corporate Goodwill

Several cases involving the taxation of goodwill in the context of the sale of a corporate enterprise were decided. To avoid a successful IRS assertion that goodwill belongs to the corporation rather than to the individual, taxpayers should understand both positive and negative factors which affect that determination, and plan accordingly. Goodwill, for federal tax purposes was defined by Justice Story as “[t]he advantage or benefit, which is acquired by an establishment . . . in consequence of the general public patronage and encouragement, which it receives from habitual customers, on account of its local position, or common celebrity, or reputation for skill or affluence.”

Courts have recognized two types of goodwill: “Business Goodwill” and “Personal (or professional) Goodwill.” Business goodwill refers to going-concern value, or goodwill attaching to the enterprise. Personal goodwill, on the other hand, takes into consideration the seller’s reputation and expertise, and may be considered separate and apart from the assets of the firm. When applied to professional businesses, such as medical practices, the term personal goodwill is often referred to as “Professional Goodwill.” One author provides an example of personal goodwill in a medical practice: “[I]f a doctor was a neurosurgeon with extensive experience, an excellent reputation for successfully treating highly complex and difficult neurological problems, and a good bedside manner, it is likely that patients would come to see the doctor not because of an established practice with a solid reputation in a particular locale, but because of the surgeon’s unique skills, abilities, and reputation.”

Several cases involving professional service corporations inform the contours of what may be properly characterized as professional goodwill. In Norwalk v. Com’r, T.C. Memo 1998-279 (1989), the Tax Court held that in the absence of a noncompetition agreement or other agreement with the corporation whereby goodwill in connection with existing clients became the property of the corporation, the goodwill constituted professional goodwill, since the clients had no meaningful value to the corporation. However, in Schilbach v. Com’r, T.C. Memo 1991-556, a different (and adverse) result was reached where the Court found that the sole shareholder of a professional corporation was unable to obtain malpractice insurance, was leaving the state, and it appeared doubtful that the physician would “set up a new practice in direct competition with [the purchaser].”” The Court in Schilbach imposed a 25 percent accuracy-related penalty under [then] IRC § 6661.

In a more recent case, Howard v. United States, No. 10-35768, decided by the Ninth Circuit Court of Appeals in 2011, the Court noted that “there is no corporate goodwill where ‘the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation’; Martin Ice Cream Co., 110 T.C. at 207-08 (finding that “personal relationships . . . are not corporate assets when the employee has no employment contract [or covenant not to compete] with the corporation.’; Macdonald v. Com’r, 3 T.C. 720, 727 (1944) (finding “no authority which holds that an individual’s personal ability is part of the assets of the corporation . . . where . . . the corporation does not have a right by contract or otherwise to the future services of that individual.” In determining whether goodwill has been transferred to a professional practice, we are especially mindful that “each case depends upon particular facts. And in arriving at a particular conclusion . . .we take into consideration all the circumstances . . . [of] the case and draw from them such legitimate inferences as the occasion warrants.” Grace Brothers v. Com’r, 173 F.2d 170, 176 (9th Cir. 1949).

In Howard, the Ninth Circuit found that the taxpayer’s dental practice was the property of the “Howard Corporation” and its sale did not generate professional goodwill. The purchase contract did recite that “[t]he personal goodwill of the [p]ractice . . . [was] established by Dr. Howard . . . [and] is based on the relationship between Dr. Howard and the patients.” However, in rejecting the significance of the contractual language, and in affirming an order of summary judgment in favor of the IRS, the Ninth Circuit concluded that the purchase agreement did not reflect the “realities” of the transaction, noting: “By now it is well established that “the incidence of taxation depends upon the substance, not the form of [a] transaction.” Com’r v. Hansen, 360 U.S. 446, 463 (1959). . . Self-serving language in a purchase agreement is not a substitute for a careful analysis of the realities of the transaction.”

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In Bross Trucking v. Com’r, T.C. Memo 2014-17, the IRS alleged that where the sons succeeded to father’s business, which suffered a loss of goodwill from negative publicity, the assets of the company were distributed to father as ordinary income, and that father made a gift of the corporate goodwill to sons. The Tax Court held for the taxpayer, finding that there was little corporate goodwill for the corporation to have distributed. Citing to Martin Ice Cream v. Com’r, 110 T.C. 189 (1998), the Tax Court found that corporate goodwill was lacking, since (i) Mr. Bross had no employment or noncompetition agreement with Bross Trucking; (ii) clients patronized Bross Trucking by reason of the relationships “forged” by Mr. Bross; (iii) goodwill was “the expectation of continued patronage,” the regulatory problems encountered by Bross Trucking actually resulted in a loss of corporate goodwill; (iv) the sons of Mr. Bross had personally “cultivat[ed]” relationships with clients; and accordingly (v) the sons’ profiting thereby from “independently created relationships” was not the same as “receiving transferred goodwill.””

III.     Adequate Disclosure on Gift Tax Returns

The three-year period of assessment for timely filed gift tax returns presumes that “adequate disclosure” has been made. In Estate of Sanders v. Com’r, T.C. Memo 2014-100, the estate argued in a motion for partial summary judgment that the statute had run on the ability of the IRS to challenge the value of the gift. The Tax Court cited Reg. §301.6501(c)-1(f)(2)(iv) for the proposition that a gift is adequately disclosed if the taxpayer provides a “detailed description of the method used to determine the fair market value of the property.” In this case, the Tax Court denied the motion for partial summary judgment, concluding that a genuine dispute existed as to whether the gift tax returns adequately disclosed the value of the gift. Although the Regulations do not explicitly require that the taxpayer engage an expert to value a gift when preparing a gift tax return, it may make sense to do so anyway. If no expert appraisal for a large gift is made at the time of the gift, it may be necessary to engage an expert later — even after the donor dies — if the IRS challenges the adequacy of initial disclosure, as it did in Estate of Sanders. It may be more difficult at a later time to accurately value the gift. Gifts of some assets, such as real estate, may be far easier to value at the time of the gift, rather than many years later. Other gifts, for example, the gift of a rare coin, might not be more difficult to value at a later time.

IV.    Overpayment of Estate Tax Applied to Deferred Portion of Tax

In Estate of McNeely v. U.S., 2014 WL 2617418, USTC §60679 (D. Minn. 2012), the estate made an estimated estate tax payment of $2.494 million. The estate also sought to defer payment of estate tax under IRC §6166. The estate tax return when filed showed an actual nondeferrable estate tax liability of only $512,226. The request by the estate for a refund of $1.9179 million was denied. The District Court for Minnesota held for the government in a refund action brought by the estate, reasoning that under IRC §6402, the IRS may in its discretion credit an overpayment to an outstanding tax liability.

V.     3.8 Percent Net Investment Income Tax

In Frank Aragona Trust v. Com’r, 142 T.C. No 9 (2014), the trust conducted real estate operations through an LLC. The children of the deceased grantor were trustees. The issue was whether the 3.8 percent tax on net investment income applied to the trust, which claimed that through its activities which were “regular, substantial and continuous,” the trust qualified as a “real estate professional,” and could therefore deduct its rental real estate losses. At issue was also whether the trust materially participated in the real estate activities through the trustees. The trust prevailed. The Tax Court ruled that the trust could indeed qualify as a “real estate professional.” Even though the trust could not itself perform “personal services,” those services could be provided by the trustees. The court also rejected the IRS argument that the trustees did not materially participate in the real estate activities, finding that the trustees were in fact involved in the daily activities of the real estate business.

VI.     Conservation Easements

The Second Circuit affirmed a decision of the Tax Court which held that the donation of a conservation easement consisting of the façade of a brownstone in Brooklyn’s Fort Greene Historic District had not been shown to reduce the value of the property, and that the IRS was correct in challenging the charitable deduction taken by the taxpayer under IRC §170(f)(B)(iii). Schneidelman v. Com’r, Docket No. 13-2650 (6/18/2014). [The taxpayer donated the easement and claimed a charitable deduction of $115,000, premised upon the reduction in value of the property by reason of the gift. Following audit, the IRS determined that the taxpayer had not established a fair market value for the easement. The Tax Court agreed and found that the taxpayer was not entitled to claim the deduction because it had not obtained a “qualified appraisal” showing a reduction in value of the property.]

The Court noted preliminarily that its review of factual matters determined by the Tax Court was “particularly narrow when the issue is one of value” and that the conclusion of the Tax Court must be upheld if supported by “substantial evidence.” The Court then recited the familiar precept that the fair market value of property is based upon a hypothetical willing buyer–willing seller rule. The Court acknowledged that while encumbrances on real property generally reduce value, the grant of a conservation easement may, according to the regulations, increase the value. In the instant case, the appraisal the taxpayer obtained failed to take into account the particular facts and circumstances. The appraiser merely opined as to an IRS “accepted range” of percentages, which was inadequate.

The IRS, on the other hand, analyzed “the particular terms of the easement, zoning laws, and regulations” and concluded that the grant of the easement did not materially affect the value of the property. Ironically, the witness proffered by the taxpayer — the Chairman of the Fort Greene Association — testified that the Fort Greene Historic District was an “economic engine,” from which the Tax Court had properly concluded that the preservation of the façade was a benefit, rather than a detriment, to the property. The case underscores the importance of obtaining a qualified appraisal. Ironically, even if the taxpayer had been armed with a qualified appraisal, she would probably not have emerged victorious. Courts have been skeptical of deductions taken for conservation easements for good reason. It is difficult to perceive how promising not to destroy the façade of an historic building could reduce its value.

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