SENATE ESTATE TAX ACTION DELAYED

Prior announcements to the contrary notwithstanding, the Senate will NOT be taking any action on the House's current bill for estate tax reduction until after the Fourth of July Recess. Here is the announcement [Warning - Republican partisan language is included in the announcement!]:

FRIST ANNOUNCEMENT REGARDINGTIMING OF DEATH TAX VOTE WASHINGTON, D.C. — U.S. Senate Majority Leader Bill Frist, M.D., (R–Tenn.) today announced that the Senate will not vote on a permanent reduction of the death tax before the Fourth of July recess: “The House of Representatives made tremendous progress last week toward achieving a permanent solution to the death tax. Now it’s up to the Senate to decide whether it can improve upon the House bill or whether this is the bill that should be sent to the President for his signature. Everyone should be clear: The Senate will vote on a permanent reduction to this tax — a tax that destroys small businesses and family farms. The vast majority of my Democratic colleagues have so far refused to address this issue; it’s my hope that their constituents will use the upcoming recess to explain the importance of supporting a reasonable and permanent solution to this unfair tax.”

CONTRACTUAL ALLOCATION OF TAX LIABILITIES MAY HAVE MORE VALUE THAN PREVIOUSLY SUSPECTED

Oftentimes, parties to a contract allocate who will be responsible for paying present or future taxes. Such agreements can occur in regard to the purchase, sale, or division of a business, a divorce scenario, or in other business and personal situations. Legal advisors to the parties generally advise them that the IRS will not be bound by their allocation of the tax liability - that is, the IRS can pursue whoever it determines is the appropriate party to collect against. Nonetheless, such agreements are still valuable since if the IRS pursues the party who does not have the contractual liability, that party has a contractual claim against the responsible party to recover the tax.

A recent case provides another benefit of such agreements.

Collen and Donald Crawford divorced. Donald agreed to assume an entire debt owed to to the IRS and to indemnify Colleen should the IRS collect the tax from her. As a result, he was awarded sole ownership of a family business, as well as certain real property, which he agreed to sell and apply the proceeds to the IRS debt. However, he didn't satisfy it and in September 2004, IRS issued a Notice of Intent to Levy and a Notice of Federal Tax lien to Colleen regarding the tax debt.

Colleen filed a request for a Collection Due Process Hearing under Internal Revenue Code Sec. 6330(b). As part of that request, she suggested an alternative proposal for collecting the debt. She proposed that IRS first attempt to recover the debt from Donald and, in addition, she would attempt to work out an installment agreement to pay off any of the debt that could not be collected. After holding a due process hearing regarding the collection process, the IRS upheld its determination that it should collect the taxes from Colleen. IRS determined that her proposal was not viable because it was not authorized by law in that it did not attempt to satisfy the outstanding debt from her assets but instead required IRS to seek the assets of another party.

Collen went to district court arguing that the IRS appeals officer abused his discretion by basing his ruling on an improper understanding of the law. Specifically, Colleen challenged his decision that collection of the outstanding taxes from her ex-husband was not a viable collection alternative that the IRS was required to consider under Code Sec. 6330.

The court noted that although the IRS was not bound by Colleen and Donald's divorce decree, they had split their assets in a manner that would facilitate payment of the tax liability by Donald through the sale of property he received in the divorce. The court stated that Colleen's collection alternative was a proposal to withhold collection from her until it was determined whether it would facilitate the tax collection and provide a less intrusive means of collection to go after the assets earmarked for payment of the tax liability as defined in the divorce decree. It concluded that her request fell within the alternative contemplated by Reg. § 301.6630-1(e)(3) and should have been considered. The court stressed that it was not saying that her proposed collection alternative had to be accepted by IRS. The error was not that it was rejected, but that it was rejected without the proper consideration required by the statute.

The net effect of the ruling is that tax liability allocation agreements may have more value than previously suspected. While they still cannot bind the IRS as to who to pursue for collection, in the right circumstances they can at least require the IRS to consider the collection mechanisms agreed to by the parties.

Crawford v. U.S., 97 AFTR 2d 2006-1875 (DC NV 3/24/2006)

UNANTICIPATED EVENT DOES NOT ALLOW A COURT TO REWRITE AN UNAMBIGUOUS WILL [FLORIDA]

Ralph E. Davis passed away. In his estate proceedings, his surviving spouse claimed her elective share of his estate. Under Florida law, a surviving spouse can elect to take a fixed percentage of his or her spouse's assets, instead of receiving what the deceased spouse left for the surviving spouse under a Last Will. Under the applicable law and the residuary clause of the Last Will, Mr. Davis' remaining assets after the wife's elective share would pass under Florida intestacy law (which is an ordering list of who receives assets, based generally on closeness of familial relationship, that exists under statutory law).

Mr. Davis' Last Will did not specifically provide for what would happen if his wife claimed her elective share. The trial court ruled that since he did not address this issue, it could take evidence on what Mr. Davis' intent was as to what would happen in this circumstance, and rewrite the Will to provide for the passage of the remaining assets in accordance with this determined intent.

Was this a reasonable approach? Maybe. Was this an approach allowable under Florida law? Nope. The 2nd Circuit Court of Appeals, in reviewing the trial court decision, started with the rule:

The court may not alter or reconstruct a will according to its notion of what the testator would or should have done. . . . It is not the purpose of the court to make a will or to attempt to improve on one that the testator has made. Nor may the court produce a distribution that it may think equal or more equitable. In re Estate of Barker, 448 So. 2d 28, 31-32 (Fla. 1st DCA 1984) (quoting 18 Fla. Jur. 2d Decedent's Property § 358, at 216).

Applying this rule, the Court of Appeals reversed the trial court and its made up determination of how to pass the assets, and directed that the assets pass under Florida's intestacy rules, as required by the Last Will and applicable law.

Owens and Clement v. Estate of Davis, 2nd DCA, June 23, 2006.

ESTATE TAX REPEAL UPDATE

With action for estate tax repeal stalled in the Senate, on June 19 House Ways and Means Committee Chair Bill Thomas (R-CA) introduced H.R. 5638, the “Permanent Estate Tax Relief Act of 2006.” This bill, while not repealing the estate tax, allows for substantial reductions in estate, gift, and GST taxes. Key aspects of the bill include:

-elimination of the provisions of existing law that would provide for no estate tax in 2010;

-reunification of estate and gift tax credit amounts;

-increase of exemption amount to $5 million by January 1, 2010;

-rate of tax on estates up to $25 million reduced to capital gains tax rates, and to twice those rates above the $25 million;

Earlier today, the bill was passed by the House. In its passage, the bill was modified to index the $5 million exclusion for inflation.

The next step will be a Senate vote on whether to proceed on the bill, which will require 60 votes to pass. This vote is expected to happen next Wednesday or Thursday.

RESTRAINTS ON ALIENATION VIA WILL [FLORIDA]

Joint owners of property, that own the property as tenants in common, generally have the ability to sell their interest in the property, or to seek a severance of their interest from the interests of their co-owners. If the property cannot be physically divided to accomplish a severance, it will be sold and the proceeds divided among the co-owners.

The question for the day is whether a testator can provide under his or her Last Will that the recipients of property passing under the Will to several beneficiaries can be restricted by the provisions of the Will from selling or severing their interests without the consent of the other co-owners. This was the issue in Vinson et al v. Johnson et al, 31 Fla. L. Weekly D1659c (1st DCA June 16, 2006). In that case, the decedent provided in his Last Will that "[t]he “Vinson Estate” shall not be subject to partition or forced sale by any heir, but shall only be sold upon agreement of all heirs." The Vinson Estate was a 34 acre farm and home in Alachua County, Florida. Several of the heirs sought partition of the Vinson Estate, challenging the enforceability of the restriction in the Will.

The Court held that the restriction was an impermissible restraint on alienation, and was unenforceable - therefore, partition was allowed. The Court noted that the restrictions on alienation (transfer) were inconsistent with basic rights of ownership in property. By denying the right to sell or realize the value of the property, the heirs were denied an essential aspect of ownership. The Court did note that a testator may restrict or postpone the right of partition FOR A LIMITED TIME when necessary to accomplish the plan of the Will. Such a restriction might be upheld if it merely keeps the property intact for a limited time, for example, until the youngest of the children reaches the age of majority. But to prohibit the sale of property during the entire lifetime of each of the children would be inconsistent with the devise itself. The Court also noted that the right to partition can be waived by agreement, but that merely accepting a devise under a Will does not constitute agreement for this purpose.

Testators seeking to restrict the ability of heirs to sell property or to keep a parcel of property together for the benefit of numerous beneficiaries should thus use a trust or similar devise to accomplish such goals in lieu of restrictions on alienation.

APPLICABLE FEDERAL RATES - UPDATE FOR JULY 2006

JULY 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.99% (4.93%/June -- 4.79%/May -- 4.71%/April)

-Mid Term AFR - Semi-annual Compounding - 4.99% (5.00%/June -- 4.78%/May -- 4.67%/April)

-Long Term AFR - Semi-annual Compounding - 5.22% (5.25%/June -- 4.94%/May -- 4.73%/April)

DIRECTION OF RATES: Mixed

PROPOSED RULES FOR 10% OWNERSHIP LIMITS UNDER PORTFOLIO INTEREST RULES

Absent the application of a tax treaty or other applicable exclusion, foreign taxpayers who receive interest from U.S. payors unrelated to a U.S. trade or business are subject to a 30% withholding tax. However, if Internal Revenue Code requirements are followed to qualify the obligations under which the interest is paid as "portfolio interest obligations," the foreign receipient is not subject to U.S. income tax.

One limitation on the ability to use these rules is that the foreign recipient cannot be a 10% or more shareholder of a U.S. corporate payor, or a 10% or more partner of a U.S. partnership payor. While related party rules exist, neither the Code nor the legislative history specifically addresses how the 10-percent shareholder test is to apply when interest is paid to a partnership that has foreign partners. That is, neither the Code nor the legislative history explicitly provides whether the 10-percent shareholder test should be applied at the foreign partner level, the partnership level, or both levels. Different results may obtain whether one is testing if a partnership itself owns the disqualified 10% or more ownership interest, or whether the affected foreign partner itself owns that disqualified interest.

Pursuant to proposed regulations, the IRS and the Treasury Department have concluded that the 10-percent shareholder test should apply at the foreign partner level to the nonresident alien individual or foreign corporation that is the beneficial owner of the income. Accordingly, the proposed regulations provide that when interest is paid to a partnership, the persons who receive the interest for purposes of applying the 10-percent shareholder test are the nonresident alien individual partners and the foreign corporations that are partners in the partnership. The 10-percent shareholder test is then applied by determining each such person's ownership interest in the obligor.

When interest is paid to a simple trust or a grantor trust, an issue also arises as to whether the 10-percent shareholder test should be applied at the trust or beneficiary or owner level. Similar to the foregoing provisions for partnerships, the proposed regulations provide that when interest is paid to a simple trust or grantor trust and such interest is distributed to or included in the gross income of a nonresident alien individual or foreign corporation that is a beneficiary or owner of such trust, as the case may be, the withholding agent is to apply the rules of the proposed regulations with respect to determining whether a 10-percent shareholder has received interest, at the beneficiary or owner level.

Preamble to Prop Reg 06/13/2006 ; Prop Reg § 1.871-14 , Prop Reg § 1.881-2.

INTEREST RATES FOR TAX OVERPAYMENTS AND UNDERPAYMENTS

The IRS has announced the interest rates for tax overpayments and underpayments for the calendar quarter beginning July 1, 2006.

For noncorporate taxpayers, the rate for both underpayments and overpayments will be 8% (up from 7%).

For corporations, the overpayment rate will be 7% (up from 6%). Corporations will receive 5.5% (up from 4.5%) for overpayments exceeding $10,000. The underpayment rate for corporations will be 8% (up from 7%), but will be 10% (up from 9%) for large corporate underpayments.

EARLY RETIREMENT PAYOFF SUBJECT TO FICA WITHHOLDING

Both public and private employers at times offer early retirement bonuses/payoffs to their employees to trim the number of employees. FICA taxes are taxes imposed on "wages" to fund Social Security and Medicare benefits. The 6th Circuit Court of Appeals recently determined that early retirement payments made to tenured teachers in Michigan public schools were "wages" and thus subject to FICA taxes.

The teachers argued that the payments were made in exchange for tenure rights, and thus were not paid in exchange for services and not subject to FICA taxes. The Court, however, was persuaded by the following quote from CSX Corp. Inc. v. United States, 52 Fed. Cl. 208 (Ct. Fed. Cl. 2002) holding that:

[R]ights to vacation pay, sick pay, layoff pay, and seniority -- constituted part of the employee's total compensation package and, hence, constituted wages. Therefore, when these job-related benefits are relinquished in favor of a lump-sum payment, the transaction simply amounts to a redemption, paid in cash, of wage amounts previously paid in kind. Because a separation payment is simply an exchange of equivalent values, what were wages at the start remain wages at the end.

By then equating tenure as merely "seniority" they had no problem treating the payments as wages subject to FICA. The Court was comfortable equating tenure rights as wages (and not some other type of asset the payment for which would not be wages) because they were earned through service to the employer, and further were not contracted for at the time of employment. This was enough for the Court to distinguish the case of North Dakota State Univ. v. United States, 255 F.3d 599 (8th Cir. 2001) where the 8th Circuit Court held that similar payments to tenured college professors were NOT subject to FICA taxes. Was there really enough of a distinction between the tenure here and the tenure in North Dakota to justify a different tax result? Maybe not, but the Court seemed to think so.

Appoloni v. U.S., 97 AFTR 2d 2006-XXXX (CA6 06/07/2006)

UNFAVORABLE FAMILY PARTNERSHIP CASE

In 1996, Lillie Rosen established a limited partnership and funded it with marketable securities and cash. A trust held for her benefit obtained a 99% limited partnership interest, and her children each acquired a 0.5% general partner interest. Through 2000, Ms. Rosen gifted away interests in the partnership, so that at her death in 2000 her trust and various family members and trusts owned limited partnership interests.

For estate tax purposes, the IRS sought to treat Ms. Rosen as owning all of the assets of the partnership in her gross estate for estate tax purposes pursuant to Code Section 2036(a). The Tax Court ruled in favor of the IRS.

Section 2036(a)(1) will treat a decedent as owning property that was transferred away so long as it was not transferred in a bona fide sale for adquate and full consideration if the decedent retained possession or enjoyment of, or the right to income from, the transferred property. In applying this rule, the first question is whether there was a bona fide sale for full value. The Tax Court indicated that for this exception to apply, it must be shown that (1) the family limited partnership was formed for a legitimate and significant nontax reason and (2) each transferor received a partnership interest proportionate to the fair market value of the property transferred. The Tax Court found that there was no legitimate and significant nontax reason for a whole host of reasons, including:

-the overwhelming reason for the partnership was to avoid Federal estate and gift taxes;

-the partners did not negotiate or set any of the terms of the partnership;

-the partnership was not funded until three months after it was set up;

-the childrens' share was de minimis;

-substantially all of the decedent's assets were transferred to the partnership;

-decedent was unable to meet her financial obligations without using funds of the partnership;

-the assets contributed were solely marketable securities and cash; and

-decedent was old and in poor health at the time of formation.

The Court thus found that there was no sale for full consideration. The Court then went on to find that the course of distributions and disbursements for the benefit of Ms. Rosen from the partnership, and the other facts of the situation, gave rise to an understanding for the decedent to retain possession or enjoyment of the transferred assets, and thus Section 2036(a) applied.

Note that the estate tax inclusion was not limited to the portion of the partnership owned by Ms. Rosen at her death, but also included the partnership assets attributable to the limited partnership interests that Ms. Rosen had gifted away prior to her death - her estate was thus being taxed on assets that were not owned by her at her death.

Estate of Rosen, TC Memo 2006-115.

THE TIPPING POINT

At what point do you say that the income tax compliance burdens imposed by the Internal Revenue Code are too significant? Forget about measurements of how many pages are now in the Internal Revenue Code, Treasury Regulations, IRS pronouncements, etc. - a recent IRS announcement includes one simple fact that shows we have reached the tipping point.

The IRS recently announced that the nation's largest tax return was filed electronically - the return of General Electric. The IRS indicated that if printed on paper, the return would be approximately 24,000 pages long.

24,000 pages.

24,000 pages.

24,000 pages!

IR-2006-84, May 31, 2006

SHOULD A WILL SIGNING BE VIDEOTAPED?

Just because a Last Will or trust is properly prepared and signed does not mean it will govern the disposition of a decedent's assets. A successful claim that the decedent lacked testamentary capacity at the time of signing, or was subject to undue influence, could result in a modification or rejection of the Last Will or trust.

If there is a concern over a future challenge, the suggestion is often made that the signing of the documents be videotaped to provide a record of the state of mind of the signor, since the signor will not be able to testify after his death as to these issues. Situations when this might arise include an elderly or frail person, or when former beneficiaries or natural objects of the bounty of the testator are being written out of the documents.

Generally, videotaping should be discouraged. The principal reasons for this are:

-Unless the attorney routinely videotapes ALL signings, the fact that the attorney videotaped THIS signing raises an inference that the attorney himself or herself had reason to believe that lack of capacity or undue influence may have been an issue, and will thus lend some credence to the arguments of the challenger.

-There is a risk that the video taping may not come off well. For example, the testator may appear physically or mentally worse off than is actually the case. The camera may make the testator nervous, or there may be bad lighting or sound. Once the recording is done, if it didn't come off well, the attorney or testator can't merely throw it away with no consequences. If it is discovered that the signing was taped and then the tape was destroyed, a savvy attorney in a later challenge can make a strong argument that the testator or the attorney had something to hide by reason of the destruction of the tape.

-The testator may inadvertently say something that provides ammunition to a challenge that they wouldn't already have. In the hands of a skilled litigator, any word, gesture, glance, can be used to create questions as to capacity or influence. This is not a scripted taping with a professional actor.

There are other mechanisms available to help sustain the validity of a Last Will or trust document - in most cases, video taping should not be one of them.

PROPOSED IMMIGRATION LAW CONTAINS INCOME TAX PROVISIONS

Congress, and many in the nation, are divided on many of the issues of immigration reform. On May 25, the Senate passed the “Comprehensive Immigration Reform Act of 2006” (S. 2611) by a vote of 62 to 36. Accordingly, the bill is now ready for conferencing with the House-passed “Border Protection, Antiterrorism, and Illegal Immigration Control Act of 2005” (H.R. 4437).

In conference, members of the House and Senate will try to reconcile the two different bills into one that can be approved by Congress, which if not vetoed by President Bush, would become law. The Senate version has income tax provisions included. Under the Senate version, illegal immigrants seeking a change in status (e.g., from illegal to legal alien) would be be required to pay all outstanding tax liabilities. Further, they would also would be barred from collecting a tax refund for tax years before 2006, and from filing a claim for the Code Sec. 32 earned income tax credit or any other tax credit otherwise allowable under the Code before 2006.

Until the conference committee works out the differences between the House and Senate version, we won't know whether these tax provisions will find their way into the final bill.