TAX EXEMPT ENTITIES PARTICIPATING IN TAX SHELTER TRANSACTIONS

The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), enacted on May 17, 2006, includes new excise taxes and disclosure rules under Code Sections 4965 and 6033 that target certain potentially abusive tax shelter transactions to which a tax-exempt entity is a party. The managers of these entities, and in some cases the entities themselves, can be subject to excise taxes if the entity is a party to a prohibited tax shelter transaction. In Notice 2006-65, the IRS issued guidance as to the applicability of these new rules. Some of the key aspects include:

-Entities that may be affected by the new provisions include, but are not limited to, charities, churches, state and local governments, Indian tribal governments, qualified pension plans, individual retirement accounts, and similar tax-favored savings arrangements.

-Prohibited tax shelter transactions include (a) transactions that are identified by the IRS as potentially abusive “listed” tax avoidance transactions pursuant to Code Sections 6707A(c)(2) and 6011, and (b) reportable transactions that are (i) within the meaning of § 1.6011-4(b)(3) of the Income Tax Regulations, and (ii) transactions with contractual protection within the meaning of § 1.6011-4(b)(4) of the Income Tax Regulations.

-A tax-exempt entity, if subject to these rules and if a party to a prohibited tax shelter transaction, must disclose to the IRS (a) that such entity is a party to the prohibited tax shelter transaction; and (b) the identity of any other party to the transaction which is known to such tax-exempt entity.

Managers and trustees of tax-exempt entities conducting any activities that are more than plain vanilla activities should review these requirements to avoid penalties under these rules.

CAUTION NEEDED WITH POST-DEATH IRA ROLLOVERS TO A SURVIVING SPOUSE

Charlotte Gee’s husband died in 1998. He was the owner of an IRA. Charlotte then had the IRA, with a balance of $1,010,998, transferred to her own separate IRA. Charlotte was age 51 at the time.

In 2002, Charlotte directed that a $977,887.79 distribution be made to her from her IRA. She was under age 59 ½ at the time.

APPLICABLE RULE 1: Section 72(t) imposes a 10-percent penalty tax on distributions on IRAs received by beneficiaries under the age of 59 ½.

APPLICABLE RULE 2: Section 72(t)(2)(A)(ii) provides an exception to the 10-percent penalty tax for distributions "made to a beneficiary (or to the estate of the employee) on or after the death of the employee."

THE ISSUE: Can Charlotte use APPLICABLE RULE 2 to avoid a 10% penalty tax under APPLICABLE RULE 1 for her distribution? In a recent Tax Court case, Charlotte argued that the funds from her deceased husband's IRA did not lose their character as funds from her deceased husband's IRA, even though she rolled them over to her own IRA - thus, she should be able to use the APPLICABLE RULE 2 exception.

THE RESULT: The 10-percent penalty tax (here, $97,789) will apply. Once the funds were put in her IRA, they became part of her IRA and thus distributions later made to her were not distributions to a beneficiary after the death of the IRA employee.

The only good news for Charlotte in the Tax Court opinion was that the Court found reasonable cause for Charlotte’s erroneous reporting. Thus, the 20% accuracy related penalty will not apply to her.

Charlotte T. Gee, et vir. v. Commissioner, 127 T.C. No. 1 (2006).

CHARITABLE CONTRIBUTIONS OF REMAINDER INTERESTS IN RESIDENCES AND FARMS

Generally, when someone gives property to charity, to get an income tax deduction for the contribution they have to give their entire interest in the property, not just a partial interest. However, there is an important, but often overlooked, exception to this partial interest limitation that allows contributors to transfer a remainder interest in a residence or farm to a charity. A remainder interest in property means that someone is allowed the use of the property for their lifetime or for a term of years, and at the expiration of that term, the "remainder interest" then passes to the person or entity designated to receive the remainder interest.

Certain tax advantages accrue to the contributor in the circumstances. First, the contributor gets a current income tax deduction, even though he or she can continue to use the property and the property doesn't pass to the charity for many years. Second, the contributor can gift a life interest in the property to a third party along with a remainder interest to charity - this reduces the value of the taxable gift to the recipient of the life interest. Lastly, the charity gets immediate title to what is hopefully an appreciating asset - while the charity will not get possession of the property immediately, it is guaranteed to receive the remainder interest even if the contributor later changes his or her mind.

In regard to what residences may be transferred, the only requirement is that the property be a residence of the contributor. Thus, a second home or vacation home can qualify as a personal residence for this purpose. Even a yacht can qualify if it is used by the contributor as a residence.

There are some tricky aspects to these contributions. First, the transfer of the remainder interest must be by deed, and not by a trust. Second, there cannot be any restrictions on the remainder interest. For example, the contributor cannot require the remainderman to consent to any sale of the underlying property. Lastly, in determining the amount of the charitable contribution for deduction purposes, straight-line depreciation is calculated into the valuation, making estimates of future value, and allocations between depreciable and non-depreciable property important.

IRS TO SIGNIFICANTLY REDUCE TRANSFER TAX AUDIT STAFF

The IRS intends to eliminate the jobs of almost half of the lawyers who audit gift and estate taxes. The IRS presently has 345 estate tax lawyers. The jobs of 157 of them will be cut in less than 70 days.

Kevin Brown, an IRS Deputy Commissioner, indicated that the staff cuts are occurring because far fewer people are now subject to estate taxes under the legislation enacted a few years ago than was previously the case. Others however, believe that the cuts are an attempt to effect estate tax repeal through the back door - that is, to significantly reduce audit activity on wealthy Americans.

Whether the staff cuts will have any impact on transfer tax enforcement depends on which side you believe. If there has been a significant reduction in audit activity due to the estate tax changes, then perhaps the staff cuts will not have much of an impact on enforcement. However, if audit activity has not been substantially reduced by reason of the tax cuts, then one would expect the staff cuts to hamstring the IRS in its enforcement efforts. Of course, even if less returns are being filed, the IRS could still retain the audit personnel and then simply conduct more audits on a percentage basis of all returns filed. However, Brown indicated that the incremental benefit of auditing more estate tax returns would not produce enough revenue to be worth the cost.

APPLICABLE FEDERAL RATES - UPDATE FOR AUGUST 2006

AUGUST 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 5.19%
(4.99%/July -- 4.93%/June -- 4.79%/May)

-Mid Term AFR - Semi-annual Compounding - 5.14%
(4.99%/July -- 5.00%/June -- 4.78%/May)

-Long Term AFR - Semi-annual Compounding - 5.29%
(5.22%/July -- 5.25%/June -- 4.94%/May)

DIRECTION OF RATES: Up

ENFORCEMENT OF NONCOMPETITION COVENANTS AGAINST BUYER OF BUSINESS [FLORIDA]

A typical aspect of a sale of a business is that the SELLER agrees to not compete with the buyer in a geographic area or with existing customers of the seller for a period of time. Fla.Stats. §542.335 provides a framework for when such covenants will be enforceable.

Under a prior statute, Florida case law [Flatley v. Forbes, 483 So.2d 483 (Fla. 2d DCA 1986)]held that such covenants by a BUYER of a business were not enforceable, since there was no applicable exception for a buyer's covenant under Florida's limits on restraints of trade. This issue recently came up again when a buyer of a business promised not to go after the business of the Walt Disney World Company and its affiliates for 10 years, which business was retained by the seller.

The Appeals Court reexamined the issue, since the applicable statute had been rewritten after the Flatley case. The newer statute specifically addresses the enforcement of such covenants when made by a seller, but is silent as to buyer covenants. Nonetheless, the 5th District Court of Appeals held that such covenants when made by a BUYER can be enforceable.

Case: Henao v. Professional Shoe Repair, Inc. and Restrepo, 5th District. Case No. 5D05-2348. Opinion filed May 26, 2006.

NEW GUIDELINES ON EXTENSION TO PAY ESTATE TAXES ON REAL PROPERTY BUSINESS INTERESTS

If a decedent's estate is subject to estate taxes at his death, the taxes are generally due in full 9 months after the date of death. However, to avoid the need for a "fire sale" liquidation of businesses, Section 6166(a)(1) of the Code permits an executor to elect to pay part or all of the estate tax imposed by section 2001 in two or more (but not exceeding ten) equal installments if a decedent was a citizen or resident of the United States on the date of death and the interest is a qualified closely-held business.

Only the taxes on assets actively used in a trade or business qualify - passive assets do not. The issue often comes up that if the decedent owns real estate, but has agents, employees, or independent contractors involved in its use and management, whether the decedent (or the applicable company owned by the decedent that owns the real property) has the requisite "active" business involvement to qualify for Secton 6166 treatment.

In a recently issued Revenue Ruling, the IRS notes that the fact that some of the real estate activities are conducted by third parties such as independent contractors who are neither agents nor employees of the decedent, partnership, LLC or corporation, will not prevent the business from qualifying as an active trade or business so long as these third-party activities are not of such a nature that the activities of the decedent, partnership, LLC or corporation (and their respective agents and employees) are reduced to the level of merely holding investment property. Often, however, day-to-day real estate operations and activities are performed by independent contractors, such as property management companies. If a decedent, partnership, LLC, or corporation uses an unrelated property management company to perform most of the activities associated with the real estate interests, that fact suggests that an active trade or business does not exist.

The Revenue Ruling provides a list of factors that must be weighed in determining whether there is the requisite active trade or business exists. It also provides several factual scenarios and applies these factors to those scenarios. The factors noted are:

-The amount of time the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) devoted to the trade or business;

-Whether an office was maintained from which the activities of the decedent, partnership, LLC, or corporation were conducted or coordinated, and whether the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) maintained regular business hours for that purpose;

-he extent to which the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) was actively involved in finding new tenants and negotiating and executing leases;

-The extent to which the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) provided landscaping, grounds care, or other services beyond the mere furnishing of leased premises;

-The extent to which the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) personally made, arranged for, performed, or supervised repairs and maintenance to the property (whether or not performed by independent contractors), including without limitation painting, carpentry, and plumbing; and

-The extent to which the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) handled tenant repair requests and complaints.

The Revenue Ruling advises that this is not an exclusive list of all applicable factors, and no one factor is dispositive.

Rev. Rul. 2006-34, 2006-26 IRB 1171, 06/22/2006.

USING ETF'S TO GET AROUND THE WASH-SALE RULE

If a taxpayer investor incurs capital gains in a year, typical tax planning involves also selling securities that are presently at a loss, to generate losses to offset gains and reduce taxes. After the loss property is sold, taxpayers often want to reacquire the property because they still consider it a good investment. However, Congress believes it is inappropriate to get a tax loss if you sell a security and then immediately buy it back. Thus, under the wash-sale rule, if an investor, within 30 days before or after the day of the sale of a security at a loss, purchases a "substantially identical" security, the loss on the sale is disallowed.

ETF's (exchange traded funds) are securities in an entity that owns a basket of stocks, such as stocks that make up a particular stock index or stocks of companies in a particular market sector. In a lot of ways they are similar to similarly structured mutual funds, except that the ETF's are traded directly on the stock exchange. The expanded use of ETF's provides some mechanisms for getting around the wash sale rules for investors in sector or index mutual funds. A recent article by Seddik Meziani and James G.S. Yang in the May 2005 issue of Practical Tax Strategies discusses some of these mechanisms and strategies:

a. Incurring mutual fund losses while maintaining market exposure through an ETF. If a taxpayer sells a loss position in a mutual fund, and then reacquires the mutual fund within the wash-sale period, the wash-sale rules will disallow the loss. If the taxpayer wants to continue the market exposure that was provided in the mutual fund, it should be able to buy an ETF with similar market coverage. Since the ETF will likely not be a "substantially identical" security to the mutual fund shares, this substitution of the mutual fund shares for shares of an ETF should not be subject to the wash-sales rules.

b. Incurring a sector ETF loss while maintaining market exposure to that sector. If a taxpayer sells a loss position in a market sector ETF, the taxpayer can maintain similar market exposure by acquiring directly several of the stocks in the sector that were owned in the ETF and that made up the largest positions in the ETF. While the taxpayer will still be less diversified in the sector than through the ETF, this should still allow for materially similar market exposure (at least until the wash-sale period expires and the ETF can be reacquired.

c. Swap one ETF for another. If a taxpayer sells a loss ETF, it may be able to find an ETF that is issued by a different company that has fairly similar market coverage. This should get the taxpayer around the wash-sale rule, although there is some uncertainty as how how different the ETFs need to be.

ALTERNATIVE MINIMUM TAX OBSERVATIONS

The alternative minimum tax (the “AMT”) was initially aimed at wealthy taxpayers who qualified for significant income tax deductions and thus paid little or no income tax. In the AMT computation, such deductions and other tax preference items are not allowed or only partially allowed, and if after not allowing for such items a higher AMT tax is due than the regular income taxes, the higher AMT tax must be paid.

The number of taxpayers who are subject to AMT tax has increased significantly, as Americans earn more income and incur higher deductions. In 2006, Congress increased the income thresholds for its application, but unless such increases are extended, in 2007 the exemption levels will drop to the levels of 2000, subjecting many more people to the AMT.

A recent Congressional Research Service Report contains some interesting information about the AMT, including:

-taxpayers who claim itemized deductions for state or local taxes, miscellaneous deductions, or have large families are more likely to have to pay the AMT. This is because these are the most often used preference or add-back deductions that are disallowed or reduced in the AMT computation. This in turn leads to residents of some states having a much higher proportion of their residents being subject to AMT than others. For example, residents of states with high local tax burdens (California, New Jersey, New York) are taking more income tax deductions for those items, and thus more of them are subject to AMT when those deductions are not allowed for AMT purposes. In 2004, about 55 out of every 1,000 taxpayers in New Jersey paid AMT. In the same year, this was as low as 6 or 7 out of 1,000 in states with low local taxes.

-the number of taxpayers who will be subject to AMT in 2007 if the 2006 exemptions are not extended will increase by over 20 million from the 2004 figures. In high tax states, this increase will be felt disproportionately. For example, for California, the 606,000 taxpayers paying AMT in 2004 will rise to 4,434,000 in 2007.

-by 2010, about 31 million taxpayers will be subject to the AMT. For taxpayers with incomes in the $100,000 to $500,000 income range, it is estimated that 90% of these taxpayers will be subject to the AMT.

REGULATIONS OVERRIDE STEP TRANSACTION DOCTRINE IN CONTEXT OF COMBINED §338(h)(10) ELECTION AND SUBSEQUENT MERGER

Under Code §338(h)(10), if a corporation makes a qualified purchase of the stock of another corporation, and that corporation is a member of a consolidated group, the buyer and the selling consolidated group can jointly elect to have the selling consolidated group recognize and report any gain or loss on the transaction as though the acquired corporation (the “target”) sold all of its ASSETS while still a member of the selling consolidated group. This reporting is in lieu of the selling consolidated group reporting gain or loss on the sale of the STOCK of the target corporation. This elective treatment can result in different net gain or loss treatment to the selling consolidated group, and also allows for an adjustment to the basis of the target’s assets for the purchase since they are being deemed to be purchased and sold in the transaction.

However, if the target corporation is then merged into the buying corporation, the “step transaction doctrine” will likely void the application of Code §338(h)(10). Instead, the IRS will treat the entire transaction as a Code §368(a)(1)(A) reorganization (an “A” reorganization). This will have very different tax consequences to all of the parties.

That is, until now. Under final Regulations issued July 13, 2006, the IRS will now allow the Code § 338(h)(10) election to apply (and not “A” reorganization treatment) - the Regulations expressly override the application of the step transaction doctrine, or any other similar doctrine that might otherwise recharacterize the transaction.

T.D. 9271, Reg. §1.338(h)(10)-1

SOME LESSONS ON RELEASES

Releases are a regular feature of business and contractual life. For a myriad of reasons, such as part of settlement of a controversy, or to avoid liability before a transaction or activity is undertaken, one person will "release" another from past, present, or future liability for the stated items. A recent Florida case provides a few lessons on releases:

1. IF YOU WANT TO BE RELEASED FROM LIABILITY FOR YOU OWN NEGLIGENCE, IT IS A GOOD IDEA TO EXPRESSLY MENTION THE WORD "NEGLIGENCE" IN THE RELEASE. The appellate court noted that some District Courts of Appeal require that "negligence" be specifically included in the release language before a negligence release will be effective, while others do not. Indeed, in the instant case, the word "negligence" was not included - the defendant was released of "any and all liability, claims, demands, actions, and causes of action whatsoever" - and the appellate court concluded that negligence was still released, but in another DCA a different result could obtain. Therefore, to avoid any challenges, the term "negligence" should be included in a release if the release is intended to cover negligence.

2. IF YOU INTEND THAT THE RELEASE APPLY TO THE FUTURE, BE SPECIFIC ABOUT THAT. In the instant case, a motorcycle rider released a track from all liability and claims in 1999. The track intended that the release apply to the current use of the track, and all future use of the track. When the rider sued the track for negligence for an injury occurring in 2002, he argued that it was not covered by the 1999 release. The appellate court found that the release was not clear as to its application to future events, and thus found it did not protect the track owner from liability in 2002. Therefore, if you intend for a release to apply in the future, make sure it is explicit. The court did note that it saw nothing wrong with a properly worded release applying to future events - that is, a release does not have to be signed contemporaneously with the event at issue to be effective.

3. DON'T EXPECT TO RELY ON COURSE OF CONDUCT OR OTHER CIRCUMSTANCES TO HELP INTERPRET A RELEASE CLAUSE IN FAVOR OF THE RELEASED PARTIES. This is what the track tried to do to avoid liability for the 2002 accident. The appellate court indicated that course of conduct and other circumstances could not be considered in interpreting the meaning of the release since that violated the rule of law which places the burden on a party seeking to absolve itself of liability to do so in clear and unequivocal terms.

Case: Cain v. Banka, II, 5th District. Case No. 5D05-3986. Opinion filed June 30, 2006

CALAMITIES AND AD VALOREM TAX VALUES [FLORIDA]

Death and taxes are two certainties, in Florida, as elsewhere. But Florida has some other certainties, or at least near certainties - hurricanes and ad valorem tax value increases. When hurricanes and ad valorem tax value increases coincide, hurricane victims get a double whammy. Such items can coincide because if a home is damages by a hurricane, and then repaired or rebuilt, the home may have more value (and thus a higher ad valorem tax value) than before the storm damage, thus resulting in higher ad valorem taxes.

Recently enacted legislation provides protection to Floridians against this double whammy. L. 2006, H7109, eff. 06/27/2006, and applicable retroactively to homestead property replaced on or after 01/01/2006, provides that when homestead property is assessed for ad valorem tax purposes, changes, additions, or improvements that replace all or a portion of homestead property damaged or destroyed by misfortune or calamity will not increase the homestead property's assessed value when the square footage of the homestead property, as changed or improved, does not exceed 110% of the square footage of the homestead property before the damage or destruction. Also, assessed value will not increase if the total square footage as changed or improved does not exceed 1,500 square feet.

These rules apply to changes, additions, or improvements begun within three years after the January 1 following the damage or destruction of the homestead.

The new law also allows the continuation of the ad valorem tax homestead exemption during the period that the damaged property is uninhabitable on January 1 after the damage or destruction occurs, if the property owner notifies the property appraiser that he or she intends to repair or rebuild the property and live in the property as his or her primary residence after the property is repaired or rebuilt, and does not claim a homestead exemption on any other property. However, failure by the property owner to commence the repair or rebuilding of the homestead property within three years after January 1 following the property's damage or destruction constitutes abandonment of the property as a homestead.

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