IRS Warns Taxpayers Regarding Evasion of FIRPTA Withholding Requirements

The IRS is warning real estate and tax professionals of the withholding tax and filing requirements for two transactions in which a foreign person disposes of a U.S. real property interest:

Option Transactions. Under U.S. tax law, a foreign person that sells or exchanges a U.S. real property interest must report the gain on a U.S. tax return, and the buyer of the U.S. real property interest must withhold and pay to the IRS 10 percent of the gross amount paid to the foreign person. A U.S. real property interest includes options or contracts to acquire land or land improvements and leaseholds of land or land improvements. The disposition of such an option or contract by a foreign seller is reportable on the foreign seller's U.S. tax return and is subject to a 10 percent withholding tax payable by the buyer to the IRS. Under U.S. tax law, the buyer must determine if the seller is a foreign person. If the seller is a foreign person and the buyer fails to withhold, the buyer can be held liable for the withholding tax.

The IRS has become aware of instances in which foreign persons have acquired options or entered into contracts to purchase U.S. real property interests and sold the options or assigned the contracts before such instruments are exercised or executed and title to the underlying property is taken. Buyers of the options or contracts are failing to withhold and remit to the IRS the required 10 percent from the proceeds of the sale.

Transfer to a Shareholder. The IRS is also aware of potentially abusive transactions where a foreign corporation arranges a sale of its U.S. real property interest to a buyer and then transfers its U.S. real property interest to its foreign individual shareholder. The foreign shareholder then sells the U.S. real property interest to the buyer. The foreign shareholder takes the position that, because he or she, rather than the corporation, is selling the property, some or all of the gain inherent in the foreign corporation's U.S. real property interest is subject to a maximum capital gains rate of 15 percent. That is, the foreign shareholder claims that the transfer of the U.S. real property interest by the foreign corporation to the shareholder does not result in any tax (if the foreign corporation had directly sold the U.S. real property it would have been subject to tax at a rate as high as 35 percent).

The shareholder's position is incorrect. Generally, the foreign corporation (and not the foreign individual shareholder) is taxed on all of the gain inherent in the U.S. real property interest. The transaction is treated as a taxable sale of the U.S. real property interest by the corporation, either because the corporation is making a distribution to the foreign shareholder of the U.S. real property interest (which would constitute a deemed sale of such interest at the corporate level) or because the corporation is viewed as selling the entire U.S. real property interest directly to the buyer. In cases where the foreign corporation is treated as making a distribution of the U.S. real property, the foreign corporation is also subject to a withholding tax of 35 percent on the gain in the property, unless it qualifies for reduced withholding.

Hurricane Katrina and the Politics of Estate Tax Repeal

Hurricane Katrina postponed action that was to be undertaken on estate tax repeal at the beginning of the current Congressional session. The large emergency expenditures have further made the case for repeal more difficult, at least in the eyes of many. A recent story by Time that a Senator is out looking for a victim of Katrina that was a business owner and whose estate is subject to estate tax, so as to utilize such a victim to revitalize the repeal effort probably isn't going to help repeal efforts, either.

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IRA's, Computers & College

Distributions from qualified retirement plans and IRAs before age 591/2 generally are hit with a 10% penalty tax under Code Sec. 72(t)(1) . There are a number of exceptions to the penalty including one for distributions from an IRA used to pay for qualified higher education expenses. ( Code Sec. 72(t)(2)(E) ) For this purpose, qualified higher education expenses are expenses for tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. ( Code Sec. 72(t)(7) , Code Sec. 529(e)(3)(A) )

Is a computer required "equipment" for this purpose? According to the U.S. Tax Court, and although my own children will disagree, a computer is generally not required equipment for a college student these days. Mr. Gorski’s daughter attended Miami University in Ohio, and used IRA funds to buy a computer for her. Mr. Gorski admitted that there was a bank of computers available for student use located in the university's library but he said that there were only four or five computers available for 15,000 students at any time. He further testified that by having her own computer, his daughter would not have to use these library computers and risk walking from the library back to her dorm room late at night. The Tax Court said that while the Gorskis' concern for their daughter's safety was understandable, it and other arguments advanced by them did not prove that the purchase of a computer was required by Miami University, and imposed a 10% early withdrawal penalty on the Gorskis. Gorski, TC Summary Opinion 2005-112.

GOP to Seek Tax Rate Increase?

According to the Wall Street Journal,

"a handful of GOP Senators think a tax increase is needed to pay for Katrina pending. Their immediate target is the 15% rate on capital gains and dividends that was a crucial part of the wildly successful 2003 tax cuts. Those rates are set to expire in 2008, which would mean a big tax increase back to a 35% rate on dividends, and 20% on capital gains."

But even with Hurricane Katrina and the Gulf War, is a tax hike needed?

"$262 billion. That's the amount of additional revenue that the federal government will collect in the fiscal year that ends this month, a roughly 15% increase. This is the largest annual increase in federal revenues, even after inflation, in American history."

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Tax Planning that Violates Foreign Law

Generally, the U.S. will not assist in the collection of taxes of a foreign jurisdiction, under a long standing common law principle. This principle was brought into play earlier this year when the U.S. Supreme Court considered the issue whether a crime occurs in the U.S. under U.S. wire fraud statutes when activities are undertaken in the U.S. that result in the defrauding of non-U.S. (Canadian) tax authorities. In Pasquantino v. U.S., 96 AFTR 2d 2005-5392, (S Ct), 04/26/2005, the Supreme Court held the common law principle did not provide insulation against a U.S. wire fraud prosecution.

The Supreme Court’s interpretation of the wire fraud statute was also interesting. 18 U. S. C. §1343 prohibits the use of interstate wires to effect "any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretenses." By holding that Canada's right to receive tax revenue was "money or property," the use of U.S.interstate wires to effect such a scheme was found to be a violation of the statute.

The obligations of tax planners to consider whether their planning results in a violation of foreign law has long been debated. Pasquantino is a warning to practitioners that there are limits out there that may require them to address foreign tax law in their planning, but where those limits are is still an uncertain area.

Applicable Federal Rates - Update for October 2005

October 2005 Applicable Federal Rates Summary (Rev.Rul. 2005-66):

-Short Term AFR - Semi-annual Compounding - 3.89% (3.9% - September)
-Mid Term AFR - Semi-annual Compounding - 4.08% (4.19% - September)
-Long Term AFR - Semi-annual Compounding - 4.40% (4.52% - September)

2006 Inflation Adjustments

The following anticipated 2006 cost-of-living adjustments are expected:

a. For gifts made in 2006, the gift tax annual exclusion will increase to $12,000 (up from $11,000 for gifts made in 2005).

b. For estates of decedents dying in 2006, the limit on the decrease in value that can result from the use of special valuation will increase to $900,000, up from $870,000 in 2005.

c. For gifts made in 2006, the annual exclusion for gifts to noncitizen spouses will be $120,000 (up from $117,000 in 2005).

Subchapter S Income in the Divorce Scenario (Florida)

The Florida Supreme Court recently ruled that “pass-through” income of an S corporation that is not distributed to shareholders does NOT constitutes income within the meaning of chapter 61, Florida Statutes (2004), for purposes of calculating alimony, child support, and attorney's fees.

However, where the undistributed “pass-through” income has been retained for noncorporate purposes, such as to shield income from reach of the other spouse during dissolution, this improper motive for its retention makes it available “income.” When the issue of whether undistributed “pass-through” income was retained for corporate purposes is contested, the shareholder-spouse is given the burden of proving that income was properly retained for corporate purposes rather than impermissibly retained to avoid alimony, child support, or attorney's fees obligations by reducing the shareholder-spouse's amount of available income. In such an inquiry, the factors to be considered include the extent to which the shareholder-spouse has access to or control over the “pass-through” income retained by the corporation, limitations set forth in section 607.06401(3) governing corporate distributions to shareholders, and the purposes for which “pass-through” income has been retained. In this inquiry, the shareholder-spouse's ownership interest should be considered, but is not dispositive, even where the spouse is sole or majority shareholder in corporation and has ability to control the retention and distribution of the corporation's income.

Zold v. Zold, 30 Fla. L. Weekly S626a (Florida Supreme Court 2005)

Corporate Ruling Requests Will Be Expedited

The IRS allows taxpayers to submit ruling requests on the application of tax law to specific situations. The private letter ruling received from the IRS that addresses the issue can be relied on by the taxpayer (and only that taxpayer) as to the IRS' interpretation of the tax issue.

The IRS response time on a ruling request can at times be quite lengthy. This lengthy time often discourages taxpayers from making a request in the corporate area, since the taxpayer does not want to hold off on the planned transaction that long while waiting for the ruling.

In a helpful announcement, the IRS advised that it is beginning a pilot program to have letter rulings issued within 10 weeks of application in regard to Section 355 (corporate spin-off and split-off transactions) and Section 368 (corporate reorganization transactions).

Rev. Proc. 2005-68.

Mileage Rates Updated

Due to recent fuel price increases, the IRS announced that optional standard mileage rates for expenses incurred on or after 9/1/2005 are increased: for business use, 48.5¢ per mile; and for medical or moving use, 22¢ per mile. Rev Proc 2004-64, 2004-49 IRB 898 , is modified. ( Ann. 2005-71, 2005-41 IRB ).

IRS Indicts Survivor Star

Back in law school, my professor in Criminal Tax class shared with us how the IRS loves to indict celebrities and high profile individuals for tax fraud. The reason for this is the high amount of publicity that such indictments (and convictions) garner, thus enhancing the public perception of risk of tax fraud prosecutions should they engage in fraudulent behavior.

Over the years, I have seen this play out many times with major and minor celebrities. The most recent example is Richard Hatch, a star of the reality television show Survivor.

Hatch was recently indicted on ten counts of tax evasion and bank fraud. While his attorney calls the indictment "a publicity scheme," Hatch could end up paying fines of over $1 million and spending 73 years in jail if convicted on all counts.Hatch is accused of not reporting his $1 million in winnings and that he pocketed $36,500 in donations to his foundation. According to various internet sources, earlier this year Hatch had made a plea agreement with the government but he backed out of the deal.

Private Inurement and §501(c)(3) Status - Proposed Regulations Issued

Organizations that seek exemption from federal income tax under §501(c)(3) of the Internal Revenue Code cannot operate in a manner that its earnings benefit private individuals or organizations. An organization seeking exemption files an application with the IRS to see if it qualifies.

Once qualified, an exempt organization may be subject to a special excise tax if it operates in a manner that benefits private interests (Code §4958). Proposed regulations issued on September 8, 2005 provide proposed guidance on the interaction between Code §4958 violations and §501(c)(3) status.

These proposed regulations provide that the anticipated violation of Code §4958 by an organization applying for Code §501(c)(3) status may jeopardize the issuance of a favorable Code §501(c)(3) ruling.

Further, for organizations that already have a Code §501(c)(3) ruling, the regulations provide certain criteria to be applied by the IRS in determining whether an organization’s Code §501(c)(3) ruling should be revoked. These factors are (A) the size and scope of the organization's regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred; (B) the size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization's regular and ongoing activities that further exempt purposes; (C) whether the organization has been involved in repeated excess benefit transactions; (D) whether the organization has implemented safeguards that are reasonably calculated to prevent future violations; and (E) whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6) and §53.4958-7 of this chapter), or the organization has made good faith efforts to seek correction from the disqualified persons who benefitted from the excess benefit transaction.

Prop Reg § 1.501(c)(3)-1 , Prop Reg § 53.4958-2.

Joint Property Conversion and Need to File Claim in Probate [Florida]

Generally, anyone who believes a decedent owes him or her property must file a claim against the decedent’s death within 90 days of publication of a notice to creditors. Florida law allows for an exception where fraud exists, estoppel applies, or there is insufficient notice of the creditors period.

In a recent case, a decedent transferred property in a joint account to an account in his own name before his death. The joint tenant, his wife, did not file a timely claim against the estate. She came up with two principal defenses to her failure to file a timely claim.

The first was that under the "trust exception," a claim did not need to be filed. The trust exception generally provides that if the decedent was holding property in trust for someone, a timely probate claim need not be filed to obtain that property by the beneficiary. However, the Appeals Court recognized that the "trust exception" has been restricted to express trusts, and no longer applies to constructive or resulting trusts and would not apply in this case.

The wife also tried to claim that this situation is not a claim against an estate, but simply a determination of who owns property. The Appeals Court did not accept his argument either, finding that many creditor issues regarding property are really claims of unlawful possession or theft and should be cast as claims against the estate.

DEBRA JEAN SCOTT, v. MELISSA SCOTT REYES, Appellee. 2nd District. Case Nos. 2D04-4610 & 2D04-5345. Consolidated. Opinion filed September 9, 2005

Florida Homestead Law Quiz

Question: Decedent’s Florida Last Will provides for $150,000 specific bequest to A, and residuary beneficiary is B. Assets of estate include $50,000 cash, and $500,000 homestead. Decedent is not survived by spouse or a minor child. Should the homestead be sold to help satisfy the cash devise?

Answer: No! The Florida Supreme Court provides that the homestead in this situation is not an estate asset available to satisfy specific bequests. Instead, it passes with the residuary. If the Will had directed sale of the homestead to satisfy bequests, that would be a different story, however.

McKean v. Warburton, 30 Fla. L. Weekly S61 (Fla. September 8, 2005)

Exempt Organizations Assisting Katrina Relief

Donors to organizations that have their exempt §501(3) status recognized by the IRS receive income tax deductions for those contributions. For most organizations, this requires that the organization file a Form 1023, and then await IRS processing and eventual recognition of status.

While promising expedited review of applications of charities newly established to meet needs of those affected by Hurricane Katrina, the IRS suggested support be directed to existing exempt organizations that might be better able to deliver relief most efficiently. Form 1023 should be marked as specified to receive priority IRS attention for exempt status. (IR 2005-93)

Senate Estate Tax repeal Consideration Delayed

With promises to make estate tax repeal the first item considered when the Senate reconvened, it looked as though there might be some legislative attention to the issue today or this week. However, due to concerns about Hurricane Katrina, floor action on repeal has been indefinitely deferred.

Updated IRS Rates

September 2005 Applicable Federal Rates Summary (Rev.Rul. 2005-57):

-Short Term AFR - 3.9%
-Mid Term AFR - 4.19%
-Long Term AFR - 4.52%

October 2005 Quarter IRS Rates for Underpayments and Overpayments (Rev.Rul.2005-62):

- 7% for overpayments [6% in the case of a corporation]
- 7% for underpayments
- 9% for large corporate underpayments
- 4.5% for the portion of a corporate overpayment exceeding $10,000

Foreign Partner Withholding Tax Regulations

§1446 of the Internal Revenue Code imposes a withholding tax on a partnership's effectively connected taxable income allocable to a foreign partner. The tax is imposed at the highest applicable income tax rate of the partner. Recently issued regulations provide some helpful provisions in applying the withholding tax. These include -

-temporary regulations that allow a foreign partner to certify to the partnership certain partner-level deductions and losses that are connected with gross income that is effectively connected with the partner's U.S. trade or business and that the partner reasonably expects to be available to reduce the Code Sec. 1446 tax on its share of the partnership's ECTI.

-the ability of the partnership to consider the character of income or gain (e.g., long-term capital gain, unrecaptured Code Sec. 1250 gain, etc.) allocated to a foreign partner when computing the Code Sec. 1446 tax liability. Thus, for example, long-term capital gain that is allocable to a noncorporate foreign partner will be subject to the highest long-term capital gains rate, which currently is 15%.

-treating the deemed distribution (under Code Sec. 1446(d) ) of the partnership withholding tax as an advance or draw against the partner's distributive share of the partnership's ECTI. This allows the recipient partner to take the distribution into effect at the end of the tax year for purposes of determining whether the distribution exceeds its basis in its partnership interest - that is, after its basis is increased for its allocable share of net income of the partnership for that tax year. This applies, however, only to tax payments applicable to ECTI of that particular tax year.

Rubinger, 103 Journal of Taxation 166 (September 2005)

Florida Documentary Stamps and Related LLC's

The Florida Department of Revenue recently acknowledged that a transfer of unencumbered real property between two commonly controlled limited liability companies is not subject to Florida documentary stamp taxes. This ruling was a reasonable extension of the Florida Supreme Court case of Crescent Miami Center LLC that similarly found no taxes due on a transfer to an LLC by a limited partner of a partnership that wholly owed the LLC. Florida Technical Assistance Advisement 05(B)4-004, 06/23/2005.

IRS Disaster Relief Telephone Number

Text of IRS Notice:

The Internal Revenue Service announced today the establishment of a special toll-free telephone number for use by taxpayers affected by Hurricane Katrina. People affected by Katrina who need help with tax matters can call 1-866-562-5227. Beginning today, taxpayers can call the special number Monday through Friday from 7:00 am to 10:00 pm local time. Callers to this dedicated telephone line can find out about available tax relief, get free copies of their tax return transcripts and receive Disaster Tax Loss Kits. Callers may also be referred to the Federal Emergency Management Agency’s assistance lines for additional help. Affected taxpayers who need copies of tax returns to apply for aid or other purposes can have the normal user fee waived by writing “Hurricane Katrina” in red across the top margin of their Form 4506, Request for Copy of Tax Return. More information about tax relief for victims, making charitable contributions and links to other government web pages is available at IRS.gov.

New Law or Old Law?

What happens if you provide in your Florida last will that assets will pass at your death or at some later time to your “heirs at law,” and inbetween the time you signed your last will and your death/when the provision became active, the law of Florida is changed? Do the assets pass according to the law at the time you sign your last will, or when the provision becomes active? In the case of Karasek v. Lamping Trust, et al, Case No. 4D04-2803. August 31, 2005, Florida’s Fourth District Court of Appeals held that the answer to the question is based on the testator’s intent, and in this case, the law at the time the last will was entered into was held to apply, not the law as later amended.

This concept has application to any reference in a will or trust to an applicable law. What should a draftsman do if it is desired that the effect of the provision be varied if the law changes? Adding the phrase “as amended” to the reference to the law should be effective to accomplish that.