NEW FLEXIBILITY IN CALCULATING GAIN FROM BOOT IN REORGANIZATIONS

The Internal Revenue Code attempts to be tax-neutral in regard to corporate reorganizations. One aspect of this tax neutrality is that generally no gain or loss is recognized by a shareholder who is a party to a tax-free reorganization. For example, a shareholder of an acquired corporation can receives shares of stock in the acquiring corporation and not recognize any gain on the transaction. This nonrecognition arises under Section 354 and applies only if the reorganization involves an exchange solely for stocks and securities of a corporation that is also a party to the exchange. If the taxpayer received other property ("boot"), under Section 356 gain recognition results to the extent of boot received. No loss recognition is allowed.

A taxpayer who receives boot may have a different adjusted basis (that is, investment in the stock against which the amount of gain or loss is calculated) in the various shares he exchanges in the reorganization, and indeed may be giving up shares of different classes of stock. When boot is received, to which shares should the boot be allocated? This allocation determines how much gain arises if there is a different adjusted basis in different exchanged shares, and whether gain is long term or short term gain if there are different holding periods for the shares exchanged.

The courts have adopted the average-cost method to make the allocation, which is a pro rata allocation of the surrendered stock's bases to each block of stock received.

Earlier this year, new Treas.Regs. Section 1.356-1 provides useful flexibility to taxpayers. It adopts a tracing method. More particularly, in computing the gain, if any, recognized on an exchange, to the extent the terms of the exchange (1) specify (or trace) the other property or money that is received in exchange for a particular share of stock or security surrendered, and (2) are "economically reasonable," those terms control and the average-cost method need not apply.

NEW REPORTING ON CHARITABLE LIFE INSURANCE ARRANGEMENTS

Charitable organizations need to be aware of a new reporting requirement that came into effect under the Pension Protection Act of 2006. Under the Act, if an organization, gifts to which are eligible for a charitable deduction (for estate, income, or gift purposes), acquires an interest in certain life insurance contracts, such interest must be disclosed to the IRS. See Code Section 6050V. This disclosure requirement is only for a two year period.

It is clear that the IRS is concerned about charitable organizations lending their "insurable interest" in a life insurance policy to third parties. More particularly, there are various programs whereby a charitable organization acquires an ownership interest in a donor. The funds for the policy are generally lent to the charitable organization by a third party. When the donor dies, the charity gets the insurance proceeds, less its repayment of the loan to the third party lender.

If the third party lender had instead taken out the policy, it probably would not be enforceable, due to insurance law requirements that a beneficiary have an "insurable interest" in the insured. Generally, an "insurable interest" is an economic interest in the person whose life is insured, or a family relationship. Many states extend the "insurable interest" to include charities who own a policy on a donor’s life. Thus, the third party lender gains an indirect benefit from the policy due to the charitable nature of the beneficiary.

While the new provision does not prohibit or tax such arrangements, the IRS is gathering information and may seek further legislative reform down the line. In the meanwhile, the reporting itself may serve to dissuade charitable organizations from entering into these types of transactions.

APPRAISERS MORE AT RISK

Appraisers perform important functions for taxpayers, since many tax consequences relate to value of property. For example, a charitable contribution of property is based on the value of the property, and of course transfers of property for estate and gift tax purposes are taxable based on value.

When an appraisal is way off base, the taxpayers can be subject to substantial penalties. Under Code Section 6701(a), the appraiser himself or herself may also be subject to a $1,000 penalty, or $10,000 if a corporate tax return is involved, if it can be shown that the appraiser knew the report was false and would be used to reduce tax of another.

In addition to a the monetary penalty, after notice and opportunity for a hearing to any appraiser for whom a penalty had been assessed under Code Sec. 6701(a) the IRS could, under 31 USCS 330(c) : (a) bar the appraiser from presenting evidence or testimony in any administrative proceeding before IRS or the Treasury, and (b) provide that his or her appraisals wouldn't have any probative effect in any such proceeding.

The penalty stakes have now been increased for appraisers. New Code Section 6695A, enacted under the Pension Protection Act of 2006, imposes a new penalty on an appraiser if he or she knows, or reasonably should have known, that the appraisal would be used in connection with a return or a refund claim, and the claimed property value on the return or refund claim that is based on the appraisal results in a substantial valuation misstatement under Code Sec. 6662(e) or a gross valuation misstatement under Code Sec. 6662(h) for the property. Code Sections 6662(e) and 6662(h) relate to various valuation misstatements in regard to various income, pension, and estate and gift taxes. No penalty, however, will be imposed if the appraiser satisfies the IRS that the value established in the appraisal was more likely than not the proper value.

The penalty imposed is lesser of:

(1) the greater of: (a) 10% of the tax underpayment arising from the valuation misstatement described in (B) above, or (b) $1,000, or

(2) 125% of the appraiser’s gross income for preparing the appraisal.

Therefore, the appraiser can be penalized up to 125% of his or her appraisal fee.

The 2006 Pension Act also removes the requirement that IRS must assess a penalty under Code Sec. 6701(a) (aiding and abetting understatements) before it can bar an appraiser from presenting evidence or testimony in any administrative proceeding before IRS or the Treasury and provide that his appraisals won't have any probative effect in any such proceeding. 2006 Pension Act §1219(d).

APPLICABLE FEDERAL RATES - OCTOBER 2006

October 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.94% (5.07%/September -- 5.19%/August -- 4.99%/July)

-Mid Term AFR - Semi-annual Compounding - 4.76% (4.95%/September -- 5.14%/August -- 4.99%/July)

-Long Term AFR - Semi-annual Compounding - 4.96% (5.14%/September -- 5.29%/August -- 5.22%/July)

DIRECTION OF RATES: Down

2007 FEDERAL TAX INFLATION ADJUSTMENTS

RIA, a publisher of tax guides and research, has calculated 2007 adjustments to various Federal tax numbers that are calculated each year based on the prior year rate of inflation. These calculations are not the final IRS figures, but are typically an accurate projection of the final adjustments. Below are some of the more important inflation adjustment figures - remember, these apply in 2007, not 2006.

GIFT TAX ANNUAL EXCLUSION. The gift tax annual exclusion will be $12,000 (same as for gifts made in 2006).

ESTATE TAX SPECIAL USE VALUATION REDUCTION LIMIT. The limit on the decrease in value that can result from the use of special valuation will increase to $940,000, up from $900,000 in 2006.

PORTION OF ESTATE QUALIFYING FOR 2% INTEREST RATE ON DEFERRED ESTATE TAX. In determining the part of the estate tax that is deferred on a farm or closely-held business that is subject to interest at a rate of 2% a year, for decedents dying in 2007 the tentative tax will be computed on $1,250,000 (up from $1,200,000 in 2006) plus the applicable exclusion amount ($2 million for 2007, same as in 2006).

INCREASED ANNUAL EXCLUSION FOR GIFTS TO NONCITIZEN SPOUSES. The annual exclusion for gifts to noncitizen spouses will be $125,000 (up from $120,000 in 2006).

THRESHOLD FOR FOREIGN GIFTS THAT TRIGGERS REPORTING. If the value of the aggregate "foreign gifts" received by a U.S. person (other than an exempt Code Sec. 501(c) organization) exceeds a threshold amount, the U.S. person must report each "foreign gift" to IRS. ( Code Sec. 6039F(a) ) Different reporting thresholds apply for gifts received from (a) nonresident alien individuals or foreign estates, and (b) foreign partnerships or foreign corporations. For gifts from a nonresident alien individual or foreign estate, reporting is required only if the aggregate amount of gifts from that person exceeds $100,000 during the tax year. For gifts from foreign corporations and foreign partnerships, the reporting threshold amount will be $13,258 in 2007 (up from $12,760 in 2006).

TAX AVOIDANCE MOTIVE - EXPATRIATION. A tax avoidance motive is generally presumed for an expatriate whose average annual net income tax liability for the 5 tax years ending before the date of loss of citizenship or residency exceeds $136,000 in 2007 (up from $131,000 in 2006) or whose net worth on that date exceeds $2 million (not indexed for inflation).

FOREIGN EARNED INCOME EXCLUSION. The foreign earned income exclusion amount increases to $85,700 in 2007 (up from $82,400 in 2006).

INTEREST RATES FOR TAX OVERPAYMENTS AND UNDERPAYMENTS

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

For noncorporate taxpayers, the rate for both underpayments and overpayments will be 8% (no change from before).

For corporations, the overpayment rate will be 7% (no change from before). Corporations will receive 5.5% (no change from before) for overpayments exceeding $10,000. The underpayment rate for corporations will be 8% (no change from before), but will be 10% (no change from before) for large corporate underpayments.

DIRECT TRANSFER OF IRA ASSETS TO CHARITY

DIRECT TRANSFER OF IRA ASSETS TO CHARITY

The following is a summary analysis of the Pension Protection Act of 2006 relating to direct transfer of IRA assets to charity. The outline comes from a presentation given earlier this week. For those few of you that may have attended the presentation, you have already seen this!

1. THE PROBLEM

----a. If an amount withdrawn from a traditional individual retirement arrangement ("IRA") or a Roth IRA is donated to a charitable organization, the rules relating to the tax treatment of withdrawals from IRAs apply to the amount withdrawn and the charitable contribution is subject to the normally applicable limitations on deductibility of such contributions.

--------i. A taxpayer who takes the standard deduction (i.e., who does not itemize deductions) may not take a separate deduction for charitable contributions.

--------ii. Under present law, total deductible contributions of an individual taxpayer to public charities, private operating foundations, and certain types of private nonoperating foundations may not exceed 50 percent of the taxpayer's contribution base, which is the taxpayer's adjusted gross income for a taxable year (disregarding any net operating loss carryback).

--------iii. Contributions of cash to private foundations and certain other charitable organizations generally may be deducted up to 30 percent of the taxpayer's contribution base.

--------iv. Present law imposes a reduction on most itemized deductions, including charitable contribution deductions, for taxpayers with adjusted gross income in excess of a threshold amount, which is indexed annually for inflation. The threshold amount for 2006 is $150,500 ($75,250 for married individuals filing separate returns). For those deductions that are subject to the limit, the total amount of itemized deductions is reduced by three percent of adjusted gross income over the threshold amount, but not by more than 80 percent of itemized deductions subject to the limit.

------------(1) Although through 2009 the limit is reduced.

----b. Thus, if a taxpayer withdrew funds from an IRA and gave them to charity, he or she would likely have income equal to the withdrawal, but the offsetting charitable deduction could be limited or nonexistent, thus giving rise to income tax.

2. THE NEW PROVISION

----a. The provision provides an exclusion from gross income for otherwise taxable IRA distributions from a traditional or a Roth IRA in the case of qualified charitable distributions.

----b. Qualified charitable distributions are taken into account for purposes of the minimum distribution rules applicable to traditional IRAs to the same extent the distribution would have been taken into account under such rules had the distribution not been directly distributed under the provision.

--------i. An IRA owner who makes an IRA qualified charitable distribution in an amount equal to his RMD for that tax year is considered to have satisfied his Code Sec. 408(a)(6) minimum distribution requirement for that year, even though a charitable entity (and not the IRA owner) is the recipient of the distribution.

3. LIMITATIONS

----a. Applies for distributions made after December 31, 2005 and before January 1, 2008.

----b. The exclusion may not exceed $100,000 per taxpayer per taxable year.

----c. Transfer must be made on or after the date on which the individual for whose benefit the IRA is maintained has attained age 70-1/2 .

----d. The provision does not apply to distributions from employer-sponsored retirements plans, including SIMPLE IRAs and simplified employee pensions ("SEPs").

----e. Transfer must be direct from the IRA trustee to the charity.

--------i. A distribution made to an individual, and then rolled over to a charitable organization, would not be excludible from gross income.

----f. Charitable recipient cannot be a supporting organization described in section 509(a)(3) or a donor advised fund (as defined in section 4966(d)(2), nor a nonoperating private foundation.

----g. Applies only if a charitable contribution deduction for the entire distribution otherwise would be allowable (under present law), determined without regard to the generally applicable percentage limitations.

--------i. Thus, for example, if the deductible amount is reduced because of a benefit received in exchange, or if a deduction is not allowable because the donor did not obtain sufficient substantiation, the exclusion is not available with respect to any part of the IRA distribution.

--------ii. If the IRA owner has any IRA that includes nondeductible contributions, a special rule applies in determining the portion of a distribution that is includible in gross income (but for the provision) and thus is eligible for qualified charitable distribution treatment.

----h. No charitable deduction allowed to taxpayer for the transferred amount.

4. MISC.

----a. An individual's tax-free IRA donations may consist of one or more distributions, from one or more IRAs, donated to one or more charitable organizations, as long as the aggregate amount does not exceed $100,000 in a year.

----b. There is no carryover of unused $100,000 amounts - use it or lose it.

----c. There is nothing under the IRA charitable rollover provision that requires an IRA trustee to make distributions to charity at the direction of the account owner, or to ensure that the distributions qualify as "qualified charitable distributions."

RECENT LEGISLATIVE CHANGES TO FLORIDA'S LAND TRUST STATUTE

Florida allows for real property to be held in a special type of trust known as a "land trust." Land trusts allow for confidentiality of ownership, and can facilitate transfers of ownership of partial or complete interests in land.

In the recently completed legislative session, Florida revised its land trust statute. Some of the more significant statutory modifications include:

-Clarication that a trustee can be a beneficiary.

-Clarificatopm that a beneficiary of a land trust is not liable for the debts, obligations, or liabilities of the land trust.

-The perfection of a security interest in a beneficial interest in a land trust does not impair or diminish the authority of the trustee under the recorded instrument.

-Subsequently recorded public documents relating to the transfer or encumbrance of a beneficial interest do not diminish or impair the authority of the trustee under the previously recorded instrument.

-A trust relating to real estate will not fail because beneficiaries are not specified by name in the recorded deed of conveyance or because duties are not imposed upon the trustee.

-Homestead tax exemption is available to property held in a land trust if the beneficiary and property otherwise qualifies for it.

-Provisions are made for recording public record documents relating to succession of trustees.

SECTION 83(b) ELECTION RISK FOR PARTNERSHIP INTERESTS

A recent article notes a risk for a Code Section 83(b) election for partnership interests received for services.

Persons performing services for a partnership (or LLC taxable as a partnership) often receive an interest in the partnership as incentive compensation. When issued, the person performing the service may be obligated to provide continued services for the partnership - otherwise the partnership may be able to take back the partnership interest. Section 83 of the Internal Revenue Code indicates that the service partner need not recognize compensation income when the partnership interest is issued, due to it being subject to a "substantial risk of forfeiture" (provided it is also not transferable free of the risk of forfeiture). Instead, the service provider can defer income taxes for the receipt of the interest until the risk of forfeiture lapses or terminates.

There is a risk that the value of the partnership interest may increase signficantly between its issuance and when the substantial risk of forfeiture may lapse (and thus increase the compensation income to the service partner). To avoid the risk of such increased taxation, the service partner can make an election to be taxed on the receipt of the interest when it is received (at the value at the time of issuance) under Code Section 83(b).

The tax risk of such an election relates to what occurs if the service partner has to surrender the interest due to not continuing to provide services. Per Treas.Regs. Section 1.83-2(a), at the time of a forfeiture of the interest the service provider can recognize a loss (presumably a capital loss) to the extent of what the service partner paid for the interest over what the service partner is paid for the interest upon the forfeiture (if anything). The problem with this rule is the service provider gets no credit/loss for the ordinary income incurred by the service provider at the time of the Section 83(b) election. Further, it does not allow for any adjusted basis (and thus loss) relating to any increase in tax basis in the forfeited partnership interest that arose while the partnership interest was owned by the service partner due to being allocated his or her share of partnership income from the partnership under the partnership tax rules.

Example: A taxpayer receives a partnership interest that is subject to being forfeited if he does not work for the partnership for 5 years. The taxpayer elects to be taxed upon receipt of the partnership interest at a time that the interest is worth $50,000 - largely because he believes the partnership interest could be worth at least $200,000 in 5 years when he would otherwise be taxed for the receipt. In year 3, the taxpayer ceases to work for the partnership and has to return his partneship interest. In years 1-3, the taxpayer was allocated $30,000 of partnership income on his partnership interest, all of which he included in income. No partnership distributions were made to him during the term. According to the regulation, at the time of the forfeiture, the taxpayer has no loss from the forfeiture, since he paid nothing for his interest. He does not get a loss for the $50,000 in compensation income he received, nor does he get a loss for the $30,000 in partnership income that was allocated to him during the term.

This risk of not being able to get a loss for income so earned needs to be considered in making a determination whether to make a Section 83(b) election.

Source: Article by Richard Harris in March/April 2005 issue of Business Entities.

TRUST CONSIDERED TO BE A GRANTOR TRUST BASED SOLELY ON POWER TO PAY INSURANCE PREMIUMS ON LIFE OF GRANTOR

A grantor trust is a trust whose income is generally taxable to the grantor/settlor by reason of specific Internal Revenue Code provisions that mandate such treatment. In contrast, a nongrantor trust is a separate taxpayer whose income is generally taxable either to the trust itself and/or its beneficiaries and not the grantor.

Code Section 677(a)(3) is one of those provisions that gives rise to grantor trust status. It provides that a trust will be a grantor trust if its income, without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse. There is case law to the effect that where no insurance policy is owned by the trust, the mere power to purchase a policy and pay premiums is not enough to create grantor trust status. Thus, there is uncertainty as to when and how these provisions apply. Do they if the trust does not own an insurance policy? Do they apply only to the extent that trust income is applied to premium payments? There is conflicting authority on these questions.

A recent IRS field advice (LAFA 20062701F) muddies the water further. In the advice, a trust explicitly allowed the use of trust funds to purchase life insurance on the life of the grantor. The trust funds were used to pay premiums on life insurance on the life of the grantor, but the trust was not the owner of the policy. The advice concludes that a grantor trust existed - it was enough that the trust was authorized to pay the premiums - it did not have to own a life insurance policy to give rise to grantor trust status.

INTERNAL REVENUE CODE PROVISION FOUND UNCONSTITUTIONAL

While taxpayers may often assert constitutional arguments against the enforcement of the Internal Revenue Code, the actual finding of a provision to be unconstitutional is an extremely rare event. Subject to possible review by the U.S. Supreme Court, the U.S. Circuit Court of Appeals for the District of Columbia circuit did just that in the recent case of Murphy v. United States, No. 05-5139.

For the nonlawyers, a little constitutional background is helpful. Until the 16th Amendment to the U.S. Constitution was enacted, an income tax was not allowed. The 16h Amendment allows a tax on income, and Section 61 of the Internal Revenue Code imposes such a tax on "gross income." The U.S. Supreme Court in Helvering v. Clifford has found these provisions coextensive. It has further found that "income" means "gain derived from capital, from labor, or from both combined" (Eisner v. Macomber), and further includes all "accessions to wealth" (Commissioner v. Glenshaw Glass).

The issue in the instant case was whether a damage award for mental distress is "income" when not arising from a physical injury or physical sickness. Section 104(a) of the Code provides that gross income does NOT include the amount of damages (other than punitive damages) received on account of physical injury or physical sickness. In 1996, Congress amended the Section to further provide that "emotional distress shall not be treated as a physical injury or physical sickness" - so that mere emotional distress would not fall within the Section 104(a) exclusion from gross income.

The taxpayer challenged the 1996 amendment, claiming that the new provision is unconstitutional since by treating emotional distress damages as income, Congress is including as income something that is not income under the 16th Amendment authorizing a tax on income. The Circuit Court noted that Congress does not have the power to declare any economic benefit as income, but is bound by what was intended to be included as income under the 16th Amendment. After reviewing interpretations of the term "income" from around the time of the enactment of the 16th Amendment in 1913, and that damages for emotional distress are similar to physical damages in that they are a return of damaged "human capital" and not an asccession to wealth, the Circuit Court held that Section 104(a) is unconstitutional to the extent "it permits the taxation of an award of damages for mental distress and loss of reputation."

This finding has far reaching consequences in the area of employment law, where damages often relate to mental distress without any physical sickness or illness.