TAX GEOGRAPHY 101: ANTARCTICA IS NOT A COUNTRY

Internal Revenue Code Section 911 allows U.S. taxpayers to exclude some or all of their wage income for services performed in a foreign country when they spend most of the tax year in that country. In 1991, Dave Arnett tried to exclude wages earned while he was working in Antarctica.

The U.S. Tax Court has denied the exclusion to Mr. Arnett, based on the conclusion that Antarctica is not a foreign country since it has no government. The Tax Court relied on The Antarctic Treaty of December 1, 1959 which provides that all questions of sovereignty over Antarctica to be held in abeyance.

Interestingly, the U.S. Supreme Court has held that Antarctica is a foreign country for purposes of the Federal Tort Claims Act, and another U.S. federal court has held that is a foreign country for purposes of the Fair Labor Standards Act. Nonetheless, the Tax Court found that the definition of a foreign country is different under those laws than under the Internal Revenue Code.

Arnett v. Comm., 126 T.C. No. 4 (1/25/06)

TAX COURT INVALIDATES FOREIGN TAX RETURN FILING REGULATION

In the 1990's, the Treasury Department enacted regulations that provide if a foreign corporation did not timely file a U.S. income tax return (with some extension for the time to file over traditional filing deadlines), it can not later take income tax deductions for the applicable tax year. The effect of this regulation is that if a foreign corporation fails to timely file, if it ever does file (including by reason of an audit), its income tax liability will likely be higher by reason of the lost deductions than if it timely filed. Indeed, if the corporation had deductions that completely offset its income, it could find itself owing substantial tax when it really had no net income. This is strong medicine, designed to encourage foreign corporations to file their tax returns.

There is only one problem - there is no authority under the Internal Revenue Code to support it and indeed there is old case law that confirms that filing a timely return is not a prerequisite for obtaining deductions. In a decision favorable to taxpayers, the Tax Court has invalidated the regulations. The Tax Court concluded that it was simply wrong for the Treasury Department to attempt to resurrect a failed litigating position through the issuance of interpretative regulations that are contrary to the Internal Revenue Code.

Swallows Holding, LTD., 126 TC No. 6 (2006)

TAXPAYER'S INTENT ALLOWED TO TRUMP FORM

Generally, while the IRS has the ability to argue "substance over form," in determining the tax consequences of a situation taxpayers are generally bound by the legal form of the transaction or situation. In regard to issues involving life insurance policies, this means that taxpayers are generally bound by the "policy facts" - the objective facts of who has ownership and other rights over the policy. This further means that contrary "intent facts" will be disregarded - even if the taxpayer intended something different from what actually occurred.

In the world of insurance and insurance trusts, who owns an insurance policy, whether or when a policy is transferred, and beneficiary designations can have substantial tax consequences, especially in regard to estate and gift taxes. What happens if the parties intended one thing, but they did the paper work wrong and what they intended is not legally what occurred? Under the "policy facts" principle, they are generally stuck with the legal effect of what actually occurred.

In a recent Private Letter Ruling, the IRS provided an exception to this. In the ruling, the taxpayers had given instructions to their insurance agent to exchange a life insurance policy and then transfer the new policy into an insurance trust. Years later, they discover that the transfer to the trust was never made. The taxpayers requested a ruling that if they transfer the policy to the trust now, there will not be a current gift, and the three year rule of Code Section 2035 (which provides that a life insurance policy transferred by an owner/insured to an irrevocable trust will be taxable in the estate of the owner/insured if he or she dies within 3 years of the transfer) will not apply.

In finding an exception to the application of "policy facts," the IRS ruled favorably that there would be no current transfer and Code Section 2035 would not apply. The IRS extrapolated from existing case law and provided that where the insurance contract does not reflect the instructions of the parties, the IRS will respect the intent of the parties and characterize the tax consequences based on that intent as manifested by their instructions.

PLR 200603002

A "SURPRISE," AND A "NOT A SURPRISE"

A taxpayer who submitted a private letter ruling request received back both a "surprise," and a "not a surprise." A private letter ruling request is a submission to the IRS to rule on the tax consequences of a certain set of facts. Taxpayers generally ask specific questions of the IRS, and the IRS answers them (or at times, may decline to answer).

Let's talk about the "not a surprise" ruling first. The taxpayer here transferred an insurance policy with a certain gift tax value to an irrevocable trust. As you may know, if set up properly (including with applicable Crummey withdrawal powers), transfers of property or cash to an irrevocable trust can qualify for the $12,000 (formerly $11,000) annual exclusion gift tax exemption. That is, such transfers up to the amount of the $12,000 exclusion, are not subject to gift tax.

In the ruling, the transferred policy had a gift tax value in excess of the available exclusions. To try and get the transfers in under the exclusions, the taxpayer had the trust issue him a promissory note, so that the net value of the transfer (the value of the policy, less the value of the note) and thus the value of the gift, was under the annual exclusion amount. Then, in the following year, without any payments on the note being made, the taxpayer forgave the note, in effect making another gift that was under the annual exclusion amount. However, since it occurred in the following year, the taxpayer had a new annual exclusion amount to work with. The taxpayer thus took a gift that would have exceeded the annual exclusion amount in year one, and by using the note device, split it into two gifts over two years that were small enough to come within the two annual exclusions even though the policy was all transferred in year one.

So what was "not a surprise?" That the IRS said the note devise would not be effective to split the gift over two years, since it was never intended that the note would be paid. Thus, the IRS found a taxable gift in year one to the extent that the total value of the transferred policy exceeded the available annual exclusion amount.

What was the "surprise?" The surprise here was confined to the taxpayer - the taxpayer had requested other rulings from the IRS, and did not ask about the annual exclusion gifts. The IRS took it upon itself to provide the additional ruling described above and clearly not desired by the taxpayer, that the transfer of the policy created a taxable gift.

PLR 200603002

SEX CHANGE OPERATION - DEDUCTIBLE?

Under the category "this doesn't come up much, but I think it would be interesting to know," comes the question of deductibility of medical expenses for income tax purposes relating to sex change operations.

Generally, amounts paid for “cosmetic surgery” or other similar procedures can't be taken into account as a medical expense deduction, unless the surgery or procedure is necessary to ameliorate a deformity arising from (or directly related to) a (1) congenital abnormality, (2) personal injury resulting from an accident or trauma, or (3) disfiguring disease. So where do medical expenses relating to a sex change operation fit?

According to the IRS, without unequivocal expression of Congressional intent, taxpayer's costs for and associated with gender reassignment surgery were held not to constitute medical care for purposes of medical expense deduction under Code Section 213. The IRS believes that gender reassignment surgery is cosmetic in nature, and not shown to be treatment for illness or disease.

Chief Counsel Advice 200603025

HIGHLIGHTS OF NEW BVI CORPORATE LAW

The British Virgin Islands (BVI) is a popular jurisdiction for incorporation, both for U.S. persons conducting operations abroad and as a holding company for non-U.S. persons for U.S. interests. The BVI has recently adopted a number of changes to its Company Law. Some of the major changes include:

• New types of corporate entities, including companies limited by guarantee, segregated portfolio companies, and restricted purpose companies.
• Now allows for no par stock.
• Requires provisions for different classes of stock be included in the memorandum of association instead of being determined only by directors.
• A director does not have to be appointed until the expiration of six months.
• For a non-BVI company to be continued under BVI law, the company's existence under the non-BVI law must be terminated.

APPLICABLE FEDERAL RATES - UPDATE FOR FEBRUARY 2006

February 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.34% (4.33%/Jan -- 4.29%/Dec.)

-Mid Term AFR - Semi-annual Compounding - 4.35% (4.43%/Jan -- 4.47%/Dec.)

-Long Term AFR - Semi-annual Compounding - 4.56% (4.68%/Jan -- 4.73%/Dec.

CHANGE IN FILING LOCATIONS

As the tax filing season gets into full swing, taxpayers filing paper returns (that is, those who are not filing electronically) from some states will be filing their returns at different locations than last year.

-Returns from Delaware and Virginia now go to the IRS Center in Atlanta, Georgia;

-Returns from the District of Columbia and Maryland now go to the IRS Center in Andover, Massachusetts;

-Returns from Ohio now go to the IRS Center in Kansas City, Missouri;

-Returns from Kansas, Mississippi and West Virginia now go to the IRS Center in Austin, Texas; and

-Returns from Colorado, Nebraska, New Mexico, and South Dakota now go to the IRS Center in Fresno, California.

For taxpayers who file paper returns, the correct center addresses are on labels inside the tax packages. Taxpayers who do not receive a package should refer to the back cover of the instructions to Form 1040, 1040-A or 1040EZ.

SOME TAXES ARE MORE IMPORTANT THAN OTHERS

Assume that you are the personal representative/executor of the estate of a deceased friend or relative. Assume further that the estate does not have enough assets to pay off all of its creditors, including both the IRS for federal taxes and the state and local government for other taxes. On behalf of the estate, you pay the state and local government taxes, and then the IRS gets paid what is left.

Is there a problem here? You betcha. Generally speaking, the federal taxes take precedence over the local taxes. Under the federal claims statute, you have exposed yourself to personal liability for paying the local taxes, and thus reducing the amount that the IRS can get paid. This is personal exposure to you, even though you didn't personally profit from the payment, since the payment went to the state and local governments.

In recognition of the unfairness of (a) a personal representative/executor being held liable for taxes that are not taxes of the personal representative/executor, (b) especially when the personal representative/executor did not personally profit from the payment of the taxes to the state and local governments, and (c) the personal representative/executor not even knowing they had such a liability before making the state and local tax payments, the IRS would not really hold the personal representative/executor liable for the unpaid federal taxes, would it? You bet it would.

See U.S. v. IRBY, 97 AFTR 2d 2006-XXXX, (DC AL), 12/21/2005, for a recent case where the IRS imposed this liability on the unfortunate personal representatives/executors.

PREPAYING TUITION

Under the Internal Revenue Code, gifts from one individual to another are subject to gift tax, unless an exclusion or exemption applies. One such exclusion exists for a donor paying the tuition of another individual at a qualified school. Such qualified tuition payments are also excluded from generation skipping tax, if the transfer skips a generation (e.g., a grandfather pays the tuition of his grandchild).

What happens if the tuition paid does not relate to the current year, but is a prepayment of future tuition? Will the exclusion apply?

Yes, says the Internal Revenue Service. In Private Letter Ruling 200602002 (January 13, 2006), the IRS ruled that a grandparent's prepayment of tuition for a number of his grandchildren for multiple years through their graduation (grade 12) from the school, qualifies for both the gift tax and generation skipping tax exclusion.

As contrasted with the alternative of making a gift to a trust for education, or a transfer at death to a trust for education, both of which would be subject to estate or gift taxes (subject to available unified credit) - the prepayment during lifetime of tuition provides a useful mechanism for reducing transfer taxes if the applicable school is amendable to such arrangements.

NY ESTATE TAXES TO BE ELIMINATED?

In the world of tax, there are low tax and high tax countries. The tax rates of countries have very real effects on the flow of international capital, since all other things being equal (which of course they are not), capital will seek to locate itself in the jurisdiction with lower taxes.

The same tax competition exists between the various states in the United States. For example, New York State is generally a high tax jurisdiction, and Florida is on the lower end of the scale. Among the disparities in taxation, an important one is that New York State presently has an estate tax, and Florida does not. Due to the tax disparity, a fair number of New Yorkers move to Florida (at least upon retirement) to benefit from the lower tax environment. Yes, the weather may also have something to do with it, too.

Maybe the retirement traffic to Florida will be slowing a little - Governor Pataki of New York is proposing the elimination of New York estate taxes. Now, if he only had control over the weather, too, a key source of immigration into Florida might wither away completely!

Link to Article

KEEPING NONMARITAL ACCOUNTS SEPARATE (FLORIDA)

Under Florida law, "marital assets" are subject to equitable division and distribution upon divorce. Nonmarital assets are not.

Generally, if one spouse inherits property and properly keeps it segregated, under Florida law the inherited property does not become a marital asset. A recent case illustrates how a segregated account was held to remain a nonmarital asset, even though some facts were present that indicated perhaps it had become a marital asset. These issues are relevant for spouses that desire to protect an inheritance from future claims of a divorcing spouse, especially if there is no prenuptial or postnuptial agreement addressing these issues.

Some of the key facts:

• Husband inherited funds, and put them in a separate bank account. This was a good fact for the husband and his quest for nonmarital asset treatment.
• Husband opened the account as a joint account with his wife. This was not a good fact. Nonetheless, the appellate court held that if the other spouse is put on the account for convenience purposes only, the account will remain a nonmarital asset.
• There was no commingling of assets - no marital assets or separate assets of the wife were added to the account. This was a good fact for the husband.
• The wife was authorized to, and did, transfer assets from the account to the couple's joint account for payment of marital expenses. This was not a good fact for the husband. The court noted that "control" over the nonmarital assets by the other spouse can result in the creation of a marital asset, but under these facts, there was not enough control by the wife to convert the account to a marital asset.

It is important to note that the trial court found that the account was a marital asset, and it took an appellate court to overturn the trial court to result in nonmarital asset treatment. Thus, the case is instructive for certain situations to avoid if one wants to be clear that a nonmarital asset remains nonmarital since different courts will reach different results in close cases. These facts include keeping the other spouse off the title to the account, no commingling of assets, not using the assets for marital expenses, and not giving the other spouse control over the account. As the case illustrates, violating any one of these in a minor fashion may not be a problem, but such violations should be avoided if possible.

Greico v. Greico, 31 Fla. L. Weekly D191a (2nd DCA 2006)

MINORS CONSENTING TO THEIR OWN MEDICAL CARE (FLORIDA)

In a recent article in the Florida Bar Journal, Ann Bittinger summarizes the basic rules of when a minor can consent to his or her own medical care (or the care of the minor's own children).

WHO IS A MINOR? A person under the age of 18 who is not emancipated is a minor. A minor is emancipated under common law if financially independent and maintains a residence away from his or her parents. A minor is statutorily emancipated if a circuit court removes the disability of nonage.

GENERAL RULE. A minor cannot consent to his or her own medical treatment. A treating physician who does not obtain the proper consent of a parent or legal representative could incur liability, and may lose his or her license.

PREGNANCY ISSUES. A pregnant minor may consent to medical and surgical care relating to the pregnancy (but not to nonpregnancy medical care items).

MINOR PARENTS. A minor giving birth to a child still cannot give consent to her own medical treatment, but strangely enough, can give consent in regard to the medical care of her child.

EMERGENCIES. If statutory requirements are met, a physician may provide medical treatment to a minor in an emergency. These requirements generally relate to either the inability to determine who the parent or legal guardian is, or the parent or guardian cannot be located immediately.

MISCELLANEOUS SITUATIONS WHERE A MINOR CAN PROVIDE THEIR OWN MEDICAL CONSENT:
-Examination and treatment of sexually transmissible diseases
-Maternal health and contraceptive information and services of a nonsurgical nature, if the minors are married, have become parents, are pregnant, or may otherwise suffer probable health hazards
-Substance abuse treatment
-If 13 or older, mental health diagnostic and evaluative services or individual psychotherapy, group therapy, counseling, or other forms of verbal therapy from a licensed mental health professional.

Bittiner, Ann, Legal Hurdles to Leap to Get Medical Treatment for Children, The Florida Bar Journal/January 2006

YOUR REFUND CHECK IS IN THE MAIL?

You have filed your federal income tax return, and you are checking your mailbox for your tax refund. You keep checking, but it doesn't show up. You call the IRS, and they won't give you any information. Is this a rare occurrence? Is something sinister going on?

According to Taxpayer Advocate Nina Olson in her report to Congress, thousands of refunds are frozen by the IRS each year without any knowledge given to the affected taxpayers. Further, IRS employees are prohibited from providing any information until six months after a taxpayer's inquiry.

Such frozen refunds are part of the IRS' Questionable Refund Program, under which computers flag questionable returns that are at high risk for fraudulent refund claims. More than three-quarters of the returns investigated are for low-income families who claim the earned income tax credit, a program that provides tax refunds for the working poor.

So if you are expecting a refund check, your check may not in fact be in the mail.

More Timing Difficulties in Family Limited Partnership Formation Transactions

Prior court decisions have told us that the timing of the steps in setting up a family limited partnership are important. If a taxpayer forms the partnership, gifts interests to gift recipients (e.g., children), and THEN contributes property to the partnership, these decisions provide that the gift involved is a gift of the property contributed to the partnership, and not the partnership interests themselves. The effect of this is that the gift is an undiscounted gift - the property transferred is valued at full value, instead of being a gift of a partnership interest that usually will qualify for valuation discounts (and thus a lower gift tax value for purposes of computing gift tax).

Until now, it has been assumed that if the set up was done in the right order, the foregoing negative result would not apply. That is, if the property was transferred to the partnership first, and THEN the founding partners gifted partnership interests, this should constitute a gift of partnership interests only, and not the contributed property.

The Eight Circuit Court of Appeals has muddied the waters. By invoking the "step transaction doctrine" in a recent case, it may have opened the door to the gift being treated as a gift of the property contributed to the partnership and not a gift of partnership interests, EVEN IF the property contribution preceded the gift of partnership interests. The step transaction doctrine allows the IRS to reorder the steps of a transaction, or ignore intervening steps, in determining tax consequences if all of the steps of the transaction are integrated/interdependent. In context of these transactions, it allows the IRS to ignore the form of the transaction and reorder these steps in a way that does not allow for the desired discounting.

It is not known if this is a correct intepretation of the case, but some commentators believe it may be. Planners should now include planning to avoid a step transaction doctrine attack as part of their family limited partnership formation planning.

SENDA v. COMM., 97 AFTR 2d 2006-XXXX, (CA8), 01/06/2006

ARE FOREIGN REAL PROPERTY TAXES DEDUCTIBLE?

Most U.S. homeowners are familiar with the income tax deduction for real property taxes. What happens if you own property outside the U.S. - can you deduct real property taxes imposed in the foreign country?

The Internal Revenue Code is plain and simple on this issue - foreign real property taxes are deductible. However, Treasury Regulations impose an additional requirement - they provide that "real property taxes" (whether U.S. or foreign) must be imposed for the general public welfare, and not for "local benefits." An example of taxes imposed for local benefits are taxes imposed for benefits “such as streets, sidewalks, and other like improvements, imposed because of and measured by some benefit inuring directly to the property against which the assessment is levied." [Regs. Section 1.164-4(a)].

Is this "local benefits" requirement something the IRS really cares about? Well, Isabelle Bichindaritz found it it does, at least when foreign real property taxes are involved. Isabelle sought to deduct real estate taxes she paid when she bought property in France in 2001. The Government contested the deduction and at trial before the U.S. Tax Court, Isabelle offered an English translation of a settlement statement that she received when she bought the property in question as evidence of the taxes and deductibility. The settlement statement showed that certain taxes were calculated in connection with her purchase of the property. Not good enough, said the Tax Court. Instead, the Tax Court wanted to see something that proved that the tax was not a tax imposing a "local benefit." Since no such evidence was presented, the deduction was denied. Isabelle Bichindaritz, TC Memo 2005-298.

ONLINE ALTERNATIVE MINIMUM TAX ASSISTANCE

How do you know when the Internal Revenue Code is too complex? One clue might be the acknowledgment by the IRS that a computer is needed to figure out whether you are subject to the alternative minimum tax (AMT). And that indeed is what things have come to.

The IRS now provides an online tool to assist taxpayers in determining whether they are subject to the AMT, instead of making that analysis manually. While this is surely helpful to taxpayers, it would be even more helpful if Congress would just get rid of the AMT once and for all (as is presently being considered on Capital Hill).

To use the tool, go to AMT Assistant.

WOULD ESTATE TAX REPEAL REALLY REDUCE TAX REVENUES?

It is commonly accepted that the repeal of the estate tax would reduce tax revenues, since such taxes would no longer be collected. Here is some food for thought that this may not be the case:

• The American Family Business Institute notes that (a) the Joint Committee on Taxation has dramatically overestimated lost tax revenues for the 1997, 2003 and 2004 tax reductions, and thus should not be trusted when it estimates lost revenue for estate tax repeal, (b) repeal would boost employment by an estimated 175,000 to 200,000 jobs a year, which would provide increased federal tax receipts over time.
• A computer model of the CONSAD Research Corporation forecasts that an immediate repeal would result in a net increase in federal tax revenues of $1.7 billion between 2005 and 2014 as a result of capital gains revenue from the sale of assets by heirs, and inherited real estate being depreciated only from its original value.

SUBSTANTIALLY SIMILAR TRUSTS CAN MERGE

The Internal Revenue Code has extensive provisions regarding the merger of corporations. These provisions allow for corporate combinations without recognition of gain or loss to the participants, and for the carryover of tax attributes of a corporation into the survivor in the merger (if the particular Code requirements are met).

There are no similar Code provisions regarding a merger of trusts. Therefore, there is a risk that upon such a merger, the trusts may be deemed to have disposed of their assets for fair market value triggering gain recognition, and the trust beneficiaries may likewise be viewed as having exchanged their trust interests in a taxable transaction.

In a recent Private Letter Ruling, the IRS provided that where several identical trusts combined into one trust with similar terms, and all the trusts held similar assets, the merger would not generate gain or loss to the trusts or their beneficiaries. The IRS further went on to provide that the tax attributes of the trusts merged into the new trust, such as net operating loss carryforwards and tax basis, would carry over to the new trust.

In the Private Letter Ruling, the new trust then proceeded to subdivide into separate trusts, one for each beneficiary (but otherwise with the same terms as the initial trusts). The IRS likewise ruled that such division would not generate gain or loss to the trusts or the beneficiaries, and that the tax attributes of the trusts would pass to the successor trusts on the division.

PLR 200552009, December 30, 2005

Happy New Year Tax Changes

Have a happy and healthy New Year! Here are some tax changes effective today (January 1) that may help you out this year:

• Reduction in income taxes through annual inflation adjustments to tax brackets and increase in the standard deduction.
• Loss of benefit of itemized deductions and personal exemptions for higher income taxpayers - starting in 2006, affected taxpayers lose only 2/3 of the itemized deductions and exemption amounts that would otherwise disappear.
• The unified credit exclusion for estate taxes for persons dying in 2006 jumps from $1.5 million to $2 million. The top federal estate tax rate declines 1% to 46%.
• The annual gift-tax exclusion amount will increase from $11,000 to $12,000. This is the first increase since 2002.