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Monday, October 30, 2006


Non-U.S. persons who receive interest income or dividends from U.S. payors are typically subject to a 30% tax. The person paying the interest or dividends to the foreign person (the "withholding agent") is obligated to withhold this tax from the interest or dividend payment, and pay it over to the IRS. If the withholding agent does not withhold the tax, the IRS can nonetheless hold the withholding agent responsible for the tax if the payee does not pay it.

There are exceptions to the withholding tax, such as the portfolio interest exception which exempts interest paid on certain qualified obligations from U.S. tax, and tax treaties which may reduce or eliminate the tax. Generally, the withholding agent must receive certain documentation, like a Form W-8, from the payee before the withholding agent is released from its obligation to withhold.

What happens if a withholding agent doesn't receive the proper documentation before it makes its payment, but it turns out that no tax was due? In what many perceive to be an unfair rule, a withholding agent who doesn't withhold will still be liable for interest on the tax not withheld, even though no tax is due. Treas. Reg. § 1.1441-1(b)(7)(iii).

Well, that used to be the case. In Notice 2006-99, 2006-46 IRB, the IRS has advised that it will be amending the Regulations to avoid the interest charge against the withholding agent if it turns out the payee owed no tax. The Regulations will also clarify that no penalties will be imposed against the withholding agent in that circumstance. The Regulations will be retroactive to January 1, 2001.

Friday, October 27, 2006


Taxpayers often gift away partial interests in family real property to other members - often as gifts of tenancy in common interests. These taxpayers do not expect that the interests that are gifted away will be subject to estate tax at the donor's death. However, a recent Tax Court case demonstrates that if the donor retains economic interests in the gifted interests, or continues to use the entire property, Section 2036 can result in estate tax inclusion of the entire property.

In Estate of Margot Stewart v. Commissioner, T.C. Memo 2006-225, a mother gifted away a 49% tenants in common interest in real property to her son. The transfer qualified as a completed gift for gift tax purposes. During the mother's remaining lifetime, she continued to live in the property, she received all of the rental income that the property generated, and paid most of the expenses of the property. Due to these facts, the IRS sought to include 100% of the value of the property in the mother's estate when she died. The taxpayers objected, but the Tax Court sided with the IRS and allowed the 100% inclusion.

The case is a demonstration of what NOT to do. Reverse the facts and you come up with some guidelines towards avoiding Section 2036 inclusion when a partial interest in property is gifted away, including:

-The donor should not continue to use the entire property, unless paying fair rent for the portion the donor no longer owns.

-Divide any rental income pro rata in accordance with the percentage ownership interests.

-Divide the expenses pro rata in accordance with the percentage ownership interests.

Wednesday, October 25, 2006


UPDATE: For more information on these issues, you can visit the website This is the website of Martin Kapp, the CPA who participated in the litigation before the IRS.
Internal Revenue Code Section 162(a)(2) allows a taxpayer to deduct traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while "away from home" in the pursuit of a trade or business. For purposes of Section 162, the term "home" generally means the taxpayer's principal place of employment and not where his or her personal residence is located.

Under the Sleep or Rest Rule, which has been developed in a series of tax cases to determine whether a taxpayer is away from home on short duration business trips, (a) if the nature of a taxpayer's employment was such that when away from home, during scheduled break times, it was reasonable for him to need and to obtain sleep or rest in order to meet the exigencies or business demands of his employment, and (b) the breaks were of sufficient duration to give rise to increased expenses, expenses for this purpose would be traveling expenses under Section 162(a)(2).

Marc G. Bissonnette was a ferryboat captain for a company that carried travelers on sea voyages to destinations on Puget Sound, Washington. The company's home port was in Seattle, Washington. He worked approximately 15- to 17-hour days on turnaround runs completed within 24 hours that each included a 6-hour layover at an away from-home port during off-season voyages and a 1/2- to 1-hour layover at an away from home port during peak-season voyages. He paid for his meals and incidental expenses while traveling, and sought to deduct them. The IRS challenged the deductions, asserting that the taxpayer was not "away from home" under the Sleep or Rest Rule.

The Tax Court made short shrift of the taxpayer's arguments as to the peak season trips. The layover on those trips was less than an hour. Noting that the released time must be of a sufficient duration that it would ordinarily be related to a significant increase in expenses, the meals taken during the short layover were found not deductible.

In regard to the off-season trips, the IRS argued that the longer rest period came about solely as a result of scheduling, rather than the taxpayer's need for sleep and rest, and thus should not be deductible. The Tax Court reviewed the facts and circumstances of the taxpayer's typical workday, and disagreed, noting that it was reasonable for the taxpayer to obtain sleep or rest in order to meet the exigencies and business demands of his employment. Further, the Court noted that the released time of 6 to 7 hours was sufficient in duration that it would normally be related to an increase in expenses. Consequently, the Tax Court allowed the meal expenses for the off-season trips.

Marc G. Bissonnette, et ux. v. Commissioner, 127 T.C. No. 10 (10/23/2006)

Sunday, October 22, 2006


November 2006 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.83% (4.94%/October -- 5.07%/September -- 5.19%/August)

-Mid Term AFR - Semi-annual Compounding - 4.64% (4.76%/October -- 4.95%/September -- 5.14%/August)

-Long Term AFR - Semi-annual Compounding - 4.84% (4.96%/October -- 5.14%/September -- 5.29%/August)


Friday, October 20, 2006


Under the substantial economic test, partnerships can generally allocate income and expenses between and among their partners as they like, provided that such allocations have a bottom line effect on the economic income or loss of the affected partners. Generally, an allocation of income or expense will be respected if (a) capital accounts are maintained as the IRS requires, (b) liquidation proceeds are distributed in accordance with capital account balances at the time of liquidation, and (c) provision is made for deficit capital account restoration obligations or qualified income offsets.

In newly issued regulations, the IRS indicated that compliance with these three requirements is NOT enough to uphold allocations of foreign taxes among partners. The IRS is concerned that foreign tax payments made by a partnership may be allocated to U.S. partners (who can make effective use of such taxes by obtaining a foreign tax credit for them that can be applied against U.S. income taxes) and away from foreign partners who cannot effectively use the foreign tax credit. To come within a safe harbor allocation under the new regulations, if the above three requirements are met an allocation of foreign taxes will be respected, but only if the allocation is also proportionate to a partner’s distributive share of the partnership income to which such taxes relate.

If an allocation cannot come within this safe harbor, the foreign taxes will be tested, and potentially reallocated, under the more general "partner interest" standard of Regs. §1.704 1(b)(3).

Preamble to TD 9292, 10/18/2006 ; Reg. § 1.704-1.

Wednesday, October 18, 2006


Under existing tax rules, an individual owning property can "sell" such property to a family member or entity owned or controlled by family members in exchange for a private annuity. A private annuity is generally an agreement to pay a fixed sum each year to the seller for a fixed term of years or over the remaining lifetime of the seller.

Such a sale achieves an important estate tax planning benefit, since it can remove an appreciating asset from the future taxable estate of the seller. Thus, estate taxes are avoided on the growth in value of the sold asset that might occur before death (although estate taxes may still be augmented by the seller surviving his or her life expectancy and thus receiving annuity payments in excess of the value of the sold property).

Such planning is facilitated by IRS treatment of the gain arising on such sale. More particularly, such gain can be deferred in part until annuity payments are received. Well, at least that was the case until now.

Under proposed regulations issued October 17, 2006, the IRS is proposing to disallow any deferral of tax on gain from such sales. Instead, if such a sale is undertaken, the seller will both realize and recognize the full amount of gain from the sale in the year of sale. The new provisions will not apply to "charitable gift annuities" under Treas. Regs. § 1.1011-2.

Such regulations, if finalized, would apply to exchanges of property for an annuity contract after October 18, 2006. They would not apply to amounts received after that date under annuity contracts arising from exchanges prior to that date. There also is a limited class of private annuity transactions that would not be subject to the new rules until after April 18, 2007.

Proposed Regulations §§1.72-6 and 1.1001-1.

Monday, October 16, 2006


A little background is needed to understand the impact of recently released Treasury Regulations relating to the tax basis of an interest in a partnership by a partner.

A. Partners in a partnership may receive additional tax basis in their partnership interests based on their allocable share of liabilities of the partnership itself. That is, if the partnership borrows money, a portion of that borrowing can be allocated to the partners and increase the income tax basis of the partners in the partnership. Tax basis can be relevant for many purposes - for example, basis is needed to be able to deduct losses arising from the partnership.

B. Very generally, a partner will be allocated so much of a partnership liability to the extent that the partner bears the ultimate risk of loss relating to the repayment of the partnership obligation.

C. What happens if the partner doesn't own an interest in the partnership directly, but holds its interest through a "disregarded entity" and the owner of the disregarded entity is not responsible for the liabilities of the disregarded entity? Does the owner of the disregarded entity get to increase its basis in the partnership (since the owner is treated as the deemed partner because the disregarded entity is disregarded for income tax purposes) to the full extent that it could if it was in the shoes of the disregarded entity? This is the subject of the recent Regulations.

The Regulations do allow the partner to stand in the shoes of the disregarded entity for purposes of calculating its share of the liabilities of the partnership to determine its adjusted basis as deemed partner. HOWEVER, the amount of maximum amount of partnership liabilities that can be taken into account for this purpose is limited to the net value of the disregarded entity.

The Regulations provide a specific definition for "net value" for use in applying these rules.

T.D. 9289, 10/10/2006 ; Reg. § 1.704-2 , Reg. § 1.752-2.

Friday, October 13, 2006


A recent Florida case involving the Carvel ice-cream family raised the issue whether a decedent's probate estate is an interested party in regard to accountings issued by a revocable trust of which the decedent was the settlor. That's a bit of a mouthful - let's break it down:

-individual establishes a revocable trust during lifetime and is thus the settlor;

-the individual settlor dies; and

-during the administration of the settlor's estate, the trust issues accountings.

Does the estate have a sufficient interest in the trust as to be a required party to proceedings involving the trust accounting?

The estate of the settlor on its face appears to have an interest, since under Florida law the trust, after the settlor's death, is liable for the expenses of administration and obligations of the decedent's estate to the extent the decedent's estate has insufficient assets to pay those items. In the case, the trust also directed payment of such estate expenses. Florida Statutes defines an interested person, for the purposes of wills and trusts, as “any person who may reasonably be expected to be affected by the outcome of the particular proceeding involved. In any proceeding affecting the estate or the rights of a beneficiary of the estate, the personal representative of the estate shall be deemed an interested person.” The question before the appellate court was whether the estate, by reason of the trust being responsible for estate expenses if estate assets are insufficient, was an interested person in regard to trust accountings.

Reversing the trial court, the appellate court found the estate to be an interested person, noting that the estate, while not an income or residual beneficiary, was an intended beneficiary of the trust.

Carvel v. Godley, 31 Fla. L. Weekly D2536e (4th DCA 10/11/06)

Wednesday, October 11, 2006


Internal Revenue Code Section 911 allows U.S. citizens and residents who have a tax home abroad and either reside in a foreign country or spend almost all of their time in a foreign country to either exclude from income or deduct from income (depending on whether an employer pays their employment costs) a portion of their foreign housing costs. Computing the maximum excludible or deductible amount takes one through a maze of computations and limitations - an exercise not worth reproducing here.

The IRS has issued Notice 2006-87, which addresses one of the limitations included in the computation. More particularly, one standard limitation in the computation is a maximum amount allowable for housing expenses under Code Section 911(c)(2)(A). The standard limit for these expenses under that part of the computation is $24,720 per year.

In a break for many taxpayers living abroad, Notice 2006-87 recognizes that housing costs are different throughout the world. It contains a table that identifies locations within countries with high housing costs relative to U.S. housing costs, and provides an adjustment amount that can result in an increase in the $24,720 figure. For example, the figure is adjusted upwards to a maximum of $85,700 (for an overall maximum limitation, after the remaining limitations are figured in, of $72,516).

Individuals whose locality is not included on the table must use the generally applicable $24,720 limitation.

This table will be updated each year.

Sunday, October 08, 2006


In calculating federal estate taxes, a deduction for funeral expenses is generally allowed. Code Sec. 2053(a)(1) provides for the deduction from the gross estate for such funeral expenses as are allowed by the laws of the jurisdiction under which the estate is being administered.

Michigan allows reasonable funeral and burial expenses as a charge against the estate. A recent Tax Court case involving a Michigan estate demonstrates how NOT to qualify for the deduction in regard to expenses of a post-funeral reception.

In Estate of Sarah Davenport, TC Memo 2006-215, the estate claimed total funeral expenses of $7,796, which included amounts paid for the funeral home, cremation, obituary notice, other items and a funeral luncheon costing $3,639. The IRS allowed all of the funeral expenses, except the amount paid for the funeral luncheon.

Neither the Code nor the regs define "funeral expenses." Reg. § 20.2053-2 states that "[a] reasonable expenditure for a tombstone, monument, or mausoleum, or for a burial lot, either for the decedent or his family, including a reasonable expenditure for its future care" and "the cost of transportation of the person bringing the body to the place of burial" are examples of deductible costs.

At trial, the Estate representatives testified that the purpose of the luncheon was in large part to thank family, teachers and professionals who worked with the decedent over the years. These individuals were invited to the funeral. The Tax Court determined that no deduction would be allowed for this type of reception.
Does this mean that post-funeral receptions will not be deductible in the future? Probably not, since there were a number of mistakes made by the estate in this case that may be overcome in other cases.

First, the Court noted that the "necessity" of the expense must be demonstrated. A purpose to "thank and recognize third parties for their support" did not demonstrate this necessity. A focus on eulogizing and laying to rest the deceased would have been more helpful and may have satisfied the Court.

Second, the Court noted that the "reasonableness" of the expense must be demonstrated. Here, the estate did not provide enough information to determine reasonableness. The Court noted that insufficient evidence was provided as to what the expended amounts were for - the Court did not know whether and how much was for for the venue, decorating, catering, entertainment, or a combination of supplies and services. It also did do not know who received the claimed payment or payments. If such information had been provided, the Court could then have ruled on reasonableness.

The Court also noted other facts that would have helped demonstrate "necessity" and "reasonableness" such as having the reception at the same location as the funeral service, and being able to demonstrate an overlap in attendance between the funeral service and the reception (elements that were absent in this case).

Consequently, even with this adverse case, future expenses for post-funeral events may still be allowable if the exact charges are provided, if they are reasonable, and the event has more of the traditional funeral focus so that "necessity" can be demonstrated.

Friday, October 06, 2006


An interesting case (Castle Harbour) came out earlier this year in regard to the age old dispute as to whether to characterize an investment in an entity as debt vs. equity. This case was discussed at length in the article Partner or Lender? Debt/Equity Issues Arise in Second Circuit's Reversal of Castle Harbour, By Richard M. Lipton and Jenny A. Austin in the October 2006 issues of the Journal of Taxation.

The characterization of debt vs. equity has significant income tax consequences. Usually, taxpayers desire the "debt" label since when the investment is paid back to the "lender," deductible interest may result to the entity. Further, such a payment will not be a taxable dividend if the entity is a Subchapter C corporation. The IRS usually finds itself on the other end of the dispute, arguing that the investment is equity, since this usually generates more overall income tax and is consistent with the maxim that the IRS will adopt the position in a matter that will generate the most tax.

What is interesting about the Castle Harbour case is that the usual roles were reversed - the IRS was arguing for "debt" treatment and the taxpayer was arguing for "equity." In making its argument for "debt" treatment, the IRS was making the arguments that taxpayers usually make. Since the IRS prevailed upon the appellate court to adopt its reasoning, the reasoning adopted by the appellate court can now be used AGAINST the IRS in future cases when the IRS is seeking its more usual "equity" characterization.

In determining whether an investment was debt or equity, the 2nd Circuit Court of Appeals indicated that the applicable test was whether the funds were advanced with reasonable expectations of repayment regardless of the success of the venture (indicative of debt) or were placed at the risk of the business (indicative of an equity investment). Here are some facts and arguments employed by the IRS and adopted by the Court that may be of use to future taxpayer litigants that are looking for "debt" treatment:

--The investor in the case would be allocated profits from the venture, albeit subject to a dollar cap. The Court noted that this could increase the investor's percentage return on its investment by almost up to 2.5%. Normally, the IRS would argue that such an equity kicker belies an equity investment. In the instant case, however, the court found that the additional 2.5% possibility of return was "a relatively insignificant incremental return" and nonetheless treated the investment as debt. Thus, the Court is leaving the door open to investors to allow for some equity upside (as long as it is not too substantial) and still obtain debt treatment.

--The Court concluded that an investment labeled as equity should be recharacterized as debt even when there was no fixed repayment date. This is another fact that will be of use to investors seeking debt treatment.

The article notes that in winning the case, the IRS gained extra tax revenue - but that the precedents established by the case may cost it many times that revenue in other cases.

TIFD III-E, Inc., 98 AFTR 2d 2006-5616 (CA-2, 2006), rev'g 342 FSupp 2d 94 (DC Conn, 2004).

Tuesday, October 03, 2006


The Pension Protection Act of 2006 provides a new method of financing the cost of long-term insurance policies, by combining them with life insurance and annuity policies and contracts. More particularly, the new allows for life insurance and annuity contracts to add long-term care insurance riders and use the cash value of the life insurance and annuity contract to cover the cost of long-term care insurance premiums without incurring taxable distributions. The new law also broadens Code Section 1035 to allow for tax-free exchanges of life and annuity policies into long-term care insurance contracts. The new provision does not come into effect right away - it applies only after 2009.

In effect, the long-term care insurance premiums can be paid from the cash surrender value and the untaxed build-up in value in the life insurance or annuity policy. Such payment is not treated as a distribution from the life insurance policy or annuity, which might otherwise be taxable to the owner.

There are some negative consequences to this treatment, which in many cases will negate the tax benefits. First, the payment of the premiums on the long-term care insurance is treated as a return of basis to the owner of the policy (but it will not reduce basis below zero). Since the owner may be taxed on future distributions from a life insurance policy that exceed the owner's basis, and the tax basis also measures the income of an annuitant from an annuity, such a reduction in basis may increase future income taxes. Second, the premium paid on the long-term care insurance will NOT be deductible under Code Section 213(a) as a medical expense deduction. Thus, if the owner had paid the long-term care insurance directly instead of through the life policy, he or she would not suffer the basis deduction, and may have a medical expense deduction.
There are circumstances where such negative attributes are not really a problem. For example, the long-term care insurance may not be of a qualified nature, in which case no medical expense deduction would be available anyway even if the premium was paid directly by the owner. Or, if a life insurance policy is held until the death of the insured and substantial pre-death withdrawals are not made, the loss of tax basis in the policy is a nonevent.
Therefore, the particular circumstances of the situation will need to be reviewed to see if there is a benefit in using this new provision.
Life insurance and annuity companies will be subject to information reporting so that the IRS can track the payment of such premiums.
Applicable Code Sections: 72(e)(11), 1035, 7702B(b), 7702B(e), 6050U(a)