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Thursday, August 31, 2006


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

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

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

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

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

Tuesday, August 29, 2006


An important new provision in the Pension Protection Act of 2006 relates to rollovers of inherited qualified plan assets, such as assets from a 401(k) plan.


When an individual dies owning assets in a qualified retirement plan, and a designated beneficiary is provided for under the plan, that beneficiary becomes the new owner of the decedent's plan assets. Such plan assets must be eventually distributed out of the plan to the beneficiary. When this happens, the recipient is generally taxable in the year of distribution.

Plan beneficiaries can benefit in two key ways by deferring such distributions as long as possible. First, since such distributions are taxable, from an economic perspective the longer one can defer paying such taxes the better off one usually is. Second, while such plan assets are still in the plan, any current earnings from those assets are not subject to immediate tax and are likewise deferred until ultimate distribution.

To avoid extensive deferral of taxes, the Internal Revenue Code contains provisions that require that distributions be made out of the plans within certain time periods.


Prior to the Pension Protection Act of 2006, deferral opportunities existed for the recipients of inherited qualified plan assets. These provisions can be summarized as:

  • If the decedent/employee dies before he or she was obligated to start taking his or her own pension distributions, then distribution of the plan assets to the beneficiaries after death must be completed either (a) within five years of death, or (b) over the life expectancy of the beneficiary, beginning within one year of the employee's death.

  • If the decedent/employee was obligated to start taking his own pension distributions or had started taking them before he or she died, then his remaining interest must be distributed at least as rapidly as under the distribution method used by the decedent/employee as of the date of death.
Note, however, that beneficiaries who are spouses have additional deferral opportunities, since they can rollover the plan assets of their deceased spouse into THEIR OWN IRA. Once that is done, the surviving spouse must distribute the IRA assets in accordance with the rules that apply to his or her own IRA. Depending on the age of the surviving spouse, this will usually provide superior deferral opportunities than the above nonspousal rules.


If nonspousal beneficiaries already had the above deferral opportunities, why was a change in the law needed? Because while the law allows the above deferral opportunities, they apply only if the particular pension plan documents allow for one or more of them. Out in the real world, most company plans do not allow for them and require rapid payment of account balances to beneficiaries after the employee dies. Thus, most company plan beneficiaries cannot avail themselves of the deferral opportunities allowed under the law.


The new law now allows for the plan assets to be rolled into an "inherited IRA." Once rolled into an "inherited IRA" the beneficiary can take advantage of all of the nonspousal deferral opportunities described above, even if the qualified plan mandated earlier distribution.


Some people now believe that a nonspouse beneficiary is treated the same as a spouse. However, this is not correct.

The new IRA is treated as an "inherited IRA" and gets to use the general deferral provisions listed above. This is not the same as the spousal option to transfer plan assets to his or her own IRA - that type of transfer allows for more enhanced deferral oportunities to the spouse.


  • A trust for designated beneficiaries can elect the same rollover as an individual beneficiary
  • The rules apply to distributions made AFTER December 31, 2006.
  • The new IRA must be titled in a manner that identifies it as an inherited IRA.
  • A direct trustee-to-trustee transfer is required.
  • The rollover can be made only by a beneficiary that qualifies as a "designated beneficiary" under the Internal Revenue Code rules. Thus, for example, a probate estate that is the beneficiary cannot do a rollover.

Nonspousal beneficiaries who have inherited an interest in a plan should try to defer distributions from the plan until 2007 to take advantage of the rollover provision.

Saturday, August 26, 2006


SEPTEMBER 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 5.07% (5.19%/August -- 4.99%/July -- 4.93%/June)

-Mid Term AFR - Semi-annual Compounding - 4.95 (5.14%/August -- 4.99%/July -- 5.00%/June)

-Long Term AFR - Semi-annual Compounding - 5.14 (5.29%/August -- 5.22%/July -- 5.25%/June)


Thursday, August 24, 2006


Federal transfer tax law has various exemptions that may apply to otherwise taxable estate or gift transfers- unified credit amounts, annual exclusion gifts, generation skipping tax exemptions, etc. Taxpayers often desire to make transfers of property that come within these exemptions. Since the value of property is always open to challenge, a taxpayer that transfers a fixed fraction or percentage of property based on the taxpayer's valuation so as to come within a specific exemption amount may be subject to a nasty surprise if the IRS or a court determines a higher value for the property. In that case, the taxpayer will have given more than the targeted exemption amount, and thus will likely suffer unfavorable tax results (usually by exceeding the available exemption amount).

One way to avoid this problem is to provide in the transfer instrument that only so much of the subject property is being transferred that equals the available exemption amount (instead of transferring a fixed percentage or value of the property). Such a clause is often referred to as a "defined value gift clause." If the value of the property is higher than anticipated, the effect will be to reduce the fraction of the property that is transferred - the total gift value remains at the stated gift amount so the applicable exemption will not be exceeded.

The IRS is generally hostile to such clauses on public policy grounds since it effectually frustrates their audit of value of gifted property - if the property value is increased on audit the IRS will not collect any additional taxes on the gift itself since the amount of property gifted is automatically reduced to remain within the total dollar amount stated for the gift.

In 2003, the Tax Court in the McCord case voided the effect of a defined value gift clause. The Tax Court hung its hat on the fact that the formula used in that case defined the gift based on its "fair market value" and not its "fair market value as finally determined for federal gift tax purposes."

You would think that this was a slender thread on which to base its decision - and you would be right! The 5th Circuit Court of Appeals has now reversed the Tax Court, and gave full effect ot the defined value gift clause provided for by the taxpayers.

Does this mean defined value gift clauses will now be accepted as valid by the IRS and courts? Not necessarily. Interestingly, the IRS did not argue the public policy enforcement issues discussed above and often raised in these circumstances (based on the old case of Procter and its progeny). Therefore, a court faced with such a public policy argument might still invalidate a defined value gift clause on those grounds. Further, since this case was in the 5th Circuit, courts in other Circuits are not bound by it.

Nonetheless, the decision is helpful both in structuring defined value gifts that will be more likely to withstand IRS scrutiny and as precedent that may eventually lead to some final acceptance by the IRS or more courts as to their effectiveness.

Thursday, August 17, 2006


Under the Florida Constitution, an individual's homestead is generally exempt from the reach of his or her creditors. In 2001, the Bankruptcy Court for the Middle District of Florida held that if an individual transfers his or her homestead to a revocable trust (a common estate planning technique), this creditor protection is lost. Crews v. Bosonetto (In re Bosonetto), 271 BR 403 (Bakr. M.D. Fl. 2001).

Now, a different Bankruptcy Court judge, in the same Middle District, has held the opposite - that is, the homestead creditor protection remains available even though the owner transferred the homestead to a revocable trust for his or her benefit. In re Alexander, --- B.R. ----, 2006 WL 2055881(Bakr. M.D. Fl. 2006).

Does this mean that homesteads can be transferred to revocable trusts without fear of losing homestead protection? Nope - not yet anyway. Since the two courts are not appellate courts and are in the same District, neither decision has precedence over the year. However, if a an appeal is taken in Alexander, the decision of the appellate court should go a long way to providing a resolution of this issue (one way or the other).

Tuesday, August 15, 2006


As previously noted, the Pension Protection Act of 2006 provides that for 2006 and 2007, a person aged 70 ½ or older can make charitable gifts directly from an individual retirement account ("IRA") of up to $100,000 per year. While the Act has not yet been signed into law, it is widely expected that President Bush will do so.

This provision of the new law is a boon to taxpayers, since they do not have to treat the IRA transfer as a taxable distribution to themselves, followed by a deductible charitable contribution to a charity. Since the taxpayer may not be able to fully qualify the contribution for the charitable deduction, the taxpayer could be left with more income than deduction, and thus have to pay income tax on a portion of the transfer. Under the new law, the transfer to the charity is neither income to the taxpayer nor deductible by him or her - therefore, the taxpayer cannot end up owing income tax on the transfer.

There are some tricky qualifications that apply to the new provision. Some things to pay attention to in using the new provision include:

-The provision applies ONLY to IRA's. Distributions from other retirement plans, such as 403(b) plans, 401(k) plans, and profit sharing plans and pension plans, are not covered.

-The distribution must be made AFTER the donor attains age 70 1/2. This is different from the IRA distribution rules that cover distributions made in the entire year that an owner attains age 70 1/2.

-There is nothing that forces the IRA administrator to comply with a request to make a distribution to a charity. Therefore, some administrators may decline to make the transfers, either because they are not up-to-speed on the law, or may not want to be botheredadministrativelyy, especially if the gift amount is small. Since the provision will only apply through 2007, some administrators may be inclined to simply ignore it.

-The transfer must be made DIRECTLY from the IRA to the charity. The IRA cannot cut a check to the IRA owner who then issues his or her own check to the charity or endorses the IRA check.

-Organizations qualifying as charitable organizations because they are Section 509(a)(3) supporting organizations or are donor advised funds are not qualified recipients of these transfers.

-Don't wait too long to use the provision, since as noted above, the provision will expire after 2007 (unless extended by a law).

Friday, August 11, 2006


Generally, the recipient of life insurance proceeds at the death of an insured is not subject to income tax on those proceeds. Under Code Section 101(j) of the Pension Protection Act of 2006, an exception is created for certain employer-owned life insurance. While the new provision does have extensive exceptions, to use these exceptions certain notices and consents must be issued and obtained BEFORE the policy is issued. The requirement to comply with the notice and consent provisions before the policy is issued is a big trap for the unwary.

The following summarizes the new provision:

THE TAX. If applicable, Code Section 101(j) will tax the beneficiary on receipt of life insurance proceeds to the extent the proceeds exceed the total premiums and other amounts paid for the policy.

POLICIES SUBJECT TO THE PROVISION. The provision applies to employer-owned life insurance, which is insurance owned by a person engaged in a business, if such person (or a related person) is the beneficiary, and covers the life of someone who is an employee on the date the contract is issued.

EXCEPTIONS. If the notice and consent provisions are satisfied, the following policy proceeds will not be subject to income tax:

INSURED IS EMPLOYEE. The insured was an employee during the preceding 12 months; or

INSURED IS DIRECTOR/HIGHLY COMPENSATED. The insured, at the time the policy is issued, was a director or highly compensated individual (as defined in the new provision); or

NON-BUSINESS BENEFICIARY. The beneficiary is a member of the family of the insured, an individual who is the designated beneficiary of the insured under the contract (other than the applicable policyholder), a trust established for the benefit of any such member of the family or designated beneficiary, or the estate of the insured; or

FUNDS USED TO REDEEM INTEREST. If the recipient will use the proceeds to purchase an equity interest of a person described above as a non-business beneficiary, to the extent such proceeds are so used.

NOTICE AND CONSENT REQUIREMENTS. The notice and consent requirements that must be met before the policy is issued are that the employee:

(A) is notified in writing that the applicable policyholder intends to insure the employee's life and the maximum face amount for which the employee could be insured at the time the contract was issued,

(B) provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment, and

(C) is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee.

ANNUAL REPORTING REQUIREMENTS. Any business owning any policies subject to the new provisions are required to file an annual return with the IRS detailing information regarding such policies. This reporting arises under new Code Section 6039I.

Tuesday, August 08, 2006


In a recent tax shelter case, the 2nd Circuit Court of Appeals reversed the trial court and disallowed the allocation of income under a partnership to certain foreign entities that were effectively not subject to tax on the income. In its opinion, the Court recharacterized equity interests of the foreign partners as debt, and had some interesting observations and pronouncements in regard to the concept of debt vs equity when the purported equity interest is an interest in a partnership.

Usually, debt vs. equity considerations arise in regard to corporate stock, and relate to whether stock in a corporation or a loan to corporation will be respected as to its form, or whether the characteristics of the interest at issue and equity structure of the corporation warrant recharacterizing stock as debt, or debt as stock/equity. The Court noted that this issue usually arises in the corporate and not the partnership area, and further that in most cases involving the issue the taxpayer seeks debt treatment (usually to obtain an interest deduction for the corporation) but in this case the taxpayer is seeking equity treatment.

Some of the observations/conclusion made by the Court:

-The same debt vs. equity considerations apply in regard to partnerships as they do in the corporate area;

-The debt vs. equity examination should be conducted based on the "all-the-facts-and-circumstances" test of Culbertson, 337 U.S. 733, 742 (1949) (which it is easier for the IRS to prevail under) than applying the sham transaction doctrine (which requires the IRS to show that the taxpayer's characterization is altogether without economic substance);

-If a partner has an upside in the profits of the partnership, this is a factor in favor of equity. However, the inquiry does not end with examining the terms of the partnership agreement. Instead, the IRS and courts need to see if there is in fact a realistic possibility of such an upside. In the instant case, the Court found that as a practical matter, based on external factual considerations such as the ability to manipulate income among related entities and the ability to terminate the partnership, there was no such realistic possibility.

-If a partner's economic interest is not subordinated to creditors, this is indicative of equity. Again, however, the Court indicated that the inquiry does not end with examining the terms of the partnership agreement. In the instant case, the Court noted that the foreign partner's capital in the partnership was guaranteed by a third party, so this in effect kept such capital from being subordinated to creditors even though there was no express subordination in the partnership agreement.

-If a partner has the ability to terminate the partnership and thus obtain back their capital, this is a factor indicative of debt.

-The lack of management rights of a partner in the partnership is indicative of debt (even though this factor should not be given significant weight).

Case: TIFD III-E Inc v. U.S., 98 AFTR 2d 2006-XXX (2nd Cir 08/03/2006).

Sunday, August 06, 2006


Earlier this week, the U.S. Senate passed the Pension Protection Act of 2006. This Act was previously passed by the House of Representatives, and is on its way to President Bush for signature. The Act is quite voluminous, and contains many technical pension provisions. The Act also contains many provisions of wider interest, relating to IRA's and retirement plans, charitable contributions, and charitable exempt organizations. Some of these provisions include:

-increased contribution limits to IRAs and other qualified plans, that were due to expire, are now made permanant.

-direct rollovers from qualified plans to Roth IRAs are now allowed.

-non-spouse beneficiaries of a deceased participant's IRA or qualified plan can now make a trustee to trustee transfer to an IRA which will be treated as an inherited IRA. This important provision extends to non-spouse beneficiaries a valuable option that previously was only available to surviving spouses. Prior to this change, a non-spouse beneficiary was generally either required to distribute the inherited IRA either within 5 years, or elect to start taking distributions over the beneficiary's life expectancy.

-an annual IRA distribution of up to $100,000 made directlly to a qualified charitable organization (which does not include supporting organizations described in Code Section 509(a)(3)) can be made without the IRA owner being taxed on the distribution. The effort to enact such a provision has been ongoing for many years. By treating such distributions as not being taxable, numerous pitfalls of taking a distribution (and the income) and then seeking a charitable contribution by a subsequent contribution to charity are avoided. The provision applies, however, only if the IRA owner is over age 70 1/2. The contribution must still meet contribution rules (other than charitable contribution percentage limitation rules), such as obtaining proper substantiation and not receiving a benefit from the charity in the exchange. If the IRA has nondeductible contributions in it, special computation rules will apply.

-increased penalties for split-interest trusts failing to properly file returns.

-enhanced charitable deductions for contributions of food that is held in inventory of a business making the contribution.

-enhanced deductibility of charitable conservation easements.

-increased penalties for self-dealing, excess benefit transactions, failures to distribute income, excess business holdings, jeopardy investments and taxable expenditure excise taxes applicable to charitable organization transactions.

-recapture of tax benefits to donors of tangible personal property who took a fair market value deduction for the contribution to a charitable organization and the organization disposed of the property within 3 years of the contribution (for contributions over $5,000).

-limitation on charitable deduction for clothing and household items that are not in good used condition (or better condition).

-new limits on contributions of fractional interests in property (including recapture of tax benefits relating to a contribution if the entire property is not contributed within 10 years of the initial fractional contribution).

-expansion of definition of gross investment income for purposes of tax on such income imposed on private foundations.

-exempt organizations that are exempt from filing Form 990's must now electronically provide a notice to the IRS of such status. Failure to provide this notice for 3 years will result in revocation of exempt status.

-limitations on charitable contributions for some donor advised funds, and numerous regulatory provisions relating to donor advised funds.

-enhanced regulatory provisions for charitable supporting organizations.

While many of the new charitable provisions are aimed at specific abuses, the volume of changes and enhanced regulation will add more complexity to the charitable area and will add to the regulatory burdens of charitable organizations and their advisors.

Wednesday, August 02, 2006


The IRS periodically publishes statistics on tax related items. Some highlights from the Spring 2006 issue of the Statistics of Income Bulletin:

-For tax year 2003, individuals reported noncash charitable donations valued at $36.9 billion. Of these donations, corporate stock was the largest type, with 37.2% of the total value deducted. The average value of these stock donations was $79,279 per return. .

-Of the 130,423,626 individual income tax returns filed for tax year 2003, there were 2,536,439 returns reporting adjusted gross income of $200,000 or more.

-A total of nearly 3.3 million S corporation returns were filed for tax year 2003, an increase of 5.9% from tax year 2002. S corporations continue to be the single most popular corporate entity choice representing 61.9% of all corporate entities. The number of shareholders for S corporations increased to nearly 5.8 million, up 2.9% from the previous year. Total net income (less deficit) reported by S corporations increased to $213.7 billion for tax year 2003 from $183.5 billion reported for tax year 2002. Positive total net income was reported by 62.7% of all S corporations. Total assets increased $169.9 billion to $2,186.6 billion for tax year 2003. Less than one quarter of 1% of all S corporations reported federal tax liability, for a total tax liability of $380.9 million.

-A total of 123,205 split-interest trust information returns were filed in filing year 2004, an increase of 1.6% from filing year 2003. The largest group of trusts, charitable remainder unitrusts (CRUTs), increased by 1,958 returns from the previous filing year. In filing year 2004, charitable remainder trust returns reported $64.0 billion in total accumulations and $6.9 billion in distributions.

-For tax year 2002, individual income taxpayers contributed approximately $42.3 billion to IRAs. This represented an 18.3% increase over the contributions for 2001. In addition, $204.4 billion was deposited into IRAs during 2002 as rollovers, usually from employer-sponsored plans (such as 401(k) plans). However, year-end fair market value of IRAs fell from just over $2.6 trillion for 2001 to just over $2.5 trillion for 2002.