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Friday, December 29, 2006


Oftentimes, a taxpayer may transfer assets to a partnership or corporation, and either concurrently or later will gift interests in the entity to family members or trusts for family members. Sometimes, the transferor has no ownership interest in the transferee entity, and the funding transaction is treated as a gift. As part of the overall planning, the transferor will be employed by the transferee entity as a manager or some other function and thus will receive payments from the entity.

For some of these transactions, the IRS may interpret the compensatory income paid to the transferor as a retained income interest under Code Section 2036(a). If that is the case, at the transferor’s death the transferred assets may be subject to estate tax even though the transferor has no (or a reduced) ownership interest in them. The overall concern of the IRS is that the transferor gave away the assets to remove them (and future growth) from estate tax at his or her future death, but in effect retained the economic benefits from such transferred assets by being paid a management or other ongoing fee from the transferred assets or business.

To avoid Code Section 2036(a) inclusion, an effort should be made to establish the bona fides of the compensatory arrangement. As is often the case, some taxpayers do this better than others. A recent family limited partnership case provides instruction on how NOT to handle such arrangements.

In Korby v. Comm., 98 AFTR 2d 2006-8115, (CA8 2006), the taxpayer and his wife transferred assets to a living trust, and then into a limited partnership. The living trust was a 2% general partner, and the 98% limited partnership interests were eventually gifted to family members. Over time, the living trust received distributions from the partnership as ostensible “management fees.” The IRS challenged the arrangement, asserting that the compensatory arrangement was instead a retained Code Section 2036(a) right to income of the transferred assets, and sought to include the assets of the partnership in the estate of the taxpayer when he died.

Both the Tax Court and the appellate court agreed that the compensatory arrangement was not bona fide. The particular items that the courts noted in reaching their decision were:

a. The lack of a written management contract;

b. The lack of records as hours spent on managing the partnership;

c. The haphazard timing and amounts of payments; and

d. The failure of the recipient to report the payments as self-employment income.

Therefore, the case is instructive in reminding us about items that should be addressed in planning for bona fide compensation arrangements - a written agreement, proper record keeping, and reporting of such income as compensatory for employment tax purposes.

Wednesday, December 27, 2006


Under the recently enacted Tax Relief and Health Care Act of 2006, Congress revived and extended the income tax deductions for state and local sales tax, higher education tuition and fees, and educator expenses. Since these deductions were not in the law when the 2006 Forms 1040 were prepared, taxpayers who use paper forms must be diligent to avail themselves of these deductions since there will not be lines on the forms to remind them. Presumably, computer return preparation programs will be updated in a timely manner to assist their users in properly filing for these deductions.

For paper filers, the IRS is advising taxpayers to make the following modifications to their returns to properly file for these deductions:

STATE AND LOCAL GENERAL SALES TAX DEDUCTION. The deduction for state and local general sales taxes will be claimed on Schedule A (Form 1040), line 5, “State and local income taxes.” Enter “ST” on the dotted line to the left of line 5 to indicate you are claiming the general sales tax deduction instead of the deduction for state and local income tax.

HIGHER EDUCATION TUITION AND FEES DEDUCTION. Taxpayers must file Form 1040 to take this deduction for up to $4,000 of tuition and fees paid to a post-secondary institution. It cannot be claimed on Form 1040A. The deduction for tuition and fees will be claimed on Form 1040, line 35, “Domestic production activities deduction.” Enter “T” on the dotted line to the left of that line entry if claiming the tuition and fees deduction, or “B” if claiming both a deduction for domestic production activities and the deduction for tuition and fees. For those entering “B,” taxpayers must attach a breakdown showing the amounts claimed for each deduction.

EDUCATOR EXPENSE DEDUCTION. Educators must file Form 1040 in order to take the deduction for up to $250 of out-of-pocket classroom expenses. It cannot be claimed on Form 1040A. The deduction for educator expenses will be claimed on Form 1040, line 23, “Archer MSA Deduction.” Enter “E” on the dotted line to the left of that line entry if claiming educator expenses, or “B” if claiming both an Archer MSA deduction and the deduction for educator expenses on Form 1040. If entering “B,” taxpayers must attach a breakdown showing the amounts claimed for each deduction.

IR News Release 2006-195 12/22/2006

Monday, December 25, 2006


Internal Revenue Code Section 199 provides a deduction to domestic manufacturers and producers. In 2006 this deduction is 3%, it increases to 6% for tax years beginning in 2007-2009, and will be 9% in later years, and is applied generally to net income from manufacturing and production (subject to a number of limitations, including that the deduction cannot exceed 50% of the taxpayer's W-2 wages for the taxable year). The IRS has issued a new Industry Director Directive, which, along with an associated document titled “Minimum Checks for Section 199; Law and Explanation,” details the minimum audit checks IRS examiners are expected to complete when reviewing a corporation's deduction.

While compliance with these guidelines will not ensure complete compliance with the requirements for the deduction, they are useful for taxpayers to make sure they are meeting the basic requirements and that they will clear the major audit hurdles. The following summarizes the guidelines and issues that the IRS will review on audit:

1. Does the taxpayer's business make sense with the activity requirements of the domestic production deduction? For example, most resellers (such as clothing stores and wholesalers) should not be claiming the deduction, nor should most professional service companies since they are selling their services even if in this process they provide a tangible item such as a legal document. Auditors are advised to review the corporation's web site and annual report, among other sources, in answering this question.

2. Compare the deduction to the gross receipts or sales less returns and allowances on line 1(c) of the Form 1120 (U.S. Corporation Income Tax Return). Gross receipts reported on line 1(c) of the 1120 should be greater then the deduction. If the gross receipts on the Form 8903 match the gross receipts on line 1(c) of the Form 1120, the taxpayer may have not allocated to non-DPGR nonqualified income amounts such as gross receipts for services or for resale items
3. Is the taxpayer required to allocate gross receipts to remove nonqualified embedded service income, or determine the qualified income portion of a component of an item? If so, how did the taxpayer determine an allocation method?
4. If the taxpayer is required to use the Code Sec. 861 method to allocate and apportion deductions has the taxpayer used it and is it consistent with the application of Code Sec. 861 for foreign tax credit purposes, if applicable? The Code Sec. 861 method must be used to allocate and apportion deductions if the taxpayer's average annual gross receipts exceed $100,000,000 or total assets at the end of the tax year exceed $10,000,000.
5. Has the taxpayer applied the wage and taxable income limitations? For example, under Code Sec. 199(b)(2)(B) , for tax years beginning after May 17, 2006, W-2 wages for Code Sec. 199 purposes only include amounts that are properly allocable to domestic production gross receipts.
While these issues apply only to the small subset of taxpayers who take the deduction, it is worth the effort of those that do to review these guidelines and assure compliance with them.

Thursday, December 21, 2006


January 2007 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.82% (4.91%/December -- 4.83%/November -- 4.94%/October)

-Mid Term AFR - Semi-annual Compounding - 4.53% (4.68%/December -- 4.64%/November -- 4.76%/October)

-Long Term AFR - Semi-annual Compounding - 4.68% (4.84%/December -- 4.84%/November -- 4.96%/October)


Tuesday, December 19, 2006


The corporate reorganization provisions of the Internal Revenue Code allow for corporate acquisitions, divisions, and other reorganizations to occur with no, or reduced, gain or loss on the transactions. These provisions facilitate the transfer of assets or ownership of corporations between and among corporations when the transaction qualifies as a sanctioned "reorganization."

IRC Section 368(a)(1)(D) generally treats as a qualified 'D' reorganization reorganization a transfer of assets from one corporation to another commonly controlled corporation. A requirement for 'D' treatment is that stock or securities of the transferee corporation must be distributed in pursuance of a plan of reorganization in a transaction that qualifies under Code Sec. 354 , Code Sec. 355 , or Code Sec. 356. However, even though the Code requires the transferor corporation to receive stock of the transferee corporation and distribute it to the shareholders of the transferor corporation, the IRS does not require this stock transfer when the two corporations are owned in the same identical manner, since the issuance and distribution of the stock would be a "meaningless gesture" - that is, because the stock transfer and distribution would not effect an actual economic change in ownership of shares.

The IRS has now issued Regulations that provide parameters and guidance for when the stock issuance required by the Code is not needed. The highlights of the new Regulations are:

-If the same person or persons own, directly or indirectly, all of the stock of the transferor and transferee corporations in identical proportions, the stock issuance and distribution requirements are treated as satisfied even though no stock is actually issued in the transaction.

-In determining whether the same person or persons own the stock of both corporations, attribution of ownership rules are applied. Under these rules an individual and all members of his family that have a relationship described in Code Sec. 318(a)(1) are treated as one individual.

-The above rules will operate, even if there is only a de minimis variation in shareholder identity or proportionality of ownership in the transferor and transferee corporations.

-Preferred stock described in Code Sec. 1504(a)(4) is disregarded for purposes of determining whether the same person or persons own all of the stock of the transferor and transferee corporations in identical proportions.

-When these rules apply, the Regulations provide that a nominal share of stock of the transferee corporation is treated as being issued, which share is then further treatedas being distributed by the transferor corporation to its shareholders.

See Treas.Reg. §1.368-2T.

Saturday, December 16, 2006


More particularly, when is a lease unenforceable? There are a number of ways that can arise, but one way is if the lease provides for automatic renewals at the option of the tenant forever, according to a Florida appellate court decision.

Daily Business Forms & Supplies, Inc. rented a building and land. Under the lease, it could renew it every two years (with a slight increase in rent), with no ending time period. Any future landlord would be bound by the lease. More particularly, the lease provided:
Lease to be for a period of two years beginning October 24, 2001. Tenant has option to renew for additional subsequent two year periods upon notification to landlord of tenant's desire to continue lease within 90 days of lease anniversary. If for any reason tenant terminates lease prior to anniversary date, tenant agrees to continue making monthly rental payments to landlord until such a time that the landlord rents the property, or the anniversary of the lease, whichever comes first. Tenant has the first option to purchase property if landlord determines that property is to be sold. If property is sold to any one other than tenant, lease is binding and transferable to new landlord. If tenant determines not to renew lease, tenant will notify landlord 90 days prior to lease renewal. The monthly rental amount for the first two-year period will be $650.00 per month. Upon lease extension being executed by tenant for an additional two-year period, rent will increase to $700.00 per month. Upon completion of first two year extension, and upon notification by tenant to landlord, lease agreement will automatically renew for subsequent two-year periods there after, with rental amount increasing by $50.00 per month, per anniversary, for as long as tenant desires."
The landlord brought suit to have the lease declared invalid as an unreasonable restraint on alienation. The rule against unreasonable restraints on alienation is founded entirely upon considerations of public policy, specifically, the idea that the free alienability of property fosters economic and commercial development. The test to be utilized with respect to restraints on alienation is the test of reasonableness. The validity or invalidity of a restraint depends upon its long-term effect on the improvement and marketability of the property.

In analyzing the issue, the appellate court noted that the lease would have the potential to forever prevent the landlord (and her successors) from being able to utilize the property for any purpose other than renting the property to the corporate tenant at a predetermined rate. The landlord would, however, remain obligated to pay the property taxes and the expense of properly maintaining the exterior of the property's structure -- regardless of the cost. Based on this, the court found an unreasonable restraint on alienation, and the lease was declared void.

LAVERNE PEAVEY, Appellant, v. RODNEY REYNOLDS AND DAILY BUSINESS FORMS, ETC, Appellees. 5th District. Case No. 5D05-3640. Opinion filed December 15, 2006.

Tuesday, December 12, 2006


The Tax Relief and Health Care Act of 2006 has passed both the U.S. House of Representatives and the U.S. Senate, and it is expected that President Bush will sign it into law. Perhaps a better name would be the Tax Break Bill of 2006, with most of the provisions relating to reinstatement of tax breaks that expired at the end of 2005, and further extensions and modifications of other tax breaks. The following is a list of some of the major provisions:

-The optional itemized deduction for state and local sales and uses taxes is extended through 2007;

-The above-the-line deduction for expenses of educators is extended through 2007;

-Charitable remainder trusts that earn unrelated business income will no longer lose their exempt status, but must pay a 100% excise tax on such unrelated business income;

-The above-the-line deduction for higher education expenses is extended through 2007;

-The 15-year straight line writeoff (instead of straight-line 39 year writeoff) for qualified leasehold improvements and qualified restaurant improvements is extended for 2 years;

-Some of the rules relating to Health Savings Accounts have been liberalized;

-The Tax Court is given authority to review equitable innocent spouse relief (written about previously);
-The research expense credit is extended for two years and modified for 2007;

-The work opportunity tax credit, relating to the hiring of members of certain target groups, are extended and modified;

-Various District of Columbia tax breaks are extended for two years;

-The new markets tax credit, relating to qualified equity investments to acquire stock in a community development entity is extended for one year and modified.

There are many more provisions, including a number energy credits, but are generally of narrow interest to small groups of taxpayers.

Sunday, December 10, 2006


Generally, organizations conducting "educational" activities can qualify as exempt from income tax under Code Section 501(c)(3). A number of organizations exist to educate consumers on how to deal with consumer credit. These consumers often have existing creditor problems, and the organizations educate them on how to work through their credit problems and how to better manage their finances to avoid future problems. Often these organizations also take a direct role with the consumers in working out existing creditor problems, including budgeting, individual counseling, and escrow and payment arrangements to help satisfy existing creditors. Such activities are not "educational," but when directed towards low-income individuals and families, they qualify as exempt as "charitable" by reason of relieving the poor and distressed.
There are a number of cases and rulings that confirm the availability of exempt organization treatment for such organizations. As is often the case with exempt organizations, the availability of exempt organization treatment attracts some taxpayers that will try to characterize what is really a "for-profit" venture into one that has enough exempt characteristics to obtain an exemption ruling. With the ruling, the organization avoids federal income taxes on its exempt activities, and contributors are eligible for a tax deduction for their contributions.
A recent private letter ruling illustrates such a failed attempt. It is instructive to note some of the facts that the IRS relied upon in denying Section 501(c)(3) status to the applicant:
-over 40% of activities were related to debt consolidation and management activities, for which the consumer being helped is charged a fee;
-there was significant advertising expenses for the sale of such debt management services;
-services are not limited to lower income persons, but are "sold" to the general public;
-while the organization claimed it would provide courses and seminars focusing on money management and budgeting, it failed to substantiate an educational methodology. Further, it did not provide specific information about its seminars (i.e. agenda, literature describing the seminars, and dates and times of the seminars), as well as how it would integrate these seminars into its operations. It also failed to budget funds for educational materials, workshops, or other educational, thus creating doubt whether it would really undertake such activities;
-creditors may make fair-share "contributions" to the organization, in reality because they benefit from the activities of the organization since it effectively helps them get paid on their consumer loans and credit (that is, the counseling organization acts as a debt collection agency);
-no evidence was presented that the organization received contributions from disinterested members of the public;
-there is a risk that private individuals will inure benefits from the organization, due to (a) high compensation paid to officers, and (b) a related entity for back office debt processing and software services.
There are a number of these organizations out there. With the ruling, the Services is reminding taxpayers that unless such organizations restrict their activities to education, and/or providing services at free or low-cost to low-income taxpayers, and do not seek to find methods of providing economic benefits to founders or related parties, obtaining exempt status for these types of consumer credit counseling services will be difficult.
Private Letter Ruling 200649035. See also Private Letter Ruling 200649033.

Wednesday, December 06, 2006


There are a number of ways that a spouse can get relief from tax liabilities arising from a joint tax return. One method relates to a separate liability election under Code Section 6015(c). Another relates to qualifying for innocent spouse relief under Code Section 6015(b). Lastly, a spouse can seek equitable relief from the IRS under Code Section 6015(f).

Due to statutory changes made in 2001, the IRS has argued that its denial of equitable relief under Code Section 6015(f) is not subject to Tax Court review if no deficiency assessment was made in the particular case. A spouse may want to seek this equitable relief even in the absence of a deficiency assessment - for example, if the spouse was liable for tax declared on a joint tax return but which was not paid. There is case law support for the IRS' position of no Tax Court review in such circumstances.

To allow for review, on December 5 the House of Representatives passed by voice vote H.R. 6111, a bill allowing the Tax Court to review claims for equitable innocent spouse relief, and suspending the running of the limitations period while such claims are pending. This bill is identical to S. 3523, which was passed by the Senate by unanimous consent on Sept. 30, 2006. As a procedural matter, H.R.6111 will have to go back to the Senate for approval. Since the text is identical to S. 3523, it should easily be approved in the Senate and then sent to the President for his signature.

Monday, December 04, 2006


To assist in charitable fundraising, many companies have payroll deduction programs. Under these programs, amounts are withheld by an employer from employee pay, and the funds are then paid over directly to the charity.

The Internal Revenue Code, as modified by the 2006 tax act, requires that a contributor obtain certain written forms of substantiation before a charitable deduction is allowed for the contributor. The IRS has issued rules that provide an acceptable method of substantiation for employee contributors who make their contributions through a payroll deduction plan.

A. Two items of substantiation, if both are obtained, will meet the statutory requirements. The first is a pay stub, Form W-2, or other document furnished by the employer that sets forth the amount withheld during a taxable year by the employer for the purpose of payment to a donee organization. The second item is a pledge card or other document prepared by or at the direction of the donee organization that shows the name of the donee organization.

B. If the amount paid over exceeds $250, the pledge card or other document prepared by the donee organization also must include a statement to the effect that the organization does not provide goods or services in whole or partial consideration for any contributions made to the organization by payroll deduction. This additional information is needed because of the additional substantiation requirements imposed on charitable gifts of $250 or more. Treas. Regs. Section 1.170A-13(f)(11)(ii) provides that the contribution amount withheld from each payment of wages to a taxpayer is treated as a separate contribution for purposes of applying the $250 threshold.

Notice 2006-110, 2006-51 IRB, 12/01/2006

Saturday, December 02, 2006


Opinions on life insurance are all over the board. Some thing it is the greatest invention ever, while others are convinced it is a scam purely for the enrichment of life insurance agents and companies and refuse to consider it even when the facts cry out for it.

The truth lies somewhere inbetween. In the estate planning process, life insurance can provide substantial benefits at times, and at other times it is a waste of money and can actually be injurious to overall wealth planning and protection.
In defense of life insurance, here are 9 situations where life insurance can be a boon in the estate planning or family wealth management process:

1. REAL LACK OF LIQUIDITY IN THE CLIENT’S ESTATE. If a client’s assets are all tied up in illiquid assets, such as closely-held businesses, real estate, IRAs or deferred annuities, surviving family members will need the life insurance proceeds to pay estate taxes and for post-death living expenses. While the family can always sell those assets, adverse tax or economic consequences can result. Planning should be undertaken to avoid estate taxes on the insurance proceeds, and in selecting the proper beneficiary.

2. YOUNG COUPLE WITH CHILDREN AND PERHAPS SUBSTANTIAL DEBT. So as to assist in the repayment of debt, payment of education expenses, payment of child care expenses, and to allow for a comfortable existence for the survivor.

3. FUNDS TO REPLACE A VALUABLE EMPLOYEE. Both in your business, or perhaps within the family, such as a caregiver for an elderly family member.

4. PROVIDE CASH FOR A BUY-SELL AGREEMENT. Most co-owners of a business do not want to end up being partners with the spouse or children of a deceased co-owner. Insurance provides cash to buy out the interest of the deceased co-owner, and simultaneously provides funds to live off for the surviving spouse or family members.

5. PROVIDE REPLACEMENT FUNDS FOR CHARITABLE GIFTS MADE AT LIFETIME OR AT DEATH. Oftentimes, if the charitable gift occurs during lifetime, income tax savings can be used to fund the cost of the insurance. This is a win-win - more assets for charity without cost to the family (although the government loses out on tax dollars!).


7. PROVIDING FOR CHILDREN OF A PRIOR MARRIAGE. This type of gift to prior children may be easier to swallow for the surviving spouse since it doesn’t involve the transfer of assets in which the spouse may have developed an emotional or economic investment, especially if he or she does not have a great relationship with the children of the prior marriage. This type of gift also allows for the passage of assets to a spouse to obtain tax benefits (e.g., estate tax marital deduction, deferred IRA or pension plan payout options) while still providing for the children of the prior marriage.

8. TO COVER LIMITED ESTATE TAX EXPOSURE DURING TERM OF YEARS PLANNING DEVICES SUCH AS A QUALIFIED PERSONAL RESIDENCE TRUST OR GRANTOR RETAINED ANNUITY TRUST. These type of trusts provide estate tax benefits only if the grantor survives the term of the trust. To cover the risk of estate taxes for death before the end of the term, insurance can help.

9. A TAX-DEFERRED PRIVATE RETIREMENT POLICY. Value accumulates tax-free in a life insurance policy, similar to an IRA or pension plan. There are also ways to access the funds in the policy without current income taxes. Therefore, a properly structured policy can operate as a persona retirement plan.

Much of the foregoing was adopted from the presentation of L. Howard Payne of Sarasota, Florida for the Florida Bar CLE program "Something Old, Something New... Estate and IRA Planning in the 21st Century."

Wednesday, November 29, 2006


As unlikely as it seems, 95,746 taxpayers did not receive tax refund checks due to bad mailing addresses with the IRS. The checks, worth a total of $92.2 million, can be claimed as soon as their owners update their addresses with the IRS. Some taxpayers have more than one check outstanding.

Refund checks can go astray for a variety of reasons. Sometimes a life change results in a change of address. When a taxpayer moves or changes address and fails to notify the IRS or the U.S. Postal Service, a check sent to the taxpayer's last known address is returned to the IRS.

Think you may have missed a refund check? Taxpayers can use the "Where's My Refund?" feature on the home page of the Web site to learn the status of their refunds. This system also allows for the entry of a corrected mailing address i fthe returned check was issued within the last 12 months.

A taxpayer can also ensure the IRS has his or her correct address by filing Form 8822, Change of Address. Download the form from or request it by calling 1-800-TAX-FORM (1-800-829-3676). Another way to avoid a lost refund is to arrange for its payment via direct deposit.

IR-2006-178, Nov. 16, 2006

Monday, November 27, 2006


Florida dealers are obligated to collect sales and use tax, file tax returns, and remit the taxes to the Florida Department of Revenue. As compensation for conducting such activities, the tax filer is entitled to a collection allowance of 2.5% of the first $1,200 of tax due (a maximum of $30) on a return.

Sales and use tax dealers can now elect to donate their collection allowance to the Educational Enhancement Trust Fund. The Fund will be paid out to school districts that have adopted resolutions stating that these funds will be used to ensure that up-to-date technology is purchased for the classrooms in those districts, and the teachers are trained in the use of this technology.

The election is made on a timely sales and use tax return - a check box will be included on the return forms, beginning with the January 2007 return. It must be made with each return, and once made may not be rescinded by the taxpayer.

It appears that the donation will be made to schools in the business county of the taxpayer. However, if that county has not adopted the appropriate resolution, or the taxpayer is located out-of-state, the donation will be divided among all counties adopting the resolution.

Friday, November 24, 2006


The IRS has determined that many U.S. citizens and lawful permanent residents working at foreign embassies, foreign consular offices and international organizations in the U.S. have failed to fulfill their U.S. income tax responsibilities. Some have not timely filed U.S. tax returns. Others have failed to accurately report the tax due by underreporting income, claiming deductions for unallowable expenses, and/or failing to pay self-employment taxes. Also, many of such employees have erroneously established SEP/IRA plans, claimed deductions for contributions to the plans and used the plans as part of their retirement planning. The IRS is offering a carrot to such persons to encourage them to correct their past mistakes.

To use the initiative, the taxpayer must file accurate income tax returns for years 2003 through 2005, and pay applicable interest on any tax underpayments. A principal benefit of filing under the initiative is that penalties will be imposed on only one of those years (the year with the biggest shortfall in tax) instead of for each year.

With respect to SEP/IRA plans, taxpayers will have to pay taxes on the erroneously claimed deductions. Taxpayers will be able to move funds to other tax-favored retirement plans that would have been available to them. The IRS will not impose the annual 6% excise tax under Code Sec. 4973(a) on the excess contributions, the 10% early withdrawal penalty under Code Sec. 72(t) , or the accuracy-related penalty under Code Sec. 6662 on underpayments relating to deductions to the erroneously established SEP/IRA account. Other penalties, additions to tax, and interest will be imposed.

Persons presently under criminal investigation may not use the initiative. The initiative expires on February 20, 2007.

Ann. 2006-95, 2006-50 IRB ; IR 2006-180.

Tuesday, November 21, 2006


December 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.91% (4.83%/November -- 4.94%/October -- 5.07%/September)

-Mid Term AFR - Semi-annual Compounding - 4.68% (4.64%/November -- 4.76%/October -- 4.95%/September)

-Long Term AFR - Semi-annual Compounding - 4.84% (4.84%/November -- 4.96%/October -- 5.14%/September)


Sunday, November 19, 2006


The IRS has previously acknowledged that telephone communications for which a toll charge varies only with elapsed time, and not distance, is not subject to the Section 4242(b)(1) excise tax. Refunds or credits are available for amounts paid for long distance service that was billed to taxpayers for the 41-month period from after February 28, 2003 to before August 1, 2006. Instead of manually going through old telephone bills, business and tax-exempt organizations that were subject to the tax have now been provided with a short-cut formula method that they can use to seek a refund.

To request a refund, businesses (including sole proprietors, corporations, and partnerships) and tax-exempt organizations must complete Form 8913, Credit for Federal Telephone Excise Tax Paid. In filling out the form, businesses and tax-exempt organizations may determine the actual amount of refundable long-distance telephone excise taxes they paid for the 41 months from March 2003 through July 2006, or use the formula to figure their refunds. Businesses should attach Form 8913 to their regular 2006 income tax returns. Tax-exempt organizations must attach it to Form 990-T.

Under the formula method, businesses and tax-exempt organizations figure their refund amounts by comparing two telephone bills to determine the percentage of their telephone expenses attributable to the long-distance excise tax. The bills they should use are April 2006 and September 2006. They must first figure the telephone tax as a percentage of their April 2006 telephone bills (which included the excise tax for both local and long-distance service) and their September 2006 telephone bills (which only included the tax on local service). The difference between these two percentages should then be applied to the quarterly or annual telephone expenses to determine the amount of their refunds.

The refund is limited to 2 percent of the total telephone expenses for businesses and tax-exempt organizations with 250 or fewer employees. Larger organizations have a 1 percent cap.

For more information, see IR-2006-179.

Wednesday, November 15, 2006


The IRS acknowledges that it is behind on processing applications for exempt organization status. In an effort to explain the process (and when a taxpayer should make inquiries regarding status) the IRS is advising on how it processes exempt organization applications it receives, and anticipated timetables for some of the applications.

Upon receipt, exemption applications accompanied by the required user fee are initially separated into three groups:

(1) those that can be processed immediately based on information submitted,

(2) those that need minor additional information to be resolved, and

(3) those that require additional development.

If the application is in the first or second group, the taxpayer should receive either the determination letter or a request for additional information, via phone, fax, or letter, within approximately 60 days of the date the application was submitted. If the application falls within the third group, the taxpayer will be contacted once the application has been assigned to a specialist.

Group 3 applications can have a long wait. The IRS indicates it is only now assigning group 3 cases received in April to specialists.

To help with timing issues, the IRS website will keep this assignment date current. To check on it, go to to this site.

The IRS also posts a flowchart of the steps taken in reviewing an exempt organization application. Click here for a chart illustrating the IRS process for exempt organizations determination letter requests.

Sunday, November 12, 2006


Taxpayers sometimes receive erroneous K-1s, showing the wrong partner, shareholder, or beneficiary being allocated items of income and/or expense. The issuing entity may not always be cooperative in filing a correction with the IRS. What should a taxpayer do if he or she receives one, showing net income, and cannot get the issuer to correct it in a timely manner?

Ignoring the K-1 is one choice - that is, don’t report anything from the K-1 on the taxpayer’s tax return. The potential problem with this is IRS computer matching programs - the IRS’ computer may try to match the K-1 items with the taxpayer’s tax return - if the income items are not present this could trigger an inquiry from the IRS, or perhaps even an audit if the amounts are large enough.

One method that tax preparers have successfully used is to report the K-1 items on the taxpayer’s tax returns. Then, a corresponding negative entry is included (often referred to as a nominee entry), showing such amount being directed to the proper person if known, and their taxpayer identification number. In this way, if the IRS’ computers attempt to match, the K-1 items will show up and the computer will not flag a mismatch.

Some CPA’s suggest, however, that another method of dealing with this is to file a Form 8082 with the return, including details of the proper recipient of the K-1 on the form.

Whatever course of action is undertaken, the taxpayer doing this should keep records on the item, in case of future inquiries or audit. The taxpayer should also put the issuer on notice of the error, so at a minimum the issuer should not repeat the error in the following year.

Thursday, November 09, 2006


Section 1(h)(11) of the Internal Revenue Code provides that qualified dividends received by an individual shareholder are taxed as net capital gain. This presently results in a a 5% or 15% tax rate.

When the dividend payor is a foreign corporation, the rate only applies to foreign corporations eligible for the benefits of a comprehensive income tax treaty with the United States which the Secretary determines is satisfactory and which includes an exchange of information program. However, the special treatment also applies to foreign corporations whose stock is publicly traded.

In 2003, the IRS published a list of countries whose corporations meet these requirements. Recently, in Notice 2006-103, the IRS has revised that list.

New to the list are Barbados, Sri Lanka, and Bangladesh. The IRS notes that U.S. agreements with Bermuda, the Netherlands Antilles, and those former Soviet Republics still covered by the old U.S. - U.S.S.R. treaty are insufficient to provide net capital gains treatment for dividends issued by corporations of those countries.

Note that dividends of passive foreign investment companies (PFICs) do not qualify for this net capital gain treatment. Also, dividend recipients who do not meet certain minimum holdings periods also cannot get the benefit of the capital gains treatment.

Monday, November 06, 2006


U.S. persons working abroad are subject to U.S. taxes on their worldwide income. If a foreign country taxes the U.S. person on their income earned in that country, relief may be available through foreign tax credits, or the earned income exclusion provisions of Code Section 911.

Most practitioners also know to consult any applicable income tax treaties, to determine if there are any special provisions that limit what types or amounts of income the foreign country can tax. What is less widely known is that there are other types of international agreements that may apply to this issue and that may need to be consulted.

The first of these is a Status of Forces Agreement (SOFA). These agreements generally provide rules regulating the presence of armed forces and civilian supporting personnel of one country in the jurisdiction of another. These agreement can provide for the exclusion of such forces from local income taxes based on residence in the other country. For example, Article X.1. of the NATO Status of Forces Agreement provides:

"Where the legal incidence of any form of taxation in the receiving State depends upon residence or domicile, periods during which a member of a force or civilian component is in the territory of that State by reason solely of his being a member of such force or civilian component shall not be considered as periods of residence therein, or as creating a change of residence or domicile, for the purposes of such taxation. Members of a force or civilian component shall be exempt from taxation in the receiving State on the salary and emoluments paid to them as such members by the sending State or on any tangible movable property the presence of which in the receiving State is due solely to their temporary presence there. "
Another type of treaty or international that can also provide similar benefits are agreements of the United States Agency for International Development (USAID). These agreements may provide exemptions from local taxation for aid workers present in a foreign country.

Therefore, where military personnel, their supporting civilian personnel, or international aid workers are working in a foreign country, such agreements should be reviewed for applicability.

Thursday, November 02, 2006


A popular estate tax planning technique is a sale of an interest in a corporation or a partnership to a grantor trust (also known as a sale to a defective grantor trust). If properly structured, future growth in the value of the sold interest will not be subject to estate tax when the transferor dies. Further, no income tax arises on the sale.

If the sales price equals the fair market value of what was sold, there is no gift on the transaction, and no gift tax return reporting is of the transaction is required. Since valuing an interest in an entity is not an exact science, gift tax exposure exists if the IRS can establish a higher value than the sales price. Many practitioners elect not to report the transaction, so as to avoid the risk of IRS scrutiny. Since the transaction doesn't typically show up on a gift tax or income tax return, IRS scrutiny is thus substantially diminished.

This type of thinking may shortly fall by the wayside. On a recently released draft Form 706 (estate tax return), the IRS now has a question whether a decedent at any time during his or her lifetime transferred or sold an interest in a partnership, a limited liability company or a closely-held corporation to a trust that was in existence at the decedent’s death and that was (1) created by the decedent during his or her lifetime or (2) created by someone other than the decedent under which the decedent possessed any power, beneficial interest or trusteeship. This question will bring to the IRS' attention a sale to grantor trust transaction, at least at the time of the decedent's death, thus inviting IRS scrutiny of the transaction.

If the IRS determines that a gift occurred on the sale, it can impose gift taxes, penalties, and interest, even if the sale transaction occurred many years prior to death. If this question makes it into the final Form 706, practioners may now want to specifically disclose sale to grantor trust transactions on gift tax returns to get the statute of limitations running since there is a good chance that IRS scrutiny may arise later at the time of estate tax audit due to the Form 706 disclosure. If the IRS does not challenge the transaction within 3 years, this will usually foreclose further tax adjustments by the IRS (including at the subsequent death of the transferor). This is especially true since very few gift taxes are audited.

Monday, October 30, 2006


Non-U.S. persons who receive interest income or dividends from U.S. payors are typically subject to a 30% tax. The person paying the interest or dividends to the foreign person (the "withholding agent") is obligated to withhold this tax from the interest or dividend payment, and pay it over to the IRS. If the withholding agent does not withhold the tax, the IRS can nonetheless hold the withholding agent responsible for the tax if the payee does not pay it.

There are exceptions to the withholding tax, such as the portfolio interest exception which exempts interest paid on certain qualified obligations from U.S. tax, and tax treaties which may reduce or eliminate the tax. Generally, the withholding agent must receive certain documentation, like a Form W-8, from the payee before the withholding agent is released from its obligation to withhold.

What happens if a withholding agent doesn't receive the proper documentation before it makes its payment, but it turns out that no tax was due? In what many perceive to be an unfair rule, a withholding agent who doesn't withhold will still be liable for interest on the tax not withheld, even though no tax is due. Treas. Reg. § 1.1441-1(b)(7)(iii).

Well, that used to be the case. In Notice 2006-99, 2006-46 IRB, the IRS has advised that it will be amending the Regulations to avoid the interest charge against the withholding agent if it turns out the payee owed no tax. The Regulations will also clarify that no penalties will be imposed against the withholding agent in that circumstance. The Regulations will be retroactive to January 1, 2001.

Friday, October 27, 2006


Taxpayers often gift away partial interests in family real property to other members - often as gifts of tenancy in common interests. These taxpayers do not expect that the interests that are gifted away will be subject to estate tax at the donor's death. However, a recent Tax Court case demonstrates that if the donor retains economic interests in the gifted interests, or continues to use the entire property, Section 2036 can result in estate tax inclusion of the entire property.

In Estate of Margot Stewart v. Commissioner, T.C. Memo 2006-225, a mother gifted away a 49% tenants in common interest in real property to her son. The transfer qualified as a completed gift for gift tax purposes. During the mother's remaining lifetime, she continued to live in the property, she received all of the rental income that the property generated, and paid most of the expenses of the property. Due to these facts, the IRS sought to include 100% of the value of the property in the mother's estate when she died. The taxpayers objected, but the Tax Court sided with the IRS and allowed the 100% inclusion.

The case is a demonstration of what NOT to do. Reverse the facts and you come up with some guidelines towards avoiding Section 2036 inclusion when a partial interest in property is gifted away, including:

-The donor should not continue to use the entire property, unless paying fair rent for the portion the donor no longer owns.

-Divide any rental income pro rata in accordance with the percentage ownership interests.

-Divide the expenses pro rata in accordance with the percentage ownership interests.

Wednesday, October 25, 2006


UPDATE: For more information on these issues, you can visit the website This is the website of Martin Kapp, the CPA who participated in the litigation before the IRS.
Internal Revenue Code Section 162(a)(2) allows a taxpayer to deduct traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while "away from home" in the pursuit of a trade or business. For purposes of Section 162, the term "home" generally means the taxpayer's principal place of employment and not where his or her personal residence is located.

Under the Sleep or Rest Rule, which has been developed in a series of tax cases to determine whether a taxpayer is away from home on short duration business trips, (a) if the nature of a taxpayer's employment was such that when away from home, during scheduled break times, it was reasonable for him to need and to obtain sleep or rest in order to meet the exigencies or business demands of his employment, and (b) the breaks were of sufficient duration to give rise to increased expenses, expenses for this purpose would be traveling expenses under Section 162(a)(2).

Marc G. Bissonnette was a ferryboat captain for a company that carried travelers on sea voyages to destinations on Puget Sound, Washington. The company's home port was in Seattle, Washington. He worked approximately 15- to 17-hour days on turnaround runs completed within 24 hours that each included a 6-hour layover at an away from-home port during off-season voyages and a 1/2- to 1-hour layover at an away from home port during peak-season voyages. He paid for his meals and incidental expenses while traveling, and sought to deduct them. The IRS challenged the deductions, asserting that the taxpayer was not "away from home" under the Sleep or Rest Rule.

The Tax Court made short shrift of the taxpayer's arguments as to the peak season trips. The layover on those trips was less than an hour. Noting that the released time must be of a sufficient duration that it would ordinarily be related to a significant increase in expenses, the meals taken during the short layover were found not deductible.

In regard to the off-season trips, the IRS argued that the longer rest period came about solely as a result of scheduling, rather than the taxpayer's need for sleep and rest, and thus should not be deductible. The Tax Court reviewed the facts and circumstances of the taxpayer's typical workday, and disagreed, noting that it was reasonable for the taxpayer to obtain sleep or rest in order to meet the exigencies and business demands of his employment. Further, the Court noted that the released time of 6 to 7 hours was sufficient in duration that it would normally be related to an increase in expenses. Consequently, the Tax Court allowed the meal expenses for the off-season trips.

Marc G. Bissonnette, et ux. v. Commissioner, 127 T.C. No. 10 (10/23/2006)

Sunday, October 22, 2006


November 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.83% (4.94%/October -- 5.07%/September -- 5.19%/August)

-Mid Term AFR - Semi-annual Compounding - 4.64% (4.76%/October -- 4.95%/September -- 5.14%/August)

-Long Term AFR - Semi-annual Compounding - 4.84% (4.96%/October -- 5.14%/September -- 5.29%/August)


Friday, October 20, 2006


Under the substantial economic test, partnerships can generally allocate income and expenses between and among their partners as they like, provided that such allocations have a bottom line effect on the economic income or loss of the affected partners. Generally, an allocation of income or expense will be respected if (a) capital accounts are maintained as the IRS requires, (b) liquidation proceeds are distributed in accordance with capital account balances at the time of liquidation, and (c) provision is made for deficit capital account restoration obligations or qualified income offsets.

In newly issued regulations, the IRS indicated that compliance with these three requirements is NOT enough to uphold allocations of foreign taxes among partners. The IRS is concerned that foreign tax payments made by a partnership may be allocated to U.S. partners (who can make effective use of such taxes by obtaining a foreign tax credit for them that can be applied against U.S. income taxes) and away from foreign partners who cannot effectively use the foreign tax credit. To come within a safe harbor allocation under the new regulations, if the above three requirements are met an allocation of foreign taxes will be respected, but only if the allocation is also proportionate to a partner’s distributive share of the partnership income to which such taxes relate.

If an allocation cannot come within this safe harbor, the foreign taxes will be tested, and potentially reallocated, under the more general "partner interest" standard of Regs. §1.704 1(b)(3).

Preamble to TD 9292, 10/18/2006 ; Reg. § 1.704-1.

Wednesday, October 18, 2006


Under existing tax rules, an individual owning property can "sell" such property to a family member or entity owned or controlled by family members in exchange for a private annuity. A private annuity is generally an agreement to pay a fixed sum each year to the seller for a fixed term of years or over the remaining lifetime of the seller.

Such a sale achieves an important estate tax planning benefit, since it can remove an appreciating asset from the future taxable estate of the seller. Thus, estate taxes are avoided on the growth in value of the sold asset that might occur before death (although estate taxes may still be augmented by the seller surviving his or her life expectancy and thus receiving annuity payments in excess of the value of the sold property).

Such planning is facilitated by IRS treatment of the gain arising on such sale. More particularly, such gain can be deferred in part until annuity payments are received. Well, at least that was the case until now.

Under proposed regulations issued October 17, 2006, the IRS is proposing to disallow any deferral of tax on gain from such sales. Instead, if such a sale is undertaken, the seller will both realize and recognize the full amount of gain from the sale in the year of sale. The new provisions will not apply to "charitable gift annuities" under Treas. Regs. § 1.1011-2.

Such regulations, if finalized, would apply to exchanges of property for an annuity contract after October 18, 2006. They would not apply to amounts received after that date under annuity contracts arising from exchanges prior to that date. There also is a limited class of private annuity transactions that would not be subject to the new rules until after April 18, 2007.

Proposed Regulations §§1.72-6 and 1.1001-1.

Monday, October 16, 2006


A little background is needed to understand the impact of recently released Treasury Regulations relating to the tax basis of an interest in a partnership by a partner.

A. Partners in a partnership may receive additional tax basis in their partnership interests based on their allocable share of liabilities of the partnership itself. That is, if the partnership borrows money, a portion of that borrowing can be allocated to the partners and increase the income tax basis of the partners in the partnership. Tax basis can be relevant for many purposes - for example, basis is needed to be able to deduct losses arising from the partnership.

B. Very generally, a partner will be allocated so much of a partnership liability to the extent that the partner bears the ultimate risk of loss relating to the repayment of the partnership obligation.

C. What happens if the partner doesn't own an interest in the partnership directly, but holds its interest through a "disregarded entity" and the owner of the disregarded entity is not responsible for the liabilities of the disregarded entity? Does the owner of the disregarded entity get to increase its basis in the partnership (since the owner is treated as the deemed partner because the disregarded entity is disregarded for income tax purposes) to the full extent that it could if it was in the shoes of the disregarded entity? This is the subject of the recent Regulations.

The Regulations do allow the partner to stand in the shoes of the disregarded entity for purposes of calculating its share of the liabilities of the partnership to determine its adjusted basis as deemed partner. HOWEVER, the amount of maximum amount of partnership liabilities that can be taken into account for this purpose is limited to the net value of the disregarded entity.

The Regulations provide a specific definition for "net value" for use in applying these rules.

T.D. 9289, 10/10/2006 ; Reg. § 1.704-2 , Reg. § 1.752-2.

Friday, October 13, 2006


A recent Florida case involving the Carvel ice-cream family raised the issue whether a decedent's probate estate is an interested party in regard to accountings issued by a revocable trust of which the decedent was the settlor. That's a bit of a mouthful - let's break it down:

-individual establishes a revocable trust during lifetime and is thus the settlor;

-the individual settlor dies; and

-during the administration of the settlor's estate, the trust issues accountings.

Does the estate have a sufficient interest in the trust as to be a required party to proceedings involving the trust accounting?

The estate of the settlor on its face appears to have an interest, since under Florida law the trust, after the settlor's death, is liable for the expenses of administration and obligations of the decedent's estate to the extent the decedent's estate has insufficient assets to pay those items. In the case, the trust also directed payment of such estate expenses. Florida Statutes defines an interested person, for the purposes of wills and trusts, as “any person who may reasonably be expected to be affected by the outcome of the particular proceeding involved. In any proceeding affecting the estate or the rights of a beneficiary of the estate, the personal representative of the estate shall be deemed an interested person.” The question before the appellate court was whether the estate, by reason of the trust being responsible for estate expenses if estate assets are insufficient, was an interested person in regard to trust accountings.

Reversing the trial court, the appellate court found the estate to be an interested person, noting that the estate, while not an income or residual beneficiary, was an intended beneficiary of the trust.

Carvel v. Godley, 31 Fla. L. Weekly D2536e (4th DCA 10/11/06)

Wednesday, October 11, 2006


Internal Revenue Code Section 911 allows U.S. citizens and residents who have a tax home abroad and either reside in a foreign country or spend almost all of their time in a foreign country to either exclude from income or deduct from income (depending on whether an employer pays their employment costs) a portion of their foreign housing costs. Computing the maximum excludible or deductible amount takes one through a maze of computations and limitations - an exercise not worth reproducing here.

The IRS has issued Notice 2006-87, which addresses one of the limitations included in the computation. More particularly, one standard limitation in the computation is a maximum amount allowable for housing expenses under Code Section 911(c)(2)(A). The standard limit for these expenses under that part of the computation is $24,720 per year.

In a break for many taxpayers living abroad, Notice 2006-87 recognizes that housing costs are different throughout the world. It contains a table that identifies locations within countries with high housing costs relative to U.S. housing costs, and provides an adjustment amount that can result in an increase in the $24,720 figure. For example, the figure is adjusted upwards to a maximum of $85,700 (for an overall maximum limitation, after the remaining limitations are figured in, of $72,516).

Individuals whose locality is not included on the table must use the generally applicable $24,720 limitation.

This table will be updated each year.

Sunday, October 08, 2006


In calculating federal estate taxes, a deduction for funeral expenses is generally allowed. Code Sec. 2053(a)(1) provides for the deduction from the gross estate for such funeral expenses as are allowed by the laws of the jurisdiction under which the estate is being administered.

Michigan allows reasonable funeral and burial expenses as a charge against the estate. A recent Tax Court case involving a Michigan estate demonstrates how NOT to qualify for the deduction in regard to expenses of a post-funeral reception.

In Estate of Sarah Davenport, TC Memo 2006-215, the estate claimed total funeral expenses of $7,796, which included amounts paid for the funeral home, cremation, obituary notice, other items and a funeral luncheon costing $3,639. The IRS allowed all of the funeral expenses, except the amount paid for the funeral luncheon.

Neither the Code nor the regs define "funeral expenses." Reg. § 20.2053-2 states that "[a] reasonable expenditure for a tombstone, monument, or mausoleum, or for a burial lot, either for the decedent or his family, including a reasonable expenditure for its future care" and "the cost of transportation of the person bringing the body to the place of burial" are examples of deductible costs.

At trial, the Estate representatives testified that the purpose of the luncheon was in large part to thank family, teachers and professionals who worked with the decedent over the years. These individuals were invited to the funeral. The Tax Court determined that no deduction would be allowed for this type of reception.
Does this mean that post-funeral receptions will not be deductible in the future? Probably not, since there were a number of mistakes made by the estate in this case that may be overcome in other cases.

First, the Court noted that the "necessity" of the expense must be demonstrated. A purpose to "thank and recognize third parties for their support" did not demonstrate this necessity. A focus on eulogizing and laying to rest the deceased would have been more helpful and may have satisfied the Court.

Second, the Court noted that the "reasonableness" of the expense must be demonstrated. Here, the estate did not provide enough information to determine reasonableness. The Court noted that insufficient evidence was provided as to what the expended amounts were for - the Court did not know whether and how much was for for the venue, decorating, catering, entertainment, or a combination of supplies and services. It also did do not know who received the claimed payment or payments. If such information had been provided, the Court could then have ruled on reasonableness.

The Court also noted other facts that would have helped demonstrate "necessity" and "reasonableness" such as having the reception at the same location as the funeral service, and being able to demonstrate an overlap in attendance between the funeral service and the reception (elements that were absent in this case).

Consequently, even with this adverse case, future expenses for post-funeral events may still be allowable if the exact charges are provided, if they are reasonable, and the event has more of the traditional funeral focus so that "necessity" can be demonstrated.

Friday, October 06, 2006


An interesting case (Castle Harbour) came out earlier this year in regard to the age old dispute as to whether to characterize an investment in an entity as debt vs. equity. This case was discussed at length in the article Partner or Lender? Debt/Equity Issues Arise in Second Circuit's Reversal of Castle Harbour, By Richard M. Lipton and Jenny A. Austin in the October 2006 issues of the Journal of Taxation.

The characterization of debt vs. equity has significant income tax consequences. Usually, taxpayers desire the "debt" label since when the investment is paid back to the "lender," deductible interest may result to the entity. Further, such a payment will not be a taxable dividend if the entity is a Subchapter C corporation. The IRS usually finds itself on the other end of the dispute, arguing that the investment is equity, since this usually generates more overall income tax and is consistent with the maxim that the IRS will adopt the position in a matter that will generate the most tax.

What is interesting about the Castle Harbour case is that the usual roles were reversed - the IRS was arguing for "debt" treatment and the taxpayer was arguing for "equity." In making its argument for "debt" treatment, the IRS was making the arguments that taxpayers usually make. Since the IRS prevailed upon the appellate court to adopt its reasoning, the reasoning adopted by the appellate court can now be used AGAINST the IRS in future cases when the IRS is seeking its more usual "equity" characterization.

In determining whether an investment was debt or equity, the 2nd Circuit Court of Appeals indicated that the applicable test was whether the funds were advanced with reasonable expectations of repayment regardless of the success of the venture (indicative of debt) or were placed at the risk of the business (indicative of an equity investment). Here are some facts and arguments employed by the IRS and adopted by the Court that may be of use to future taxpayer litigants that are looking for "debt" treatment:

--The investor in the case would be allocated profits from the venture, albeit subject to a dollar cap. The Court noted that this could increase the investor's percentage return on its investment by almost up to 2.5%. Normally, the IRS would argue that such an equity kicker belies an equity investment. In the instant case, however, the court found that the additional 2.5% possibility of return was "a relatively insignificant incremental return" and nonetheless treated the investment as debt. Thus, the Court is leaving the door open to investors to allow for some equity upside (as long as it is not too substantial) and still obtain debt treatment.

--The Court concluded that an investment labeled as equity should be recharacterized as debt even when there was no fixed repayment date. This is another fact that will be of use to investors seeking debt treatment.

The article notes that in winning the case, the IRS gained extra tax revenue - but that the precedents established by the case may cost it many times that revenue in other cases.

TIFD III-E, Inc., 98 AFTR 2d 2006-5616 (CA-2, 2006), rev'g 342 FSupp 2d 94 (DC Conn, 2004).

Tuesday, October 03, 2006


The Pension Protection Act of 2006 provides a new method of financing the cost of long-term insurance policies, by combining them with life insurance and annuity policies and contracts. More particularly, the new allows for life insurance and annuity contracts to add long-term care insurance riders and use the cash value of the life insurance and annuity contract to cover the cost of long-term care insurance premiums without incurring taxable distributions. The new law also broadens Code Section 1035 to allow for tax-free exchanges of life and annuity policies into long-term care insurance contracts. The new provision does not come into effect right away - it applies only after 2009.

In effect, the long-term care insurance premiums can be paid from the cash surrender value and the untaxed build-up in value in the life insurance or annuity policy. Such payment is not treated as a distribution from the life insurance policy or annuity, which might otherwise be taxable to the owner.

There are some negative consequences to this treatment, which in many cases will negate the tax benefits. First, the payment of the premiums on the long-term care insurance is treated as a return of basis to the owner of the policy (but it will not reduce basis below zero). Since the owner may be taxed on future distributions from a life insurance policy that exceed the owner's basis, and the tax basis also measures the income of an annuitant from an annuity, such a reduction in basis may increase future income taxes. Second, the premium paid on the long-term care insurance will NOT be deductible under Code Section 213(a) as a medical expense deduction. Thus, if the owner had paid the long-term care insurance directly instead of through the life policy, he or she would not suffer the basis deduction, and may have a medical expense deduction.
There are circumstances where such negative attributes are not really a problem. For example, the long-term care insurance may not be of a qualified nature, in which case no medical expense deduction would be available anyway even if the premium was paid directly by the owner. Or, if a life insurance policy is held until the death of the insured and substantial pre-death withdrawals are not made, the loss of tax basis in the policy is a nonevent.
Therefore, the particular circumstances of the situation will need to be reviewed to see if there is a benefit in using this new provision.
Life insurance and annuity companies will be subject to information reporting so that the IRS can track the payment of such premiums.
Applicable Code Sections: 72(e)(11), 1035, 7702B(b), 7702B(e), 6050U(a)

Saturday, September 30, 2006


The Internal Revenue Code attempts to be tax-neutral in regard to corporate reorganizations. One aspect of this tax neutrality is that generally no gain or loss is recognized by a shareholder who is a party to a tax-free reorganization. For example, a shareholder of an acquired corporation can receives shares of stock in the acquiring corporation and not recognize any gain on the transaction. This nonrecognition arises under Section 354 and applies only if the reorganization involves an exchange solely for stocks and securities of a corporation that is also a party to the exchange. If the taxpayer received other property ("boot"), under Section 356 gain recognition results to the extent of boot received. No loss recognition is allowed.

A taxpayer who receives boot may have a different adjusted basis (that is, investment in the stock against which the amount of gain or loss is calculated) in the various shares he exchanges in the reorganization, and indeed may be giving up shares of different classes of stock. When boot is received, to which shares should the boot be allocated? This allocation determines how much gain arises if there is a different adjusted basis in different exchanged shares, and whether gain is long term or short term gain if there are different holding periods for the shares exchanged.

The courts have adopted the average-cost method to make the allocation, which is a pro rata allocation of the surrendered stock's bases to each block of stock received.

Earlier this year, new Treas.Regs. Section 1.356-1 provides useful flexibility to taxpayers. It adopts a tracing method. More particularly, in computing the gain, if any, recognized on an exchange, to the extent the terms of the exchange (1) specify (or trace) the other property or money that is received in exchange for a particular share of stock or security surrendered, and (2) are "economically reasonable," those terms control and the average-cost method need not apply.

Wednesday, September 27, 2006


Charitable organizations need to be aware of a new reporting requirement that came into effect under the Pension Protection Act of 2006. Under the Act, if an organization, gifts to which are eligible for a charitable deduction (for estate, income, or gift purposes), acquires an interest in certain life insurance contracts, such interest must be disclosed to the IRS. See Code Section 6050V. This disclosure requirement is only for a two year period.

It is clear that the IRS is concerned about charitable organizations lending their "insurable interest" in a life insurance policy to third parties. More particularly, there are various programs whereby a charitable organization acquires an ownership interest in a donor. The funds for the policy are generally lent to the charitable organization by a third party. When the donor dies, the charity gets the insurance proceeds, less its repayment of the loan to the third party lender.

If the third party lender had instead taken out the policy, it probably would not be enforceable, due to insurance law requirements that a beneficiary have an "insurable interest" in the insured. Generally, an "insurable interest" is an economic interest in the person whose life is insured, or a family relationship. Many states extend the "insurable interest" to include charities who own a policy on a donor’s life. Thus, the third party lender gains an indirect benefit from the policy due to the charitable nature of the beneficiary.

While the new provision does not prohibit or tax such arrangements, the IRS is gathering information and may seek further legislative reform down the line. In the meanwhile, the reporting itself may serve to dissuade charitable organizations from entering into these types of transactions.

Saturday, September 23, 2006


Appraisers perform important functions for taxpayers, since many tax consequences relate to value of property. For example, a charitable contribution of property is based on the value of the property, and of course transfers of property for estate and gift tax purposes are taxable based on value.

When an appraisal is way off base, the taxpayers can be subject to substantial penalties. Under Code Section 6701(a), the appraiser himself or herself may also be subject to a $1,000 penalty, or $10,000 if a corporate tax return is involved, if it can be shown that the appraiser knew the report was false and would be used to reduce tax of another.

In addition to a the monetary penalty, after notice and opportunity for a hearing to any appraiser for whom a penalty had been assessed under Code Sec. 6701(a) the IRS could, under 31 USCS 330(c) : (a) bar the appraiser from presenting evidence or testimony in any administrative proceeding before IRS or the Treasury, and (b) provide that his or her appraisals wouldn't have any probative effect in any such proceeding.

The penalty stakes have now been increased for appraisers. New Code Section 6695A, enacted under the Pension Protection Act of 2006, imposes a new penalty on an appraiser if he or she knows, or reasonably should have known, that the appraisal would be used in connection with a return or a refund claim, and the claimed property value on the return or refund claim that is based on the appraisal results in a substantial valuation misstatement under Code Sec. 6662(e) or a gross valuation misstatement under Code Sec. 6662(h) for the property. Code Sections 6662(e) and 6662(h) relate to various valuation misstatements in regard to various income, pension, and estate and gift taxes. No penalty, however, will be imposed if the appraiser satisfies the IRS that the value established in the appraisal was more likely than not the proper value.

The penalty imposed is lesser of:

(1) the greater of: (a) 10% of the tax underpayment arising from the valuation misstatement described in (B) above, or (b) $1,000, or

(2) 125% of the appraiser’s gross income for preparing the appraisal.

Therefore, the appraiser can be penalized up to 125% of his or her appraisal fee.

The 2006 Pension Act also removes the requirement that IRS must assess a penalty under Code Sec. 6701(a) (aiding and abetting understatements) before it can bar an appraiser from presenting evidence or testimony in any administrative proceeding before IRS or the Treasury and provide that his appraisals won't have any probative effect in any such proceeding. 2006 Pension Act §1219(d).

Thursday, September 21, 2006


October 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.94% (5.07%/September -- 5.19%/August -- 4.99%/July)

-Mid Term AFR - Semi-annual Compounding - 4.76% (4.95%/September -- 5.14%/August -- 4.99%/July)

-Long Term AFR - Semi-annual Compounding - 4.96% (5.14%/September -- 5.29%/August -- 5.22%/July)


Tuesday, September 19, 2006


RIA, a publisher of tax guides and research, has calculated 2007 adjustments to various Federal tax numbers that are calculated each year based on the prior year rate of inflation. These calculations are not the final IRS figures, but are typically an accurate projection of the final adjustments. Below are some of the more important inflation adjustment figures - remember, these apply in 2007, not 2006.

GIFT TAX ANNUAL EXCLUSION. The gift tax annual exclusion will be $12,000 (same as for gifts made in 2006).

ESTATE TAX SPECIAL USE VALUATION REDUCTION LIMIT. The limit on the decrease in value that can result from the use of special valuation will increase to $940,000, up from $900,000 in 2006.

PORTION OF ESTATE QUALIFYING FOR 2% INTEREST RATE ON DEFERRED ESTATE TAX. In determining the part of the estate tax that is deferred on a farm or closely-held business that is subject to interest at a rate of 2% a year, for decedents dying in 2007 the tentative tax will be computed on $1,250,000 (up from $1,200,000 in 2006) plus the applicable exclusion amount ($2 million for 2007, same as in 2006).

INCREASED ANNUAL EXCLUSION FOR GIFTS TO NONCITIZEN SPOUSES. The annual exclusion for gifts to noncitizen spouses will be $125,000 (up from $120,000 in 2006).

THRESHOLD FOR FOREIGN GIFTS THAT TRIGGERS REPORTING. If the value of the aggregate "foreign gifts" received by a U.S. person (other than an exempt Code Sec. 501(c) organization) exceeds a threshold amount, the U.S. person must report each "foreign gift" to IRS. ( Code Sec. 6039F(a) ) Different reporting thresholds apply for gifts received from (a) nonresident alien individuals or foreign estates, and (b) foreign partnerships or foreign corporations. For gifts from a nonresident alien individual or foreign estate, reporting is required only if the aggregate amount of gifts from that person exceeds $100,000 during the tax year. For gifts from foreign corporations and foreign partnerships, the reporting threshold amount will be $13,258 in 2007 (up from $12,760 in 2006).

TAX AVOIDANCE MOTIVE - EXPATRIATION. A tax avoidance motive is generally presumed for an expatriate whose average annual net income tax liability for the 5 tax years ending before the date of loss of citizenship or residency exceeds $136,000 in 2007 (up from $131,000 in 2006) or whose net worth on that date exceeds $2 million (not indexed for inflation).

FOREIGN EARNED INCOME EXCLUSION. The foreign earned income exclusion amount increases to $85,700 in 2007 (up from $82,400 in 2006).

Sunday, September 17, 2006


The IRS has announced the interest rates for tax overpayments and underpayments for the calendar quarter beginning October 1, 2006.
For noncorporate taxpayers, the rate for both underpayments and overpayments will be 8% (no change from before).
For corporations, the overpayment rate will be 7% (no change from before). Corporations will receive 5.5% (no change from before) for overpayments exceeding $10,000. The underpayment rate for corporations will be 8% (no change from before), but will be 10% (no change from before) for large corporate underpayments.

Friday, September 15, 2006



The following is a summary analysis of the Pension Protection Act of 2006 relating to direct transfer of IRA assets to charity. The outline comes from a presentation given earlier this week. For those few of you that may have attended the presentation, you have already seen this!


----a. If an amount withdrawn from a traditional individual retirement arrangement ("IRA") or a Roth IRA is donated to a charitable organization, the rules relating to the tax treatment of withdrawals from IRAs apply to the amount withdrawn and the charitable contribution is subject to the normally applicable limitations on deductibility of such contributions.

--------i. A taxpayer who takes the standard deduction (i.e., who does not itemize deductions) may not take a separate deduction for charitable contributions.

--------ii. Under present law, total deductible contributions of an individual taxpayer to public charities, private operating foundations, and certain types of private nonoperating foundations may not exceed 50 percent of the taxpayer's contribution base, which is the taxpayer's adjusted gross income for a taxable year (disregarding any net operating loss carryback).

--------iii. Contributions of cash to private foundations and certain other charitable organizations generally may be deducted up to 30 percent of the taxpayer's contribution base.

--------iv. Present law imposes a reduction on most itemized deductions, including charitable contribution deductions, for taxpayers with adjusted gross income in excess of a threshold amount, which is indexed annually for inflation. The threshold amount for 2006 is $150,500 ($75,250 for married individuals filing separate returns). For those deductions that are subject to the limit, the total amount of itemized deductions is reduced by three percent of adjusted gross income over the threshold amount, but not by more than 80 percent of itemized deductions subject to the limit.

------------(1) Although through 2009 the limit is reduced.

----b. Thus, if a taxpayer withdrew funds from an IRA and gave them to charity, he or she would likely have income equal to the withdrawal, but the offsetting charitable deduction could be limited or nonexistent, thus giving rise to income tax.


----a. The provision provides an exclusion from gross income for otherwise taxable IRA distributions from a traditional or a Roth IRA in the case of qualified charitable distributions.

----b. Qualified charitable distributions are taken into account for purposes of the minimum distribution rules applicable to traditional IRAs to the same extent the distribution would have been taken into account under such rules had the distribution not been directly distributed under the provision.

--------i. An IRA owner who makes an IRA qualified charitable distribution in an amount equal to his RMD for that tax year is considered to have satisfied his Code Sec. 408(a)(6) minimum distribution requirement for that year, even though a charitable entity (and not the IRA owner) is the recipient of the distribution.


----a. Applies for distributions made after December 31, 2005 and before January 1, 2008.

----b. The exclusion may not exceed $100,000 per taxpayer per taxable year.

----c. Transfer must be made on or after the date on which the individual for whose benefit the IRA is maintained has attained age 70-1/2 .

----d. The provision does not apply to distributions from employer-sponsored retirements plans, including SIMPLE IRAs and simplified employee pensions ("SEPs").

----e. Transfer must be direct from the IRA trustee to the charity.

--------i. A distribution made to an individual, and then rolled over to a charitable organization, would not be excludible from gross income.

----f. Charitable recipient cannot be a supporting organization described in section 509(a)(3) or a donor advised fund (as defined in section 4966(d)(2), nor a nonoperating private foundation.

----g. Applies only if a charitable contribution deduction for the entire distribution otherwise would be allowable (under present law), determined without regard to the generally applicable percentage limitations.

--------i. Thus, for example, if the deductible amount is reduced because of a benefit received in exchange, or if a deduction is not allowable because the donor did not obtain sufficient substantiation, the exclusion is not available with respect to any part of the IRA distribution.

--------ii. If the IRA owner has any IRA that includes nondeductible contributions, a special rule applies in determining the portion of a distribution that is includible in gross income (but for the provision) and thus is eligible for qualified charitable distribution treatment.

----h. No charitable deduction allowed to taxpayer for the transferred amount.

4. MISC.

----a. An individual's tax-free IRA donations may consist of one or more distributions, from one or more IRAs, donated to one or more charitable organizations, as long as the aggregate amount does not exceed $100,000 in a year.

----b. There is no carryover of unused $100,000 amounts - use it or lose it.

----c. There is nothing under the IRA charitable rollover provision that requires an IRA trustee to make distributions to charity at the direction of the account owner, or to ensure that the distributions qualify as "qualified charitable distributions."

Wednesday, September 13, 2006


Florida allows for real property to be held in a special type of trust known as a "land trust." Land trusts allow for confidentiality of ownership, and can facilitate transfers of ownership of partial or complete interests in land.

In the recently completed legislative session, Florida revised its land trust statute. Some of the more significant statutory modifications include:

-Clarication that a trustee can be a beneficiary.

-Clarificatopm that a beneficiary of a land trust is not liable for the debts, obligations, or liabilities of the land trust.

-The perfection of a security interest in a beneficial interest in a land trust does not impair or diminish the authority of the trustee under the recorded instrument.

-Subsequently recorded public documents relating to the transfer or encumbrance of a beneficial interest do not diminish or impair the authority of the trustee under the previously recorded instrument.

-A trust relating to real estate will not fail because beneficiaries are not specified by name in the recorded deed of conveyance or because duties are not imposed upon the trustee.

-Homestead tax exemption is available to property held in a land trust if the beneficiary and property otherwise qualifies for it.

-Provisions are made for recording public record documents relating to succession of trustees.

Saturday, September 09, 2006


A recent article notes a risk for a Code Section 83(b) election for partnership interests received for services.

Persons performing services for a partnership (or LLC taxable as a partnership) often receive an interest in the partnership as incentive compensation. When issued, the person performing the service may be obligated to provide continued services for the partnership - otherwise the partnership may be able to take back the partnership interest. Section 83 of the Internal Revenue Code indicates that the service partner need not recognize compensation income when the partnership interest is issued, due to it being subject to a "substantial risk of forfeiture" (provided it is also not transferable free of the risk of forfeiture). Instead, the service provider can defer income taxes for the receipt of the interest until the risk of forfeiture lapses or terminates.

There is a risk that the value of the partnership interest may increase signficantly between its issuance and when the substantial risk of forfeiture may lapse (and thus increase the compensation income to the service partner). To avoid the risk of such increased taxation, the service partner can make an election to be taxed on the receipt of the interest when it is received (at the value at the time of issuance) under Code Section 83(b).

The tax risk of such an election relates to what occurs if the service partner has to surrender the interest due to not continuing to provide services. Per Treas.Regs. Section 1.83-2(a), at the time of a forfeiture of the interest the service provider can recognize a loss (presumably a capital loss) to the extent of what the service partner paid for the interest over what the service partner is paid for the interest upon the forfeiture (if anything). The problem with this rule is the service provider gets no credit/loss for the ordinary income incurred by the service provider at the time of the Section 83(b) election. Further, it does not allow for any adjusted basis (and thus loss) relating to any increase in tax basis in the forfeited partnership interest that arose while the partnership interest was owned by the service partner due to being allocated his or her share of partnership income from the partnership under the partnership tax rules.

Example: A taxpayer receives a partnership interest that is subject to being forfeited if he does not work for the partnership for 5 years. The taxpayer elects to be taxed upon receipt of the partnership interest at a time that the interest is worth $50,000 - largely because he believes the partnership interest could be worth at least $200,000 in 5 years when he would otherwise be taxed for the receipt. In year 3, the taxpayer ceases to work for the partnership and has to return his partneship interest. In years 1-3, the taxpayer was allocated $30,000 of partnership income on his partnership interest, all of which he included in income. No partnership distributions were made to him during the term. According to the regulation, at the time of the forfeiture, the taxpayer has no loss from the forfeiture, since he paid nothing for his interest. He does not get a loss for the $50,000 in compensation income he received, nor does he get a loss for the $30,000 in partnership income that was allocated to him during the term.

This risk of not being able to get a loss for income so earned needs to be considered in making a determination whether to make a Section 83(b) election.

Source: Article by Richard Harris in March/April 2005 issue of Business Entities.

Wednesday, September 06, 2006


A grantor trust is a trust whose income is generally taxable to the grantor/settlor by reason of specific Internal Revenue Code provisions that mandate such treatment. In contrast, a nongrantor trust is a separate taxpayer whose income is generally taxable either to the trust itself and/or its beneficiaries and not the grantor.

Code Section 677(a)(3) is one of those provisions that gives rise to grantor trust status. It provides that a trust will be a grantor trust if its income, without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse. There is case law to the effect that where no insurance policy is owned by the trust, the mere power to purchase a policy and pay premiums is not enough to create grantor trust status. Thus, there is uncertainty as to when and how these provisions apply. Do they if the trust does not own an insurance policy? Do they apply only to the extent that trust income is applied to premium payments? There is conflicting authority on these questions.

A recent IRS field advice (LAFA 20062701F) muddies the water further. In the advice, a trust explicitly allowed the use of trust funds to purchase life insurance on the life of the grantor. The trust funds were used to pay premiums on life insurance on the life of the grantor, but the trust was not the owner of the policy. The advice concludes that a grantor trust existed - it was enough that the trust was authorized to pay the premiums - it did not have to own a life insurance policy to give rise to grantor trust status.

Sunday, September 03, 2006


While taxpayers may often assert constitutional arguments against the enforcement of the Internal Revenue Code, the actual finding of a provision to be unconstitutional is an extremely rare event. Subject to possible review by the U.S. Supreme Court, the U.S. Circuit Court of Appeals for the District of Columbia circuit did just that in the recent case of Murphy v. United States, No. 05-5139.

For the nonlawyers, a little constitutional background is helpful. Until the 16th Amendment to the U.S. Constitution was enacted, an income tax was not allowed. The 16h Amendment allows a tax on income, and Section 61 of the Internal Revenue Code imposes such a tax on "gross income." The U.S. Supreme Court in Helvering v. Clifford has found these provisions coextensive. It has further found that "income" means "gain derived from capital, from labor, or from both combined" (Eisner v. Macomber), and further includes all "accessions to wealth" (Commissioner v. Glenshaw Glass).

The issue in the instant case was whether a damage award for mental distress is "income" when not arising from a physical injury or physical sickness. Section 104(a) of the Code provides that gross income does NOT include the amount of damages (other than punitive damages) received on account of physical injury or physical sickness. In 1996, Congress amended the Section to further provide that "emotional distress shall not be treated as a physical injury or physical sickness" - so that mere emotional distress would not fall within the Section 104(a) exclusion from gross income.

The taxpayer challenged the 1996 amendment, claiming that the new provision is unconstitutional since by treating emotional distress damages as income, Congress is including as income something that is not income under the 16th Amendment authorizing a tax on income. The Circuit Court noted that Congress does not have the power to declare any economic benefit as income, but is bound by what was intended to be included as income under the 16th Amendment. After reviewing interpretations of the term "income" from around the time of the enactment of the 16th Amendment in 1913, and that damages for emotional distress are similar to physical damages in that they are a return of damaged "human capital" and not an asccession to wealth, the Circuit Court held that Section 104(a) is unconstitutional to the extent "it permits the taxation of an award of damages for mental distress and loss of reputation."

This finding has far reaching consequences in the area of employment law, where damages often relate to mental distress without any physical sickness or illness.

Thursday, August 31, 2006


Owners of valuable art often like to enjoy their artwork at home, while still obtaining a charitable deduction for the art. One way that they have been able to do this was to gift a fractional interest in the art to a charity, while also retaining a fractional interest. If they did things right, they could get a deduction and keep the art for part of the year. The charity also had possession of the art for part of the year, although there is even law to the effect that the charity did not even have to take possession of the art - its legal right to do so would be enough to justify the deduction.

This situation was perceived as an abuse by Congress, and new limits on this technique were enacted as part of the Pension Protection Act of 2006. More particularly, the new provisions require that if a fractional interest is gifted to charity and a charitable deduction is desired, the donor must transfer to the charity all of his or her remaining interests by the earlier of (a) 10 years from the initial transfer, and (b) his or her death. Thus, the donor can no longer retain a fractional interest ownership indefinitely, but must eventually transfer his or her remaining ownership interest to the charity. Further, the new provisions require that the charity obtain substantial physical possession of the property and use the property in a use which is related to its exempt purpose.
If these new restrictions are violated, the tax savings from the prior fractional charitable gifts (plus interest on the tax) are "recaptured" and thus made be paid to the IRS by the donor. Further, a penalty of 10% of the recaptured tax is imposed.

The bigger problem is not with these restrictions - it is with the deduction for the gifts of fractional interests to charity after the first gift. The provisions indicate that the deduction for income, estate, and gift tax purposes for the subsequent fractional transfers is limited to the appropriate fractional portion of THE LOWER OF the fair market value of the gifted property (a) at the time of the initial gift, or (b) at the time of the current gift.

Therefore, if the artwork goes up in value after the first fractional gift, when the subsequent factional gifts are made (and assuming that a fair market value deduction is otherwise allowable), a full deduction will not be available. This means that for a gift during lifetime a full income tax deduction for the current value will not be available, and a taxable gift will result for the appreciation in value of the gifted portion from the time of the initial gift to the current gift (although in reading the statute there may be a way to read it to avoid such a taxable gift). Similarly, if the remaining fractional interest of the donor is transferred to charity at death, the appreciation that occurred can result in estate tax since the estate tax charitable deduction will not be as high as the gross estate inclusion value for the fractional interest.

Due to this valuation rule, fractional gifts of artwork are likely to be substantially diminished.