FLORIDA LLC ACT REVISION [FLORIDA]

My partner, Rick Josepher, was involved through the Florida Bar in a major update to Florida’s limited liability company provisions which were recently enacted into law. The following is a summary regarding the new provisions that he prepared.

In its session which ended May 3rd, the Florida legislature  enacted legislation (herein, the “New Act”) which substantially amends the Florida’s existing Limited Liability Company Act.

The New Act creates a new portion of ch. 608, F.S., which it delineates as part II of the LLC act. The existing LLC statutes are designated as part I of the chapter. Until January 1, 2015, part I remains in effect as to LLCs in existence before January 1, 2014. As of January 1, 2015, all LLCs are subject to part II, and part I is repealed.

A summary of the provisions of the New Act is contained in the Florida Senate’s Bill Analysis and Fiscal Impact Statement (the “Senate Statement”). Below are portions of the Senate Statement, modified in part.

The New Act is the result of efforts by representatives of the Business Law Section, the Tax Section, and the Real Property, Probate, and Trust Law Section of The Florida Bar, which included members of our firm. The New Act is substantially based on the Revised Uniform Limited Liability Company Act of 2006 as amended in 2011 (RULLCA) with deviations to reflect unique situations present in Florida.

The New Act:

• Expands the list of nonwaivable default rules in s.608.105, F.S., which cannot be “trumped” by the operating agreement;
• Modifies rules for the power of members and managers to bind the company;
• Modifies provisions addressing the LLC’s management structure (including the elimination of the term “managing member”);
• Modifies default management and voting rules;
• Modifies provisions relating to member dissociation and company dissolution;
• Modifies provisions for service of process on LLCs;
• Modifies provisions for derivative actions;
• Modifies appraisal rights provisions, including adding events that trigger appraisal rights, and   provides clarifications to the procedural aspects of the appraisal rights provisions, particularly in dealing with organic transactions approved by way of written consent.
• The New Act does not change the rules regarding charging orders, and therefore the 2011 amendments to s. 608.433, F.S., made as a result of the Olmstead Patch continue unchanged; and
• Adds provisions to permit interest exchanges and in-bound domestications by non-U.S. entities.

Below is a description of some of the changes in the New Act:

Operating Agreement

The New Act retains many similarities to current law. Like current law, the New Act provides a gap-filler provision for when the operating agreement does not provide a specific rule. Additionally, the New Act delineates matters that the operating agreement may not alter. This is a far more extensive list than exist under current law.

Management

Currently Florida law contains the concept of a “managing member,” who is elected from among the existing members. The term “managing member” is fairly unique to Florida and is not used in the statutes in any of the more prominent states. The New Act changes existing law by eliminating the concept of a “managing member.” This change was made to eliminate the confusion and disparate interpretations under existing law as to the ramifications that having a managing member has on the nature of the management structure of the LLC. 

Interest Exchange

Current law does not apply the concept of interest exchange to LLC’s. The New Act applies this concept from corporate law to LLCs. In an interest exchange, the separate existence of the acquired entity is not affected and the acquiring entity acquires all of the interest of one or more classes of the interests in the acquired entity. An interest exchange also allows for an indirect acquisition through the use of consideration in an exchange that is not provided by the acquiring entity, such as consideration from another or related entity.

Domestication

The new act, for the first time, allows domestications of non-U.S. entities who wish to become domestic LLCs in Florida. A domestication allows the domesticating entity to retain its status and existence in the non-U.S. jurisdiction in which it currently exists. The New Act allows domestication of all non-U.S. entities. Much like a merger, the New Act requires a plan of domestication and approval of domestication and allows amendment or abandonment of the plan. The plan becomes effective upon the passage and filing of the articles of domestication.

CORPORATE SUSPENSION BLOCKS TAX COURT ACCESS

Most states will suspend or involuntarily dissolve a corporation if it does not pay local taxes or fees. Such suspensions and dissolutions can typically be reversed after the corporation files to be restored and pays any back taxes and fees (and probably a penalty).

Taxpayers are permitted to contest IRS proposed deficiencies by filing a timely petition in U.S. Tax Court. In a recent Tax Court case, a corporate taxpayer filed a Tax Court petition to contest a proposed tax deficiency. Because the California Franchise Tax Board had suspended the powers, rights and privileges of the corporation and such suspension was in effect when the Tax Court petition was filed, the Tax Court dismissed the petition for lack of jurisdiction. Citing a procedural rule that provides that the "capacity of a corporation to engage in such litigation...shall be determined by the law under which it was organized," the Court found under California law the corporation had no authority to litigate during the suspension, and thus the Court could not take jurisdiction. In 2000, the Tax Court similarly ruled in David Dung Le, M.D., Inc. v. Commissioner, 114 TC 268 (2000).

Thus, tax practitioners are cautioned to check the good standing of any entity filing a Tax court petition, and to bring the entity in to good standing before filing the petition if needed.

John C. Hom and Associates, Inc. v. Commissioner, 140 T.C. No. 11

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OVDI PRE-CLEARANCE LETTERS AND THEIR REVOCABILITY

The first step a taxpayer with undisclosed or unreported offshore accounts or assets undertakes in seeking to enter the Offshore Voluntary Disclosure Initiative (OVDI) is to apply for pre-clearance from the IRS Criminal Investigation Lead Development Center. If a pre-clearance letter is issued, the taxpayer then submits a Voluntary Disclosure Letter that discloses substantial information regarding the offshore items and underreporting.

In a recent article in the Journal of Taxation, author Brian P. Ketcham notes that earlier this year, the IRS took the unusual step of withdrawing pre-clearance letters previously issued to certain Bank Leumi customers. The author was troubled by this because the initial pre-clearance letter encourages applicants to make self-incriminating statements when they proceed with the next step in the OVDI process of submitting a Voluntary Disclosure Letter – statements that the government could use in a future criminal prosecution of the applicant if one is undertaken.

Mr. Ketcham’s article discusses case law that perhaps could be used to dismiss any future criminal indictment of such applicants. However, Mr. Ketcham goes on to point out that by withdrawing the pre-clearance letters, presumably based on criteria for rejection that was not previously disclosed to applicants, the IRS raises issues whether it will fully deal in good faith both under the OVDI or other future amnesty programs. By not acting in good faith, the IRS may be causing long-term damage to such programs based on taxpayer distrust which will lead to fewer taxpayers entering such programs.

Ketcham, Brian P., Can IRS Be Trusted? A Troubling New Development in the Offshore Voluntary Disclosure Program, Journal of Taxation, Apr 2013

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FLORIDA BAR CLE PRESENTATION - TAX AND COMPLIANCE REQUIREMENTS IN WEALTH PROTECTION STRUCTURES

For anyone that is interested, I will be speaking on the above topic on Thursday afternoon on May 18. Since the Bar now broadcasts its CLE live on the Internet, you can watch it online if you register (and pay!). Below is the full program. For more information or to register, go here and search in May for course number 1461R.

 

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IRS GOES BACK 41 YEARS TO ASSESS GIFT TAX

If a taxpayer does not file a tax return, the statute of limitations for most federal taxes never commences. Thus, in theory, the IRS can go back as many years it wants to such an “open” year to audit and assess tax.

In practice, the IRS rarely goes back too far. In the income tax arena, six years is the general rule of thumb. In a recent case, the IRS has raised eyebrows by seeking to assess gift taxes on a transfer that occurred 41 years ago.

In 1972, Sumner Redstone transferred stock in a family company to other family members in settlement of a family dispute. The IRS is now seeking $1.1 million in gift taxes and penalties, plus interest per its view that the transfer was a gift. A Tax Court petition challenging such treatment was filed in April, 2013. The taxpayer is asserting that the transfers were nontaxable settlement payments and not taxable gifts. The interest on the tax amount has been estimated by some to at least equal the tax due, given 41 years of interest.

Our firm does a substantial amount of estate and trust litigation. Since most of these cases eventually settle, issues arise whether settlement payments are taxable gifts or are instead non-gift settlements. I will be interested to see how the Redstone issue is resolved by the Tax Court, if it gets to trial.

The Tax Court docket sheet can be viewed here. I have been unable to locate an online copy of the Petition itself (the above information has come from other online sources) – if anyone has a link feel free to email it to me at crubin@floridatax.com and I will post it in an update. Thank you to my partner, Jordan Klingsberg for bringing this case to my attention.

Redstone v. Commissioner, T.C., No. 008097-13

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IRS CHASING DOWN ‘QUIET DISCLOSURES’

In a recent report, the General Accounting Office (GAO) encourages the IRS to do more to uncover and pursue taxpayers who made quiet disclosures in regard to their non-U.S. accounts.

In recent years, the IRS has encouraged taxpayers with non-U.S. accounts and non-U.S. entities to enter into its Offshore Voluntary Disclosure Initiative programs if they had previously not reported the income from and/or the existence of those accounts and entities. When applicable, the OVDI programs avoid criminal exposure for the prior nonreporting. It also reduces the penalty exposure of the taxpayer, although significant penalties (based on the highest balance or value of the offshore accounts or assets) can still apply. The OVDI programs also provide a method of filing disclosure returns without penalty if all income taxes relating to income from the reportable assets had been properly paid when due.

In lieu of entering an OVDI program or otherwise filing in accordance with the program, some taxpayers have opted to file amended or initial returns for prior years reporting their non-U.S. accounts and companies. Such so-called "quiet disclosures" were often undertaken to attempt to correct the prior reporting deficiencies in this new era of enhanced enforcement activity, while avoiding having to pay the OVDI program penalties. Undoubtedly, many such taxpayers sought to fly under the radar - they would correct their prior underreporting but hopefully not be examined and thus avoid reporting penalties.

The GAO report notes that there are substantially more amended filings for prior years that likely relate to offshore reporting than people entering into the OVDI program. Thus, the GAO suspects there are a large number of taxpayers who made quiet disclosures.

The report also notes that the IRS has already reviewed at least several thousand amended returns based on its criteria to find suspect filings, and had found several hundred quiet disclosures. The report notes that:

An IRS official told us that the tax returns that were identified as part of a quiet disclosure will be examined and that cases already examined had penalties assessed. Because they were quiet disclosures, the official said the taxpayers did not receive the reduced offshore penalty.

The IRS offshore initiative office did indicate to the GAO that it had no current plans to conduct efforts as to uncovering quiet disclosures. The GAO report encourages the IRS to do some further research, employing some of the research methodologies used by the GAO to uncover more quiet disclosures.

The GAO also encouraged the IRS to conduct further efforts to determine the extent that taxpayers that are making their first time foreign reporting may have underreported non-U.S. accounts in prior years which they are not reporting currently. Unlike taxpayers who make a quiet disclosure and thus correct prior filing deficiencies, the GAO is concerned that some taxpayers who are making first time disclosures may have had their accounts in prior years but are only now starting to report - there is a good chance that such taxpayers may have unpaid taxes, interest and penalties relating to prior years. The GAO advises that the IRS can easily find suspect situations simply by asking when the newly reported filers opened the accounts they are now starting to report.

In summary, the GAO report advises us that the IRS has undertaken some reviews to uncover and audit taxpayers who made quiet disclosures. While not presently doing further research in this area, based on GAO prompting, further IRS research may be undertaken in this regard. Further, the report may stir greater IRS interest in reviewing the circumstances of first-time disclosures to determine if prior tax obligations may have been avoided.

GAO Report to Congressional Requesters (March 2013), OFFSHORE TAX EVASION: IRS Has Collected Billions of Dollars, but May be Missing Continued Evasion

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UNUSUAL RESULTS IN OFFSHORE ACCOUNT CASE

79 year-old Mary Estelle Curran received good new when she was sentenced for criminal tax evasion and failing to file reports of foreign bank accounts on UBS Swiss accounts she inherited from her husband.

The good news was that the judge awarded no jail time and only probation, and then immediately revoked the probation. The bad news was that Ms. Curran entered into an agreement to pay a fine of $21 million dollars (half of the highest balance of the offshore accounts).

Even more unusual than the immediate revocation of probation and the very large penalty were the comments of the judge, who called the situation "tragic" and note that the government "should have used a little more discretion." The judge further urged Ms. Curran to seek a pardon from the President.

You can read more about the sentencing here and read the settlement agreement here.

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BAD PLANNING IN FOREIGN ASSET PROTECTION TRUST SCENARIO

Foreign asset protection trusts are often established by U.S. persons to shield their assets from creditors. Typically, assets transferred to the trust can be paid to or applied for the benefit of the U.S. grantor(s) and their family members only in the discretion of the trustee. The trustee is typically a trust company situated in the foreign jurisdiction. So that the grantor has some measure of control over the situation, the grantor typically has power to remove and replace the trustee. Thus, if the trustee is uncooperative, the grantor has the ability to try to find and install a more cooperative one.

In a recent South Florida case, the U.S. government is a creditor of a deceased husband and his wife. The wife is a discretionary beneficiary of non-U.S. trusts, and she has the power to change trustees. The IRS has a lien on the trust assets – however, since the assets are situated outside of the U.S. with a non-U.S. trustee, the U.S. courts have no jurisdiction over the foreign trustee.

The bad planning in this situation is that the wife has the power to appoint a trustee situated anywhere in the world (including in the U.S.). Thus, the court is now ordering her to exercise that power to remove the current trustee and replace it with a U.S. trustee. Once that is done, the trustee will be within the jurisdictional reach of the court, and the assets of the trust will be reachable.

A better plan would have been to limit replacement trustees to those situated in the jurisdiction of the trust, or at least to jurisdictions outside of the U.S. Further, taxpayers should not engage in transfers that put assets beyond the reach of the IRS – such activities can result in criminal liability.

U.S. v. Grant, 2013 WL 1729380 (S.D.Fla., April 22, 2013)

APPLICABLE FEDERAL RATES–MAY 2013

 

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IS THE IRS READING EMAILS WITH A SEARCH WARRANT?

Last week, the ACLU created a stir when it suggested that the IRS may be reading taxpayers’ emails without obtaining a search warrant. Read more about that from the ACLU here. At least at some point in time in the past, according to the IRS’ 2009 “Search Warrant Handbook,” the IRS believed that the Fourth Amendment protections against unreasonable searches and seizures did not apply to email messages stored on a server.

Under the federal Electronic Communications Privacy Act, email stored on an email provider’s server can be obtained without a warrant if it has been on the server for more than 180 days or has been opened. However, the Sixth Circuit Court of Appeals in U.S. v. Warshak in 2010 requires a probable cause warrant before compelling email providers to turn over messages.

However, the head of the IRS told a Senate finance committee yesterday (April 16) that the agency does require a warrant before requesting emails from an internet provider. However, the ACLU still indicates there are open questions, such as whether the IRS only seeks a warrant for emails under 180 days old, whether it acts differently when it is in jurisdictions outside of those in the Sixth Circuit Court of Appeals, and whether it seeks a warrant for other electronic communications such as text messages and private massages on social media sites such as Facebook and Twitter.

PART-TIME LANDLORDS THAT WORK FULL TIME WILL HAVE A HARD TIME QUALIFYING AS REAL ESTATE PROFESSIONALS

Taxpayers that own rental real estate property will often want to qualify as “real estate professionals” under Section 469 (the “passive loss rules”). If they do that, their losses from their real estate activities can be used to offset other income beyond the $25,000 that is allowed – otherwise, they can only apply those losses against passive activity income.

Normally, a taxpayer will need to show that he or she spent at least 750 hours in the year on rental activities to qualify as a real estate professional for this purpose. However, there is a second requirement that must be met, which will make the real estate professional label difficult to obtain for taxpayers who also work other jobs, as demonstrated in a recent Tax Court case.

In Hassanipour, T.C. Memo 2013-88, Mr. Hassanipour owned 28 rental units in California. With that number of units, it should have been easy to show the 750 hours requirement was met. However, the passive loss rules also require that more than one-half of the personal services performed in trades or businesses by the taxpayer during the year are performed in real property trades or businesses in which the taxpayer materially participates. Since Mr. Hassanipour also worked a full time job outside of the real estate professional, he thus would have also had to show that he worked more than the 1500-1600 hours or so that he worked at his other job. This obviously is a much higher burden, and Mr. Hassanipour was unable to satisfy the court that he worked that level of time in both his regular job and in his real estate business. This burden will also make it difficult for others working full-time jobs to qualify as real estate professionals.

Taxpayers who can meet the hours requirements should keep contemporaneous time records to be able to prove it if questioned. Further, unlike Mr. Hassanipour, they should NOT present to the court evidence of contemporaneous time records on a paper calendar that bears a copyright date on it that is AFTER the years it was supposedly being used to track.

Hassanipour, T.C. Memo 2013-88

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SO MUCH FOR "PERMANENT" - TRANSFER TAX RATES AND EXEMPTIONS ARE BACK IN PLAY

Late last year, Congress and the President agreed to "permanent" transfer tax revisions that set the unified credit equivalent exemption at $5.25 million in 2013, indexed it for inflation, and set the maximum rate at 40%. At long last, the moving target of exemption and rate changes that have varied annually since 2001 was dead and buried.

Not for long, however. President Obama's budget proposal has reopened the issue. It calls for a $3.5 million exemption, without indexing for inflation. It would also move the maximum rate up to $45%. These changes would take place in 2018, which would again likely rekindle gift tax planning in 2017 before the old rates and exemptions expire.

This of course is only a proposal. Nonetheless, the four month period of "permanence" has reached its end.

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TAXPAYERS WAIT TOO LONG FOR ASSIGNMENT

If a taxpayer owns appreciated property and transferors it to another, and that successor owner sells the property, the gain from the sale is reportable by the successor owner, not the donor. However, if the gift occurs too close to the sale date, the assignment of income doctrine will attribute the gain back the transferor. A recent cases demonstrates what “too close” means.

In the case, the transferred assets were member interests in LLCs that owned stock in a closely held corporation. In early 2000, the stockholders of the company retained an investment banking firm to sell the business. On November 16, 2000, Agilent Technologies made a bid to purchase all of the stock. On November 21, 2000, the board of directors of the corporation agreed to the offer, subject to certain conditions. On November 24, 2000, the board gave its final approval. A formal Agreement and Plan of Merger was entered into on that day. Trading in the stock was restricted by those agreements, pending closing. Also on November 24, 2000, the owners of the LLC sold their shares to 3 Cayman Island corporations in exchange for annuities. Presumably, based on rules in effect in 2000, it was intended that the gains from sale would be taxed on a deferred basis (but this is not certain). The sale of shares to Agilent was publicly announced on November 27, and the Agilent sale closed on January 8, 2001.

The transfers of the LLC interests occurred too late to avoid the assignment of income doctrine, ruled the District Court of the Virgin Islands. Thus, the gains from the sale of the stock of the closely held company to Agilent were taxable to the original LLC owners.

The court relied heavily on Ferguson v. Comm'r, 174 F.3d 997, 1003 [83 AFTR 2d 99-1775] (9th Cir. 1999). In that case, a transfer occurred too late to shift the incidence of taxation when the subsequent sale was “practically certain to proceed” and not a remote hypothetical possibility, and it was “quite unlikely” that the anticipated sale would not occur. In this case, all sale approvals had been obtained, and the owners were contractually bound to sell. Thus there was “no real risk” that the sale transaction would not occur.

Gail Vento LLC v. U.S., 111 AFTR 2d 2013-XXXX, (DC VI), 03/28/2013

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GRANDFATHERED BUY-SELL AGREEMENTS

Code §2703 severely restricts the ability of a buy-sell agreement to control estate tax values in a closely held entity. A recent private letter ruling reminds us that older agreements are not subject to Code §2703.

More particularly, agreements entered into before October 8, 1990, and that are not “substantially modified” after that date are not subject to Code §2703. Apparently, there are still a few of these older agreements out there.

The private letter ruling recognized that the older agreement was not subject to Code §2703.  The ruling also sought confirmation that certain changes being made now to the agreement are not substantial modifications that will subject it to Code §2703.  Treas. Regs. §25.2703-1(c) provides guidance on what is a substantial modification for this purpose.

One modification to the agreement was to extend the repayment term. The IRS viewed this as only a de minimis change to the quality, value, or timing of the rights of a party to the agreement because the agreement requires payment of a reasonable rate of interest.

The other modification was a clarification that the “prime rate” used in the agreement is a rate that is to be adjusted semiannually. This change was not a substantial modification because the regulations provide a substantial modification does not include a modification that results in an option price that more closely approximates the fair market value. Here, an adjustable interest rate should result in payments that more closely approximate fair market value.

Note that agreements that are not subject to Code §2703 still must meet the requirements of  Treas.Reg. § 20.2031-2(h), Rev. Rul. 59-60, 1959-1 CB 237, and applicable case law before the purchase price provided therein will control for federal estate tax valuation purposes.

Private Letter Ruling 201313001

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PERSONAL USE OF CORPORATE PROPERTY IN A USRPI HOLDING COMPANY STRUCTURE

To insulate the ultimate individual owners from U.S. estate taxes, nonresident aliens often hold U.S. real property in a U.S. corporation, which corporation is owned by a foreign corporation. The foreign corporation is owned by the ultimate nonresident alien owners (either directly or through intermediate non-U.S. entities).

If the real property is a residential unit that will be personally used by the individuals involved (or other family members or friends), the payment of rent for the personal use should be considered. A recent Tax Court case illustrates the results that can arise when there is no rental payment.

The case advises us:

1. Holding the property in a corporation does not automatically create deductions for residence expenses and depreciation. Trade or business activity is needed for deductions to be allowed under Code §162. The Tax Court denied the corporate deductions for these items since there was no trade or business activity.
2. However, some “incidental” personal use will not void otherwise applicable trade or business expenses (“In  general, where the acquisition and maintenance of property such as a yacht or a residence are primarily associated with profit-motivated purposes and personal use can be said to be distinctly secondary and incidental, a deduction for maintenance expenses and depreciation will be permitted. Int’l Artists, Ltd. v. Commissioner, 55 T.C. 94, 104 (1970)”). However, in the case at issue the personal use was primary, not incidental.
3. Personal use of the property without rent will constitute a deemed distribution from the U.S. corporation to its foreign parent corporation, with additional deemed distributions through the entire ownership chain on down to the individual stockholders.
4. The amount of the deemed distribution is the fair rental value of the personal use.
5. Such distributions will be taxed as dividends to the extent of earnings and profits of the paying entities. Absent an income tax treaty applying, such dividends from the U.S. corporation to the foreign parent corporation will be subject to 30% withholding if a “dividend” (i.e., to the extent of E&P). The case was remanded to determine the earnings and profits of the U.S. corporations.
6. A question that was not addressed was whether there were any “deemed rent payments” that could give rise to constructive earnings and profits. This would create E&P that could be used to create taxable dividends. Absent such constructive E&P, presumably there would not be much, if any, E&P in the U.S. real property holding corporations.
7. Even if there is no E&P, the deemed distributions will be treated as either return of capital or capital gains under Code §301. This could alter future computations of capital gain on sale or liquidation and/or eventually create current capital gain from deemed rent once the aggregate deemed distributions exhaust the tax basis in the shares of the company.
8. The inclusion of rental income on the tax return of the U.S. corporation (which occurred here at the suggestion of the clients), absent an actual rent payment, does not avoid these issues.

Note that similar principles can apply to real property owned by LLC’s and dividends (albeit without the application of U.S. withholding taxes on E&P distributions under the corporate income tax rules).

Thanks to Carlos Somoza of Kaufman, Rossin & Co., P.A. for sending me a copy of this case.

G.D. Parker, Inc. v. Comm., TC Memo 2012-327

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PARTIAL WIN FOR GOLFER IN TREATY CASE

A recent Tax Court case addressed some interesting athlete and treaty issues. The Court ended up siding with the golfer on some, but not all, of the golfer's positions.

Sergio Garcia is a professional golfer. In the tax years at issue, he was a party to an endorsement agreement with TaylorMade Golf Co. Garcia was obligated to use certain TaylorMade products, both on and off the golf course (the "personal services" income). TaylorMade also had the right to use Garcia's name and image in advertising and other promotions (the "royalties" income). The distinction between personal services income and royalties income was important because under the applicable Switzerland - U.S. income tax treaty, royalties income is taxable only in Switzerland. Personal services income could be taxed by the U.S. as to personal services performed in the U.S.

ALLOCATION OF PAYMENTS BETWEEN ROYALTIES INCOME AND PERSONAL SERVICES INCOME. The endorsement agreement allocated 85% of the TaylorMade payments to Garcia as royalties income, and the rest as personal services income. The IRS claimed, at least initially, that all of the payments were for personal services. 

The Tax Court rejected that the contract allocation was binding based on a claim that the parties were adverse to each other in making this allocation. The Court did not believe that TaylorMade was adverse to Garcia simply because it did not want to suffer the bad publicity of the IRS disputing its tax allocation.

The Tax Court determined that 65% of the income was royalty income, thus reducing Garcia's claimed percentage but still allowing him a major allocation to royalties. This was a factual analysis, but the Court borrowed from other cases (including Goosen v. Commissioner) that dealt with similar contracts. The case is instructive for others as to the factors the Court will review in testing such allocations.

WHAT PORTION OF PAYMENT QUALIFIES AS A ROYALTY? The key test employed was what portion of the payments were "for the right to use a person's name and likeness...because the person has an ownership interest in the right."

SUPREMACY OF ROYALTIES ARTICLE OVER ARTISTES AND SPORTSMAN'S ARTICLE OF TREATY. The royalties article of the treaty gives exclusive taxing jurisdiction of royalties to Switzerland  - “Royalties derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State.”  To be able to tax the royalties payment, the IRS argued that as an athlete, the Artistes and Sportsmen article overrides the royalties article and applied to Garcia, thus allowing the U.S. to tax those payments  - "income derived by a resident of a Contracting State as an entertainer, such as a theatre, motion picture, radio, or television artiste, or a musician, or as a sportsman, from his personal activities as such exercised in the other Contracting State may be taxed in that other State.” 

In resolving disputes between the articles, the Treasury Technical Explanation provides that "the controlling factor will be whether the income in question is predominantly attributable to the performance itself or other activities or property rights.”  Applying this test, the Court found that:

we believe that even though petitioner's golf play and personal services performed in the United States has some connection to his U.S. image rights, income from the sale of such image rights is not predominantly attributable to his performance in the United States. Rather, the image rights are a separate intangible that generated royalties (as defined by article 12(2)) for petitioner when TaylorMade paid him for their use. 

Thus, the Court concluded the royalties article prevailed and that the U.S. had no jurisdiction over the royalty portion of the payments.

SERGIO GARCIA V. COMM., 140 TC No. 6 (3/14/2013)

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APPLICABLE FEDERAL RATES–APRIL 2013

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NRA GAIN ON SALE OF PARTNERSHIP INTEREST TREATED AS CREATING EFFECTIVELY CONNECTED INCOME

Nonresidents are generally not subject to U.S. income taxes on their capital gains if present in the U.S. for less than 183 days in the tax year. Code Section 741 treats the gain from the sale or exchange of a partnership interest as capital gain (subject to some limited exceptions). Therefore, if a nonresident who has been in the U.S. for less than 183 days sells a U.S. partnership interest, then it appears that any resulting gain is capital gain, which is not subject to U.S. income tax.

A recent Legal Advice Issued by Field Attorney advises that such gains will be subject to U.S. income tax if the partnership was engaged in a U.S. trade or business. The LAFA strings together several Code provisions to support this conclusion, but such provisions do not fully resolve the issue (contrary to the IRS’ position).

Code Section 875(1) states that “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.” This provision thus supports the conclusion that the NRA partner of a partnership that is engaged in U.S. trade or business is himself deemed engaged in a U.S. trade or business. However, the partnership interest of the partner is not directly used in the business. Therefore, Code Section 875(1) without more should not convert the gain on sale of a partnership interest into effectively connected income (ECI) that is taxable to the NRA.

Code Section 864(c)(2) looks like it may support such gain as ECI when it provides that ECI includes (A) the income, gain, or loss is derived from assets used in or held for use in the conduct of such trade or business, or (B) the activities of such trade or business were a material factor in the realization of the income, gain, or loss. But the face of the statute again does not provide direct support to ECI since under (A) the partnership interest itself is not used in the trade or business, and it is unclear how under (B) the partnership trade or business activities become a material factor in the sale of the partnership interest.

The foregoing nontaxation arguments have force when the partnership is viewed as an entity. However, we all know that the IRS at times will treat a partnership as an aggregate of its assets and treat its partners as owning such assets. It is by applying an aggregate theory that the IRS counsel concludes that the sale of the partnership interest generates ECI for the selling NRA partner. However, given the express entity methodology used in Code Section 741, a strong argument against the use of the aggregate theory here exists.
                              
The IRS is not without support in this area. Rev.Rul. 91-32 supports the use of the aggregate theory in this context, and the IRS counsel cites to it.

There have been proposals to codify Rev.Rul. 91-32 in recent years. However, the very existence of such codification attempts raises the question of the correctness and authority of the Revenue Ruling until the Code is changed.

Notwithstanding this IRS analysis and Rev.Rul. 91-32, there are those that still consider this an unresolved issue, at least until some court weighs in on the issue.

Note that if the gain is not subject to tax, Code Section 754 may operate on the sale to step up the basis of the partnership assets, thus reducing future gains on sales of assets by the partnership allocable to the sold partnership interest.

Legal Advice Issued by Field Attorney 20123903F

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MERE RECORDING OF DEED DOES NOT COMMENCE FOUR YEAR STATUTE OF LIMITATIONS ON FRAUDULENT CONVEYANCE [FLORIDA]

Under fraudulent conveyance law, a creditor of a debtor can reach property of the debtor that the debtor transferred to third parties if the transfer is a fraudulent conveyance. However, Fla.Stats. §726.110(1) provides that an action to reach such transferred property must be commenced within 4 years of the transfer, or if later, within 1 year after the transfer was or could reasonably have been discovered. Thus, if the transfer occurred more than 4 years ago, a creditor cannot sue if the property owner can show that the transfer “was or could reasonably have been discovered” within the preceding 1 year period. If the transfer was not discovered and could not reasonably have been discovered, then the statute of limitations does not expire – hiding the transfer will not yield a reward to the transferor or the transferee. 

In a Florida case, the subject property was Florida real estate. A transfer was made by the debtor, and a deed was recorded in the public records. The current owner of the real estate claimed that the recording of the deed put the creditor on notice and since both the 4 year period and the 1 year period had expired since recording, a fraudulent conveyance claim against the current owner was time barred. More particularly, the issue was whether the recording of a deed constitutes such notice that a creditor “could reasonably have discovered” the transfer for purposes of the above rules. 

The trial court dismissed the fraudulent claim as time-barred. However, the 1st District Court of Appeals reversed and held that the mere recordation of the deed was not enough notice to start the 1 year rule of the statute as being a transfer that is reasonably discoverable. The DCA noted that recording statutes are there to put third persons who have a reason to examine the records on notice of a transfer – such as subsequent purchasers or would-be lienors. Authorities in other jurisdictions typically (but not unanimously) distinguish between subsequent purchasers and creditors alleging fraudulent transfers int his context. 

The DCA ultimately determined that: 

It is not reasonable to require a defrauded creditor to monitor the land records in all 67 couties or, indeed, outside the state, as well, as a routine practice.

Desak v. Vanlandingham, 37 Fla.L.Weekly D2354 (1st DCA)

CO-GUARANTORS LIMIT AMOUNT AT RISK

Code §465 limits deductions for taxpayers in business and investment activities to the amount the taxpayer has "at risk" in the venture. Amounts of owners that are contributed to capital are generally at risk. Also at risk are amounts that are borrowed by the venture, and for which the taxpayer is personally liable for repayment or has pledged property as security for repayment.

However, Code §465(b)(4) provides that the taxpayer is NOT at risk for amounts for which the taxpayer is ‘protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements." A recent Chief Counsel Advice explores this limit in context of an LLC owner that guarantees debt of an LLC.

The first issue raised in the CCA was whether the guarantor's rights of indemnification against the LLC borrower protected the guarantor against loss under Code §465(h)(4). That is, under state law, a guarantor who has to pay is entitled to be indemnified for the payment made against the original borrowing party. Here, the Chief Counsel's  office recognized that this indemnification right was meaningless since if the LLC did not pay the debt it would be because it had no assets to do so. Therefore, notwithstanding the indemnification right, the guarantor was the 'payer of last resort in the worst-case scenario' since it could not recoup its loss from payment on the guaranty from the LLC obligor.

The second issue was a little different. Here, the guarantor had other co-guarantors. If the lender came after the guarantor and collected the full amount from the guarantor, the guarantor would have rights of contribution from its co-guarantors. Therefore, applying the worst-case scenario, the guarantor would not be on the hook for 100% of the loan amount. Therefore, the guarantor's at risk amount, for purposes of taking deductions, is limited to the amount that the guarantor could not collect from its co-guarantors.

Chief Counsel Advice 201308028

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ADDING ACCRUED INTEREST TO PRINCIPAL BALANCE DOES NOT GENERATE A DEDUCTION

Cash basis taxpayers may deduct “qualified residence interest” when paid. Qualified resident interest is generally interest on a loan taken out to purchase a qualified residence, or to refinance it within certain dollar limits.

In a recent Tax Court case, a taxpayer accrued interest on his home mortgage. Per an adjustment clause under the mortgage a portion of the interest was paid, and a portion was added to the principal of the mortgage. The taxpayer deducted all of the accrued mortgage interest, including the portion that was not paid but was added to the mortgage. The IRS contested the deduction for the capitalized portion of the interest.

The Tax Court ruled for the IRS. Other precedent provides that the delivery of a promissory note to satisfy an interest obligation is not payment of the interest obligation. The reasoning for such a rule is that the note may never be paid, and if it is not paid, the taxpayer has not parted with anything (other than his or her promise to pay). Unable to distinguish that situation from adding interest to the principal amount of a mortgage, the Court held the capitalized interest amount was not deductible.

Philip C. Smoker, TC Memo 2013-56

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WHEN IS A NOTICE ADDRESSED TO A PERSON OUTSIDE OF THE UNITED STATES?

Seems like a simple question, but is it? Is a notice addressed to a person outside of the U.S. if at the time of mailing the person is physically in the U.S., even though they reside outside of the U.S.? What about if it was mailed to a U.S. address? What if it was mailed to a U.S. address and the taxpayer was in the U.S. when it was delivered? More than one tax case has struggled with these questions, including one recently decided by the Tax Court. In the recent case, the Tax Court itself could not even agree on the answers, with some judges filing dissenting opinions to the majority decision.

A taxpayer who received a Notice of Deficiency has 90 days from the date the IRS mails it to file a petition in Tax Court to contest the asserted tax. Otherwise, the taxpayer will need to pay the tax first, and then sue for a refund in federal District Court or the Claims Court. However, Code §2613(a) provides a 150 period in certain circumstances:

Within 90 days, or 150 days if the notice is addressed to a person outside the United States, after the notice of deficiency authorized in section 6212 is mailed (not counting Saturday, Sunday, or a legal holiday in the District of Columbia as the last day), the taxpayer may file a petition with the Tax Court for a redetermination of the deficiency. (emphasis added)

So in the recent case, the taxpayer formerly resided in the U.S., but took up residency in Canada. She still had a San Francisco home and post office box, and the IRS mailed the notice to her U.S. post office box. Coincidentally, the taxpayer was in the U.S. when the notice was mailed, and was still there when it was delivered to her P.O. box, but she did not pick it up. She went back to Canada and the notice was eventually forwarded to her in Canada. She filed a petition in Tax Court, but more than 90 days after the date of mailing and less than 150 days after the mailing date.

There were lots of ways the Tax Court could have ruled her petition untimely – she was in the U.S. when it was mailed, and when it was delivered, and it was mailed to a U.S. address. Nonetheless, the Court ruled in favor of the taxpayer and allowed her petition. The Court noted that “the crucial criterion to be gleaned from the decided cases is whether the `person' is physically located outside the United States so that the notice of deficiency mailed to its United States address will be delayed in reaching it in a foreign country *** and thereby hamper its ability to adequately respond by filing a petition to litigate its case in this Court.” Thus, the Court held:

“She was a Canadian resident (i.e., when the notice was mailed and delivered); was not at the address to which the notice was delivered; and received the notice, in Canada, 127 days after the notice's mailing date. Although petitioner was in San Francisco when the notice was mailed and delivered, her status as a person “outside of the United States” is largely a function of her residency and is not vitiated by her brief presence in the United States.”

Note that the opinion never lets us know whether the taxpayer was a U.S. citizen, or a resident for income tax purposes (by reason of the # of days present in the U.S. or green card status). That is because the 150 rule can be used by U.S. taxpayers and not just nonresidents, if they are physically outside of the U.S.

Deborah L. Smith v. Commissioner, 140 T.C. No. 3 (2013)

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LIMITED REACH OF THE ESTATE TAX

With the increase of the unified credit equivalent amount to $5.25 million and its indexing for inflation, clearly there will be a lot less fewer estates subject to estate tax than when exemptions were lower. The Congressional Research Service issued a report on February 15, 2013 that estimates the number of estates that will be subject to the tax, and these figures are REALLY LOW. They also apply an interesting “how many taxable estates are expected in a given state” analysis.

The conclusions of the report are:

a. The estate tax will affect less than 0.2% of decedents over the next decade.

b. The estate tax is concentrated among high income taxpayers: 96% is paid by the top quintile, 93% by the top 5%, 72% by the top 1%, and 42% by the top 0.1%.

c. About 0.2% of estates with half or more of their assets in businesses will be subject to the estate tax.

d. About 65 farm estates (or approximately one per state) are projected to be subject to the estate tax, and constitute 1.8% of taxable estates. Less than a fourth (0.4%) is projected to have inadequate liquidity to pay estate taxes. Less than 1% (0.8%) of farm operator estates are projected to pay the tax.

e. About 94 estates (about two per state) with half their assets in small business and who expect their heirs to continue in the business are projected to be subject to
the estate tax; they constitute 2.5% of total estates. Less than a half (1.1%) are projected to have inadequate liquidity to pay estate taxes.

The Estate and Gift Tax Provisions of the American Taxpayer Relief Act of 2012, Congressional Research Service, February 15, 2013

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APPLICABLE FEDERAL RATES–MARCH 2013

I’ve made a few changes this month. I’ve changed some formatting, but more importantly I have added the §7520 rates to the chart. Also, I am including a new chart that shows 20 years of the long term AFR rate, to give some long term perspective on where rates currently stand.

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DID THE TAX COURT ERR IN KITE?

Code Section 2519 is a notoriously difficult section to apply. In 2009, I wrote on article on it for Estate Planning, and ever since I’ve been providing a lot of assistance to others on its operation. So I am always interested when a new Section 2519 opinion comes out.

In Estate of Kite, the Tax Court issued an erroneous opinion as to the applicability of Section 2519, at least in my opinion. In Kite, a husband passed away, and assets were funded into a QTIP trust for his wife. Before the wife’s death, some or all of the QTIP trust assets were transferred to a family partnership. Later, the trust was terminated, and all of its assets (including the family partnership interests) were transferred to the wife. She then sold those partnership interests to family members in exchange for a private annuity two days later. She later died before any annuity payments were received, and thus the sold QTIP assets avoided taxability in the wife’s estate based on applicable private annuity rules.

The case is helpful in context of deferred private annuities – the Tax Court upheld the exclusion of the sold assets from the wife’s gross estate. However, the Court also ruled that the distribution of the trust assets to the wife and the sale for a private annuity should be integrated under the step transaction doctrine. Once the transaction was combined, the Court found that the wife had disposed of her income interest in the QTIP trust in the private annuity sale, and thus triggered a Section 2519 gift tax on the value of the remainder interest in the QTIP.

This conclusion is suspect on more than one level:

a. First, if the Court was to disregard the transfer first to Mrs. Kite, then what occurred was a sale BY THE TRUST of its assets for a private annuity. The Court, in addressing both a reinvestment of trust assets into the family partnership and other sales of trust assets to family members, acknowledges that a sale by the trust itself is not a Section 2519 disposition of an income interest since the income interest continues in the newly acquired asset. To say that Mrs. Kite disposed of her income interest in the sale is somewhat specious, since the sale was of all of the trust assets without regard to the value of the income interest alone.

b. Second, and more importantly, the Court applies a technical and strained reading of the statute to achieve a result that was never intended under Section 2519. Section 2519 is intended to avoid a surviving spouse’s estate from avoiding estate and gift tax on assets received by that spouse in a QTIP that escaped taxation at the first spouse’s death by reason of the marital deduction. That is, the first spouse’s estate got an estate tax deduction (and thus no estate taxes were imposed) on assets going into the QTIP trust. However, Code Section 2044 imposes a cost of that tax avoidance – inclusion of the QTIP trust assets remaining at the death of the surviving spouse in his or her estate. Section 2519 was passed as a backstop to Section 2044 to trigger the tax in transactions that would in effect bypass the later taxation of the QTIP trust assets at the surviving spouse’s death. In this case, the Court has instead subjected the surviving spouse to double taxation. To illustrate this, assume that Mrs. Kite received all of the trust assets, and they were worth $1 million. Let’s also assume that the value of the remainder interest is $600,000, and that Mrs. Kite sold the $1 million in assets she received from the trust for $1 million. If Mrs. Kite had died while the $1 million was still in the trust, her gross estate would include the $1 million under Section 2044. When Mrs. Kite received the $1 million in assets, if she had died the day after the full value of the trust assets would still be in her gross estate under Section 2033 (per her direct ownership of them), and thus no estate taxes on the QTIP trust assets were avoided on the termination of the QTIP trust. This is why Section 2519 does not generally apply to principal distributions to a surviving spouse from a QTIP trust. The fact that Mrs. Kite then sells those assets for $1 million in cash does not change the result – she still has $1 million in assets subject to estate tax at her death. Now, if the termination of the QTIP trust and the sale results in gift tax on the $600,000 remainder interest as the Tax Court tells us it does, that $600,000 is taxed twice. First, under Section 2519, and then when Mrs. Kite dies. Something is very wrong here for that to happen.

Now, in Kite, there was no double taxation. But that is because the private annuity functioned to exclude the value of the sold assets and the annuity from Mrs. Kite’s gross estate. If instead Mrs. Kite had sold assets for cash or a promissory note valued at $1 million, or had lived long enough to receive the annuity payments that the actuarial tables predicted, and then she died, this double taxation would show up. The fact that the private annuity functioned to avoid estate tax on this instance is a function of the tax provisions that relate to private annuities and not Section 2519. Indeed, the Tax Court opinion gives no indication that the private annuity aspect of the sale would or should change the Section 2519 result it thought was proper, and Kite as written should apply to all sales in this circumstance, not just sales by deferred private annuity (although perhaps one could argue that it only applied to deferred private annuity sales).

The case is also bad news since it muddies the waters if a surviving spouse receives any distributions from a QTIP trust and then sells the received asset. At what point in time will the sale be far enough away from the distribution date to avoid Kite? Since Section 2519 applies to a disposition of any part of the income interest, the fact that the spouse did not receive and/or sell a substantial portion of the QTIP trust assets would not avoid the applicability of Section 2519.

There is also another facet of the case that raises a question for me. It appears that in 1997, distributions of QTIP trust assets were made to relatives of Mrs. Kite, and these were reported as gifts. If in fact such distributions were made, this should have been characterized as a disposition of a part of the income interest  of Mrs. Kite (via a reduction in trust assets that are there to produce income for the income interest holder) and triggered Section 2519 at that earlier time. If Section 2519 was triggered on that earlier date, it could not have been triggered again at the time of the distribution and sale to Mrs. Kite in 2001, and since a gift tax return was filed in 1997 it would appear that the statute of limitations for additional tax due in 1997 (as would be incurred in Section 2519 applies in 1997 to the full value of the trust) should likely be closed. Thus, Code Section 2519 should not have applied in 2001.

Kite is not all bad news for taxpayers. It provides some favorable findings and rulings on the use of deferred annuities to avoid estate taxes (assuming the annuitant does not live to his or her life expectancy). It also confirms that sales of assets by a QTIP trust do not trigger Section 2519.

I used to tell people raising questions whether Section 2519 applied to a particular set of facts that the best guide for Section 2519 is whether there is an opportunity in the current transaction to avoid estate tax on some or all of the remainder interest assets of the QTIP trust – if yes, then Section 2519 likely applies. By failing to take the purpose of Section 2519 into account in Kite, and even worse, subjecting similarly situated taxpayers to double taxation, the Tax Court did not make this “gut check” and thus may have missed the mark on this one.

Estate of Virginia Kite v. Comm., TC Memo 2013-43

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LLC’S ELECTING TO BE ‘S’ CORPORATIONS

Most entities operating as ‘S’ corporations are corporations formed under state law. However, under the check-the-box rules, a limited liability company (LLC) can elect to be taxed for federal tax purposes as a corporation. With such an election, the LLC can then elect to be taxed as an ‘S’ corporation, if it otherwise meets Subchapter S requirements.

But why would anyone want to do this? How is it done? Are there any pitfalls? A recent article by James R. Hamill addresses some of these issues. A summary of the key points follows.

WHY BOTHER? Probably the main reason why someone would go the LLC route to ‘S’ status is creditor protection. Many states limit the rights of creditors of a member of an LLC to obtaining a charging order. Stock of corporations (‘S’ or not) does not receive similar protection. Therefore, an LLC electing ‘S’ status provides superior creditor protection to its owners. Since ‘S’ status does not impact state law rights as to an entity and its owners, making an election to be taxed as an ‘S’ corporation does not impact creditor rights issues.

HOW IS IT DONE? The LLC and its members could file a Form 8832 to be taxed as a corporation, and then a Form 2553 to be taxed as an ‘S’ corporation. However, Treas. Reg. Section 301.7701-3(c)(1)(v)(C) and the form instructions allow this to be done just by filing a Form 2553, without the need for a Form 8832. However, an unsigned “dummy” Form 8832 election will be needed to be filed with the initial income tax return filed for the corporation as an ‘S’ corporation.

PITFALLS? The major pitfall in this area is to make sure that the operating agreement for the LLC is modified to comply with Subchapter S requirements. The key requirement that a plain vanilla operating agreement will often violate is that prohibiting a second class of stock.  Typical LLC operating agreement provisions such as special allocations of income, gain, loss, or expense (including substantial economic effect provisions under Section 704), Section 704(c) contributed property allocations, preferential returns or liquidation rights, and provisions regarding distributions in accordance with capital accounts, will typically violate the second class of stock rules and thus need to be modified out. The article also notes that while you are engaged in modifying the standard form operating agreement, provisions regarding ‘S’ corporations that are typically found in shareholders’ agreements, such as prohibitions on transferring ownership to nonqualified owners, should be included in the operating agreement.

AVOIDING TRAPS WHEN ELECTING S CORPORATION STATUS FOR AN LLC, by James R. Hamill, Practical Tax Strategies (WGL), Jan. 2013

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IN-PLAN ROTH ROLLOVERS NOW PERMITTED

Previously, if you held assets in a 401(k) plan and you were under the age of 59 1/2, you were unable to transfer some or all of your plan assets to a Roth plan under the 401(k) plan. A Roth plan allows for later distributions from the plan to be made without income taxes to the plan participant (which is the opposite treatment of IRAs and other qualified pension plans, which are tax deductible on contribution and taxable when distributions are later made).

Under a provision of the 2012 Taxpayer Relief Act, these transfers are now permitted. Two provisos, however. First, your 401(k) plan must otherwise allow for a Roth account. Second, such a conversion will likely result in current income tax to the participant. Interest persons should consult with their plan administrators and tax advisors before making such a transfer.

Code Section 402A(c)(4)(E)

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DISCLAIMER OF INCOME INTEREST WAS NOT TAXABLE FOR NONRESIDENT

Code §2501(a)(2) provides that, except as to certain expatriates, U.S. gift taxes do not apply to the transfer of intangible property by a nonresident not a citizen of the United States. This exemption is big enough to drive a truck through, though of course, a truck is TANGIBLE property so a gift of a truck in the U.S. would not be exempt under this rule. The Internal Revenue Code does not provide a definition of “intangible” property.

In a recent Private Letter Ruling, a nonresident income beneficiary of a trust disclaimed his interest in the trust. The disclaimer was not a qualified disclaimer (which would have exempted it from gift tax), because the beneficiary had already received distributions from the trust.

The taxpayer sought a ruling that the income interest was “intangible” property, and thus the gift of the interest via the disclaimer was exempt from gift tax under §2501(a)(2). While not explicit in the ruling, the essential question here was whether one should look through the trust to look at the character of the trust assets that produce income (to determine if the assets were tangible or intangible, and if tangible, to see where they are located), or whether an income interest is inherently an “intangible” regardless of what the trust assets are comprised of.

The IRS ruled that the income interest was intangible property. However, there are two aspects of the ruling that may limit its universal application.

First, the applicable state law was silent on whether a trust income interest is intangible (or not). If a state law has rules on this issue, this could help (or hurt) a similarly situated taxpayer in that state.

Second, there was also a favorable state case that found that an income beneficiary has no ownership interest in trust assets, when the beneficiary had no other powers or discretions over the trust. Different case law in other states may result in a different result. Also, it appears important here that the beneficiary has no other rights in the trust, including powers of appointment, rights to change the terms of the trust, rights to remove the trustee, or other powers. There is some sense to this – such rights over the trust will give some indirect control over principal, and thus makes the argument for look-through treatment more compelling. Since many income beneficiaries have some other rights, such as the right to remove or replace a trustee, or a power of appointment, reliance on this ruling will be more open to question in those situations.

PLR 201250001

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OBAMACARE TAXES, AND SALES OF PARTNERSHIP AND SUBCHAPTER ‘S’ INTERESTS

Have you given any thought to how Obamacare’s new 3.8% tax on investment income and gains will apply to sales of interests in partnerships and Subchapter S corporations? No, I didn’t think so.

Here is a general overview, including information on a hidden, and frankly nauseating, compliance burden that may apply at times.

1. The starting point is that gains from such sales are subject to the tax. However, only individuals whose “modified adjusted gross income” (MAGI) exceeds certain thresholds will be subject to the tax – the “Gift of the Magi” for those of you with a literary bent. The joint filing threshold for married spouses is $250,000, $125,000 for married filing separately, and $200,000 for all others. As you can see, there is a substantial marriage penalty built into these thresholds. Over time, more and more taxpayers will be subject to the tax since the thresholds are NOT indexed for inflation.

2. Since gains (and other investment income) from trades or businesses are not subject to the tax, Code §1411(c)(4) and Proposed Reg. §1.1411-7 will allow a partner or stockholder to avoid the tax on gains from the sale of ownership interests in partnerships or S corporations that are engaged in business, at least in part. Before a partner or stockholder can use this exclusion, the following requirements must be met:

    a. The entity must be engaged in a trade or business (within the meaning of Code §162);

    b. The trade or business must not relate to the trading of financial instruments or commodities; and

    c. The selling stockholder or partner  must be engaged in at least one trade or business of the partnership or S corporation (generally applying definitions of “material participation” that are used in the passive loss rules.

If the taxpayer wants to use the above exception, this is where the compliance burden kicks in. To use the exception, a deemed sale by the partnership or S corporation of all of its assets (including goodwill) for fair market value must be undertaken, to determine what portion of the gain should be allocated to trade or business gains (as to which the partner or stockholder is deemed to materially participate and which will escape the 3.8% tax) and all other gains (which allocated portion will be subject to the 3.8% tax). Once the gains from such deemed sales are undertaken, adjustments to the amount of gain recognized by the selling owner for purposes of the tax are made.

Deemed sales mean the necessity of obtaining values for the corporate assets at the time of sale. Does this mean that appraisals and valuations of the entity assets will be needed? Probably not. The Proposed Regulations direct taxpayers to apply the principles of Treas. Regs. §1.743-1(d)(2) to make these computations. Such principles are complex and difficult to apply, but generally do not require appraisals. Instead, values of entity assets are obtained by working backwards from the purchase price for the sold ownership interest. However, if the sale is not an arms-length sale, perhaps appraisals will be needed.

How are taxpayers to make these computations if the entity does not cooperate? The IRS is concerned about that, too, and has asked for comments on that issue.

The above analysis and computations will be required all for a 3.8% tax. One can anticipate many circumstances when the accountants fees to undertake the analysis and computations come close to or exceed the tax savings from doing the analysis and computation.

The only saving grace here is that these computations will not be needed in many circumstances involving partnerships and S corporations because either all or none of the gain will be potentially subject to exclusion from tax due to:

a. All assets of the entity are used in the entity’s trades or businesses, and the selling owner materially participates in all of those trades or businesses,

b. None of the assets of the entity are used in the entity’s trades or businesses,

c. The selling owner does not materially participate in any of the entity’s trades or businesses, or

d. The selling owner is under the Obamacare MAGI thresholds.

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SHARE OF APPRECIATION NOT GRANTED IN PRENUPTIAL AGREEMENT

A recent Florida appellate court decision provides a drafting lesson in prenuptial agreements - if a spouse is to receive an interest in appreciation in an asset, the agreement should be specific on that.

In the case, a valid prenuptial agreement provided that:

6. Agreements Concerning Fran's House. The parties hereto intend to reside in Fran's house . . . . The House shall be and remain titled in Fran's name alone and, except as specifically provided in Section 6, Rudy shall have no right, title or interest in and to the House or any of Fran's Separate Property contained herein. Further, with respect to the House, the parties agree as follows:

(a) If a petition for dissolution of marriage is filed by either of the parties hereto after the date the parties are married, upon the entry of an order dissolving the marriage of the parties, Fran shall pay to Rudy a sum equal to one-half of all principal payments and any capital improvements made with respect to the House between the date of the marriage of the parties and the date on which a petition for dissolution of marriage was filed.

The parties divorced, and Rudy claimed that he was entitled to one-half of the appreciation in the House that occurred after marriage. The trial court agreed with him and awarded him that portion of the appreciation.

The court was reversed on appeal, since the plain language of the agreement only contemplates that Rudy was to receive a dollar amount equal to one half of the principal payments and capital improvements made.

It is unclear from the opinion whether Rudy thought that he was entitled to the appreciation at the time he entered into the agreement, or he just threw that argument in at the time of divorce to see if it might stick. The result here is not surprising based on the language of the agreement. The only surprising thing is that the trial court agreed with Rudy, and had to be reversed on appeal.

If it is intended that a party is to benefit by post-marriage appreciation in an asset, this should be made explicit in the agreement to avoid disappointed parties and unnecessary litigation.

Heiny v. Heiny, 38 Fla.L.Weekly D200g (2nd DCA 1/25/13)

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