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Thursday, March 30, 2006


Under a properly designed Grantor Retained Annuity Trust (GRAT), a grantor transfers property to a trust, and retains for a period of time an annual annuity payout. The taxable gift on the funding is not equal to 100% of the value of the property transferred to the trust - instead, it is reduced by the value of the annuity interest retained by the transferor.

Such annuity interests often run for the shorter of a fixed period (e.g., 2 years) or the death of the grantor. The longer the retained period of payouts to the grantor, the more valuable the retained grantor interest becomes and thus the taxable gift portion is reduced. In an effort to stretch out the retained periods, some taxpayers established trusts that provided if the grantor died before the end of the fixed term, then the annuity payments would then be paid to a surviving spouse (if the spouse survived) for the remainder of the term or until the death of the surviving spouse. This effectively increases the term and actuarial value of the retained annuity interest (and thus appears to decrease the taxable gift) since now BOTH husband and wife have to die before the fixed term expires (in our example, 2 years) for the annuity to expire before the end of the fixed term. Actuarially, this is less likely to happen than if the early termination occurred if only one person had to die during the term, and thus it is more likely that the 2 year annuity payouts will be made without death cutting them off prematurely - thus increasing the actuarial value of the retained annuity interest.

There is one problem, however, as the taxpayers in Estate of Claude C. Focardi, TC Memo 2006-56, learned from the Tax Court. In the opinion of the Tax Court, the interest of the surviving spouse is too "contingent" to be a "qualified annuity interest" for purposes of the valuation of the gift rules that allow for the subtraction of the retained grantor interest. This means that the surviving spouse’s interest is ignored, and the gift is greater because the retained interest is computed under the 1-life annuity tables instead of the 2-life tables.While there may be other case law to the contrary, the Tax Court further noted the adoption by the IRS of Treasury Regulations that mandate this result (even though they were issued by the IRS after the trusts at issue in the case were created).

Tuesday, March 28, 2006


The IRS recently released its audit data for 1995. Some of the interesting statistics for income taxes include:
  • 0.93% of all individual returns that were filed were audited. This was a 21% increase over the prior year.
  • The audit rates for corporate returns are up, too. The audit rate for returns other than Form 1120S jumped by 75%, to 1.24% from the .71% rate for 2004. The audit rate for S corporations jumped by 58%, to .30% from .19% for the year before. The audit rate for large corporations ($10 million and over) was 20.02% versus 16.74% for the year before.
  • The IRS assessed 7.455 million civil penalties against individual taxpayers. Of these, 4.420 million (59.3%) were for failure to pay, followed by 2.454 million (32.9%) for underpayment of estimated tax. On the corporation side, there were a total of 280,498 penalty assessments, 85.3% for either failure to pay or underpayment of estimated tax.
  • 74,000 offers in compromise were received by IRS, and 19,000 (25.6%) were accepted.
  • IRS initiated 4,269 criminal investigation in fiscal 2005. There were 2,859 referrals for prosecution and 2,151 convictions. Of those sentenced, 83% were incarcerated.

Sunday, March 26, 2006


Oftentimes, people working with a partnership are granted an interest in the “profits” of the partnership. For many years, there was substantial uncertainty, engendered by contradictory case law, as to whether a recipient of a profits interest is taxed upon receipt and how much they should be taxed. In Rev. Proc. 93-27 4 and Rev. Proc. 2001-43, the IRS resolved much of the uncertainty by holding that when the following four criteria are met, the issuance of a profits interest for services rendered generally will not trigger income to the service provider (and no compensation deduction to the partnership).

The four criteria to be met are (1) there is no substantial and predictable income stream, (2) the profits interest is not sold for two years, (3) the partnership interests are not publicly traded, and (4) the partnership treats this incoming individual as a partner. Testing for these criteria is made at the date of issuance of the profits interest, whether such interest is vested or not. No election to treat such an interest as vested needs to be made - the IRS, in effect, deems a Section 83(b) election to have been made in such circumstances. As to the partnership income allocable to the unvested interest, the widely-accepted view has been to treat such unvested share of allocable profits as taxable income to the service recipient.

The Revenue Procedures did not address all questions regarding treatment of profits interests. For example, they did not address what happens when the individual holding an unvested interest terminates employment prior to vesting - what happens to the build-up of previously taxed but unvested and undistributed income?

In an effort to address some of these issues, in 2005 the IRS issued proposed regulations and a proposed revenue procedure that alter somewhat the rules of the Revenue Procedures. In them, the IRS adopts a Section 83 analysis. For recipients of an interest that is subject to a substantial risk of forfeiture (such as being forfeited if they cease to work for the partnership), the recipient of the profits interest must make a decision whether to make a Section 83(b) election (a Section 83(b) election is an election to immediately include in income at its fair market value the value of property received for services that would otherwise not be subject to immediate taxation because subject to a substantial risk of forfeiture).

If the election is made, the recipient is taxable immediately on the value of the interest received, and is then treated as a partner for all purposes even if the partnership interest remains subject to a substantial risk of forfeiture. If the election is not made, the recipient is not taxed on receipt of the interest until it vests (the substantial risk of forfeiture terminates) and is allocated ordinary income on any actual distributions made to the holder from the partnership.

At least in regard to when the Section 83(b) election is made and the recipient is taxed on receipt of the interest, the proposed rules have two methods of valuation. Under the liquidation approach, which generally is available in situations similar to the four criteria under the current proposed regulations, the received interest is valued at the value of property that would be received by the recipient partner if the partnership was immediately liquidated - this will typically result in a zero value.

Under the second valuation method, if the liquidation value rules are not used, then more traditional fair market valuation rules must be applied.

For a more detailed discussion of these issues, see Prop. Regs. Tackle Compensatory Partnership Interest Issues, by Magda B. Szabo, Practical Tax Strategies (April 2006), from which much of the foregoing has been obtained.

Wednesday, March 22, 2006


For the first time in 25 years, the FDIC (The Federal Deposit Insurance Corporation) has raised the maximum coverage amount on deposit insurance for bank and savings accounts. Generally, the first $100,000 in any bank or savings account is insured against loss if the institution holding the deposit fails. Depositors with more than $100,000 at any one institution are advised to consider spreading their deposits around multiple institutions to avoid the $100,000 limit.

Under new rules effective April 1, the maximum coverage is increased from $100,000 to $250,000, but only for certain retirement accounts. Covered accounts include traditional and Roth IRAs (Individual Retirement Accounts), self-directed Keogh accounts, “457 Plan” accounts for state government employees, and employer-sponsored self-directed defined contribution plan accounts—primarily 401(k) accounts.

A press release on the changes can be viewed here.

Monday, March 20, 2006


In our December 1, 2005 posting, we discussed the Demayo case, under which Florida's Third District Court of Appeals promulgated a new exception to homestead protection against creditors. In the case, the Court allowed an individual to waive homestead protection in regard to collection of attorney's fees by reason of a waiver provision in a retainer agreement with the law firm. That posting discussed how such contractual waivers, if now given effect under Florida law, could have far reaching effects such as widespread use of such waivers in contracts.

The appellate court has rethought its position on the issue, and in an unusual move and on its own motion, has withdrawn its earlier opinion and replaced it with a new opinion that provides that such waiver by contract was NOT effective.

Some of the appellate judges do not want to give up on the issue, however. They have certified the issue as one of great public importance and thus seek the review of the Florida Supreme Court on the issue. Therefore, there may be more to come in this case.

Saturday, March 18, 2006


April 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.71% (4.53%/Mar -- 4.34%/Feb)

-Mid Term AFR - Semi-annual Compounding - 4.67% (4.46%/Mar -- 4.35%/Feb)

-Long Term AFR - Semi-annual Compounding - 4.73% (4.63%/Mar -- 4.56%/Feb)

Wednesday, March 15, 2006


If you watch any of the award shows on television, you are probably aware of the trend towards elaborate gift bags or baskets being given to celebrity award presenters. These "gifts" of jewelry, cosmetics, vacations, electronics, clothing and other similar items have skyrocketed in value, with some being valued at over $100,000. A typical viewer's jealous reaction is something like "these guys get paid millions of dollars to sing songs or act in movies, and then they get all this free stuff, too - that's not fair!"

Well if it makes our jealous viewer feel any better, the Commissioner of the Internal Revenue Service recently reminded celebrity recipients of the gift bags that they qualify as taxable income and must be reported on tax returns. Indeed, some of the recipients that aware of this have declined the bags since the taxes are probably more than the real value of the gifts to them.

To read the Comissioner's statement, click here.

Monday, March 13, 2006


It is fairly well known to practitioners that it is generally advantageous for a stockholder of a Subchapter S corporation to receive funds from the company as a distribution/dividend on his stock, rather than as compensation. This is because compensation payments are subject to employment taxes, while distributions/dividends on stock are not.

This tax advantage is equally known to the IRS. In situations where the IRS believes a stockholder provided services to the corporation but did not receive reasonable compensation, the IRS will seek to characterize some or all of the dividend distributions as compensation and thus subject the payments to employment taxes. This is particularly likely in the situation where there is only one stockholder, or when all stockholders provide services and do not receive enough compensation.

Consequently, it is advisable that shareholder/employees receive some of their cash flow from the 'S' corporation as compensation. 'S' corporations that characterize all of their payments to shareholder/employees as dividend distributions are especially vulnerable to IRS attack on this issue.

In a recent article in Practical Tax Strategies, James L. Wittenbach and Ken Milani, professors of accountancy at the University of Notre Dame's Mendoza College of Business in Notre Dame, Indiana, offer the following additional suggestions to minimize an IRS attack on this issue:

A. Develop a salary or wage policy (e.g., per month or per hour) and compensate the shareholder/employee in accordance with the policy.
B. Consider the following nonexhaustive list of factors when setting compensation in order to maintain reasonable levels of compensation:
1. The qualifications of the employee qualifications.
2. The nature, extent, and scope of work performed by the employee.
3. The nature and size of the business.
4. The financial results of the business as impacted by the employee.
5. The compensation that is paid for similar work in comparable companies and businesses.

By documenting the above issues in corporate minutes, the company will go a long way in building a solid defense that its characterization of some payments to shareholder/employees are dividends and not compensation.

Saturday, March 11, 2006


Subject to recent bankruptcy law provisions affecting its applicability, Florida's constitutional protection of the homestead against creditors provides extremely broad protection. It is not without its limits, however.

A recent case reminds us of one of those limits (at least in several District Courts of Appeal). In Zureikat v. Al Shaibani (5th DCA, Case No. 5D04-3697, March 10, 2006), the defendant invested the proceeds of his fraudulent acts in his homestead. In allowing the plaintiff to lien the homestead, the court noted that the proceeds of fraudulent or reprehensible conduct that are used to invest in, purchase, or improve a homestead are not protected.

Wednesday, March 08, 2006


Any business that has had to deal with paying its employees, calculating and deducting social security and payroll taxes, filing employment tax returns, and paying over withheld taxes, understands the appeal of outsourcing employment tax matters. However, out of sight should not mean out of mind. It's the employer's duty to pay employment taxes, and the employer remains responsible for their payment even if the failure to pay is entirely due to a payroll service provider's negligence or fraud.
The IRS understands these issues, and offers the following advice to employers who outsource their payroll tax compliance:
a. The address of record with IRS should not be changed to that of the payroll service provider. That way, if there are any issues with an account, the IRS will contact the employer and thus the employer will be timely informed of problems.
b. The employer should confirm that the payroll service provider has a a fiduciary bond to protect the employer in the event of default.
c. The service provider should enroll in and use the Electronic Federal Tax Payment System (EFTPS). EFTPS maintains a business's payment history for 16 months and can be viewed on-line. This allows an employer to immediately confirm payments electronically, 24 hours a day, 7 days a week through the Internet, or by phone. The IRS further recommends employers verify EFTPS payments as part of their bank account reconciliation process.

Tuesday, March 07, 2006


A mini-fracas is unfolding in Florida, as Governor Bush would like to return a part of the state budget surplus to Florida residents, while others in Florida prefer that the budget surplus be applied to various spending initiatives. The tax lawyer in us does not question whether the refund will arise, but instead ponders the question whether such a refund is taxable to the recipients for federal income tax purposes. I mean, that is what you were wondering when you heard about this, weren't you?

Interestingly, an IRS field attorney advice memorandum recently made available under a Freedom of Information Act request, addresses this very issue in regard to such a refund in another state.

The F.A.A. indicates that the first issue in determining taxability is whether the refund can be considered a gift - since gifts are not taxable to recipients for federal income tax purposes. While a "gift" is not defined under the Internal Revenue Code, the Supreme Court has provided that a gift proceeds from a “detached and disinterested generosity,” and is made “out of affection, respect, admiration, charity or like impulses.” Duberstein v. Commissioner, 363 U.S. 278, 285 (1960). If a payment proceeds primarily from “any moral or legal duty,” or from “the incentive of anticipated benefit” of an economic nature, it is not a gift. The F.A.A. notes that in general, payments made by a state government do not qualify as non-taxable gifts because it is not the purpose of governments to make gifts to its citizens. While there are some special circumstances where a gift will arise, it did not find one in the facts of the F.A.A. Thus, it is unlikely that Florida's refund program will be nontaxable as a gift.

The next level of analysis is whether the amount being paid to state residents is a "refund" of taxes paid by the particular recipients. If a refund, the recipients will be subject to federal income tax only to the extent the taxpayer claimed a federal deduction for the payment in the preceding year (applying the "tax benefit rule") - otherwise as a refund of paid taxes the payment will not be taxable. If the payments are not a tax refund, they will be taxable to the recipients.

In the F.S.A., the IRS found that the refund under the particular facts of that state refund program was not a "tax refund" for purposes of these rules, and would thus be taxable to the recipients. The F.S.A. provided:
...the payments in this case appear to be made to a designated class of recipients without regard to whether the recipieents made prior payments of tax, rather than payments made to persons entitled to “refunds” of taxes previously paid. While individuals eligible to receive the payments are those individuals who filed a State income tax return for the preceding year, the payment is not based upon State or local tax that an individual taxpayer reported and paid, but on whether the taxpayer claimed a personal exemption. This eligibility requirement appears to simply be a method for designating a class of individuals to whom the State desires to make a payment of surplus funds.
Therefore, if Governor Bush is successful in getting through his refund program, he may need to target the refund only to taxpayers who previously paid Florida taxes and be able to characterize the payments as a refund of those taxes, if he is concerned about the taxability of such refunds to the recipients.

Source: LAFA 20060901F

Sunday, March 05, 2006


You don't have to be an accountant to know that doing tax returns and determining tax liabilities is complicated. But when tax preparer giant H&R Block can't figure out its own taxes, maybe things are getting too complicated.
In a recent article in USA Today, it was reported that H&R Block is restating earnings for fiscal years 2004 and 2005 and the first two quarters of fiscal 2006 because it understated its tax liability by $32 million. This is not the first time H&R Block has had to do this - last year it found it understated its tax liabilites by $129 million due to errors form an acquisition.
H&R Block is not the only big company that is correcting tax accounting mistakes. Last year 183 companies corrected tax errors, up form 87 in 2004, 80 in 2003 and 27 in 2002. It is likely that some, if not all, of the increase is due to increased corporate reporting compliance arising from Sarbanes-Oxley laws.

Thursday, March 02, 2006


Income taxes are generally dischargeable in bankrutpcy. However, Section 523(a)(1)(B)(i) of the Bankruptcy Code forbids the discharge of federal income tax liability with respect to which a "return" was required to be filed but was not filed.

If a taxpayer doesn’t file a tax return, the IRS needs to prepare a substitute return for the taxpayer in order to be able to assess tax against the taxpayer (referred to as a substitute-for-return, or SFR, assessment). What happens if the IRS prepares an SFR and assesses tax against a taxpayer, and then the taxpayer wants to discharge the tax in bankruptcy? Since he needs to file a return to get the bankruptcy discharge, can he file a return after the IRS prepared an SFR, so as to make bankruptcy discharge available?

There is no statutory definition of what is a "return" for income tax purposes. Therefore, courts have adopted a four part test that must be met before a filing is considered a "return." To be a return, the filing must:

a. Purport to be a return.
b. Be filed under penalty of perjury.
c. Provide sufficient information to allow for computation of tax.
d. Represent an honest and reasonable attempt to comply with the law.

In regard to whether a return filed by a taxpayer after the IRS has prepared an SFR, courts have struggled with the last requirement - that is, whether such a return is an honest and reasonable attempt to comply with the law. Does filing many years late always mean it is not an honest and reasonable attempt? Does filing a return that is substantially the same as the SFR mean it not an honest and reasonable attempt?

This is presently a facts and circumstances test, and courts will differ in their conclusions based on the circumstances of each particular case. In a recent appellate case, the 7th Circuit Court of Appeals indicated that taxpayers will face an uphill battle in most circumstances in getting SFR taxes to be dischargeable, holding in that particular case the filing by the taxpayer was not a return. In re Payne, 431 F3d 1055 (CA-7, 2005).

This result is more problematic for taxpayers now than it used to be. In the past, special treatment was available in a Chapter 13 bankruptcy for taxes that were otherwise nonpriority/nondischargeable in Chapter 7 - therefore, Chapter 13 was often availed of to get around the SFR problem. However, this course of action was pretty much eliminated under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Therefore, taxpayers who have not filed a return and desire a bankruptcy discharge of taxes better get their tax return filed before the IRS prepares an SFR for them.
For a more detailed discussion of these issues, see Dischargeability of Taxes in Bankruptcy May Be Impossible if IRS Makes Substitute-for-Return Assessment, Journal of Taxation, Mar 2006.