MANAGEMENT FEES AS RETAINED INCOME RIGHTS UNDER SECTION 2036

Oftentimes, a taxpayer may transfer assets to a partnership or corporation, and either concurrently or later will gift interests in the entity to family members or trusts for family members. Sometimes, the transferor has no ownership interest in the transferee entity, and the funding transaction is treated as a gift. As part of the overall planning, the transferor will be employed by the transferee entity as a manager or some other function and thus will receive payments from the entity.

For some of these transactions, the IRS may interpret the compensatory income paid to the transferor as a retained income interest under Code Section 2036(a). If that is the case, at the transferor’s death the transferred assets may be subject to estate tax even though the transferor has no (or a reduced) ownership interest in them. The overall concern of the IRS is that the transferor gave away the assets to remove them (and future growth) from estate tax at his or her future death, but in effect retained the economic benefits from such transferred assets by being paid a management or other ongoing fee from the transferred assets or business.

To avoid Code Section 2036(a) inclusion, an effort should be made to establish the bona fides of the compensatory arrangement. As is often the case, some taxpayers do this better than others. A recent family limited partnership case provides instruction on how NOT to handle such arrangements.

In Korby v. Comm., 98 AFTR 2d 2006-8115, (CA8 2006), the taxpayer and his wife transferred assets to a living trust, and then into a limited partnership. The living trust was a 2% general partner, and the 98% limited partnership interests were eventually gifted to family members. Over time, the living trust received distributions from the partnership as ostensible “management fees.” The IRS challenged the arrangement, asserting that the compensatory arrangement was instead a retained Code Section 2036(a) right to income of the transferred assets, and sought to include the assets of the partnership in the estate of the taxpayer when he died.

Both the Tax Court and the appellate court agreed that the compensatory arrangement was not bona fide. The particular items that the courts noted in reaching their decision were:

a. The lack of a written management contract;

b. The lack of records as hours spent on managing the partnership;

c. The haphazard timing and amounts of payments; and

d. The failure of the recipient to report the payments as self-employment income.

Therefore, the case is instructive in reminding us about items that should be addressed in planning for bona fide compensation arrangements - a written agreement, proper record keeping, and reporting of such income as compensatory for employment tax purposes.

SPECIAL RULES FOR PAPER FORM 1040 FILERS

Under the recently enacted Tax Relief and Health Care Act of 2006, Congress revived and extended the income tax deductions for state and local sales tax, higher education tuition and fees, and educator expenses. Since these deductions were not in the law when the 2006 Forms 1040 were prepared, taxpayers who use paper forms must be diligent to avail themselves of these deductions since there will not be lines on the forms to remind them. Presumably, computer return preparation programs will be updated in a timely manner to assist their users in properly filing for these deductions.

For paper filers, the IRS is advising taxpayers to make the following modifications to their returns to properly file for these deductions:

STATE AND LOCAL GENERAL SALES TAX DEDUCTION. The deduction for state and local general sales taxes will be claimed on Schedule A (Form 1040), line 5, “State and local income taxes.” Enter “ST” on the dotted line to the left of line 5 to indicate you are claiming the general sales tax deduction instead of the deduction for state and local income tax.

HIGHER EDUCATION TUITION AND FEES DEDUCTION. Taxpayers must file Form 1040 to take this deduction for up to $4,000 of tuition and fees paid to a post-secondary institution. It cannot be claimed on Form 1040A. The deduction for tuition and fees will be claimed on Form 1040, line 35, “Domestic production activities deduction.” Enter “T” on the dotted line to the left of that line entry if claiming the tuition and fees deduction, or “B” if claiming both a deduction for domestic production activities and the deduction for tuition and fees. For those entering “B,” taxpayers must attach a breakdown showing the amounts claimed for each deduction.

EDUCATOR EXPENSE DEDUCTION. Educators must file Form 1040 in order to take the deduction for up to $250 of out-of-pocket classroom expenses. It cannot be claimed on Form 1040A. The deduction for educator expenses will be claimed on Form 1040, line 23, “Archer MSA Deduction.” Enter “E” on the dotted line to the left of that line entry if claiming educator expenses, or “B” if claiming both an Archer MSA deduction and the deduction for educator expenses on Form 1040. If entering “B,” taxpayers must attach a breakdown showing the amounts claimed for each deduction.

IR News Release 2006-195 12/22/2006

IRS AUDIT GUIDELINES ON MANUFACTURING DEDUCTION

Internal Revenue Code Section 199 provides a deduction to domestic manufacturers and producers. In 2006 this deduction is 3%, it increases to 6% for tax years beginning in 2007-2009, and will be 9% in later years, and is applied generally to net income from manufacturing and production (subject to a number of limitations, including that the deduction cannot exceed 50% of the taxpayer's W-2 wages for the taxable year). The IRS has issued a new Industry Director Directive, which, along with an associated document titled “Minimum Checks for Section 199; Law and Explanation,” details the minimum audit checks IRS examiners are expected to complete when reviewing a corporation's deduction.

While compliance with these guidelines will not ensure complete compliance with the requirements for the deduction, they are useful for taxpayers to make sure they are meeting the basic requirements and that they will clear the major audit hurdles. The following summarizes the guidelines and issues that the IRS will review on audit:

1. Does the taxpayer's business make sense with the activity requirements of the domestic production deduction? For example, most resellers (such as clothing stores and wholesalers) should not be claiming the deduction, nor should most professional service companies since they are selling their services even if in this process they provide a tangible item such as a legal document. Auditors are advised to review the corporation's web site and annual report, among other sources, in answering this question.

2. Compare the deduction to the gross receipts or sales less returns and allowances on line 1(c) of the Form 1120 (U.S. Corporation Income Tax Return). Gross receipts reported on line 1(c) of the 1120 should be greater then the deduction. If the gross receipts on the Form 8903 match the gross receipts on line 1(c) of the Form 1120, the taxpayer may have not allocated to non-DPGR nonqualified income amounts such as gross receipts for services or for resale items

3. Is the taxpayer required to allocate gross receipts to remove nonqualified embedded service income, or determine the qualified income portion of a component of an item? If so, how did the taxpayer determine an allocation method?

4. If the taxpayer is required to use the Code Sec. 861 method to allocate and apportion deductions has the taxpayer used it and is it consistent with the application of Code Sec. 861 for foreign tax credit purposes, if applicable? The Code Sec. 861 method must be used to allocate and apportion deductions if the taxpayer's average annual gross receipts exceed $100,000,000 or total assets at the end of the tax year exceed $10,000,000.

5. Has the taxpayer applied the wage and taxable income limitations? For example, under Code Sec. 199(b)(2)(B) , for tax years beginning after May 17, 2006, W-2 wages for Code Sec. 199 purposes only include amounts that are properly allocable to domestic production gross receipts.

While these issues apply only to the small subset of taxpayers who take the deduction, it is worth the effort of those that do to review these guidelines and assure compliance with them.

APPLICABLE FEDERAL RATES - JANUARY 2007

January 2007 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.82% (4.91%/December -- 4.83%/November -- 4.94%/October)

-Mid Term AFR - Semi-annual Compounding - 4.53% (4.68%/December -- 4.64%/November -- 4.76%/October)

-Long Term AFR - Semi-annual Compounding - 4.68% (4.84%/December -- 4.84%/November -- 4.96%/October)

DIRECTION OF RATES: Down

'D' REORGANIZATIONS WITHOUT A DISTRIBUTION OF SHARES

The corporate reorganization provisions of the Internal Revenue Code allow for corporate acquisitions, divisions, and other reorganizations to occur with no, or reduced, gain or loss on the transactions. These provisions facilitate the transfer of assets or ownership of corporations between and among corporations when the transaction qualifies as a sanctioned "reorganization."

IRC Section 368(a)(1)(D) generally treats as a qualified 'D' reorganization reorganization a transfer of assets from one corporation to another commonly controlled corporation. A requirement for 'D' treatment is that stock or securities of the transferee corporation must be distributed in pursuance of a plan of reorganization in a transaction that qualifies under Code Sec. 354 , Code Sec. 355 , or Code Sec. 356. However, even though the Code requires the transferor corporation to receive stock of the transferee corporation and distribute it to the shareholders of the transferor corporation, the IRS does not require this stock transfer when the two corporations are owned in the same identical manner, since the issuance and distribution of the stock would be a "meaningless gesture" - that is, because the stock transfer and distribution would not effect an actual economic change in ownership of shares.

The IRS has now issued Regulations that provide parameters and guidance for when the stock issuance required by the Code is not needed. The highlights of the new Regulations are:

-If the same person or persons own, directly or indirectly, all of the stock of the transferor and transferee corporations in identical proportions, the stock issuance and distribution requirements are treated as satisfied even though no stock is actually issued in the transaction.

-In determining whether the same person or persons own the stock of both corporations, attribution of ownership rules are applied. Under these rules an individual and all members of his family that have a relationship described in Code Sec. 318(a)(1) are treated as one individual.

-The above rules will operate, even if there is only a de minimis variation in shareholder identity or proportionality of ownership in the transferor and transferee corporations.

-Preferred stock described in Code Sec. 1504(a)(4) is disregarded for purposes of determining whether the same person or persons own all of the stock of the transferor and transferee corporations in identical proportions.

-When these rules apply, the Regulations provide that a nominal share of stock of the transferee corporation is treated as being issued, which share is then further treatedas being distributed by the transferor corporation to its shareholders.

See Treas.Reg. §1.368-2T.

WHEN IS A LEASE NOT A LEASE? [FLORIDA]

More particularly, when is a lease unenforceable? There are a number of ways that can arise, but one way is if the lease provides for automatic renewals at the option of the tenant forever, according to a Florida appellate court decision.

Daily Business Forms & Supplies, Inc. rented a building and land. Under the lease, it could renew it every two years (with a slight increase in rent), with no ending time period. Any future landlord would be bound by the lease. More particularly, the lease provided:

Lease to be for a period of two years beginning October 24, 2001. Tenant has option to renew for additional subsequent two year periods upon notification to landlord of tenant's desire to continue lease within 90 days of lease anniversary. If for any reason tenant terminates lease prior to anniversary date, tenant agrees to continue making monthly rental payments to landlord until such a time that the landlord rents the property, or the anniversary of the lease, whichever comes first. Tenant has the first option to purchase property if landlord determines that property is to be sold. If property is sold to any one other than tenant, lease is binding and transferable to new landlord. If tenant determines not to renew lease, tenant will notify landlord 90 days prior to lease renewal. The monthly rental amount for the first two-year period will be $650.00 per month. Upon lease extension being executed by tenant for an additional two-year period, rent will increase to $700.00 per month. Upon completion of first two year extension, and upon notification by tenant to landlord, lease agreement will automatically renew for subsequent two-year periods there after, with rental amount increasing by $50.00 per month, per anniversary, for as long as tenant desires."

The landlord brought suit to have the lease declared invalid as an unreasonable restraint on alienation. The rule against unreasonable restraints on alienation is founded entirely upon considerations of public policy, specifically, the idea that the free alienability of property fosters economic and commercial development. The test to be utilized with respect to restraints on alienation is the test of reasonableness. The validity or invalidity of a restraint depends upon its long-term effect on the improvement and marketability of the property.

In analyzing the issue, the appellate court noted that the lease would have the potential to forever prevent the landlord (and her successors) from being able to utilize the property for any purpose other than renting the property to the corporate tenant at a predetermined rate. The landlord would, however, remain obligated to pay the property taxes and the expense of properly maintaining the exterior of the property's structure -- regardless of the cost. Based on this, the court found an unreasonable restraint on alienation, and the lease was declared void.

LAVERNE PEAVEY, Appellant, v. RODNEY REYNOLDS AND DAILY BUSINESS FORMS, ETC, Appellees. 5th District. Case No. 5D05-3640. Opinion filed December 15, 2006.

NEW TAX BILL ON ITS WAY

The Tax Relief and Health Care Act of 2006 has passed both the U.S. House of Representatives and the U.S. Senate, and it is expected that President Bush will sign it into law. Perhaps a better name would be the Tax Break Bill of 2006, with most of the provisions relating to reinstatement of tax breaks that expired at the end of 2005, and further extensions and modifications of other tax breaks. The following is a list of some of the major provisions:

-The optional itemized deduction for state and local sales and uses taxes is extended through 2007;

-The above-the-line deduction for expenses of educators is extended through 2007;

-Charitable remainder trusts that earn unrelated business income will no longer lose their exempt status, but must pay a 100% excise tax on such unrelated business income;

-The above-the-line deduction for higher education expenses is extended through 2007;

-The 15-year straight line writeoff (instead of straight-line 39 year writeoff) for qualified leasehold improvements and qualified restaurant improvements is extended for 2 years;

-Some of the rules relating to Health Savings Accounts have been liberalized;

-The Tax Court is given authority to review equitable innocent spouse relief (written about previously);
-The research expense credit is extended for two years and modified for 2007;

-The work opportunity tax credit, relating to the hiring of members of certain target groups, are extended and modified;

-Various District of Columbia tax breaks are extended for two years;

-The new markets tax credit, relating to qualified equity investments to acquire stock in a community development entity is extended for one year and modified.

There are many more provisions, including a number energy credits, but are generally of narrow interest to small groups of taxpayers.

NOT ALL CONSUMER CREDIT COUNSELING ORGANIZATIONS ARE EXEMPT

Generally, organizations conducting "educational" activities can qualify as exempt from income tax under Code Section 501(c)(3). A number of organizations exist to educate consumers on how to deal with consumer credit. These consumers often have existing creditor problems, and the organizations educate them on how to work through their credit problems and how to better manage their finances to avoid future problems. Often these organizations also take a direct role with the consumers in working out existing creditor problems, including budgeting, individual counseling, and escrow and payment arrangements to help satisfy existing creditors. Such activities are not "educational," but when directed towards low-income individuals and families, they qualify as exempt as "charitable" by reason of relieving the poor and distressed.

There are a number of cases and rulings that confirm the availability of exempt organization treatment for such organizations. As is often the case with exempt organizations, the availability of exempt organization treatment attracts some taxpayers that will try to characterize what is really a "for-profit" venture into one that has enough exempt characteristics to obtain an exemption ruling. With the ruling, the organization avoids federal income taxes on its exempt activities, and contributors are eligible for a tax deduction for their contributions.

A recent private letter ruling illustrates such a failed attempt. It is instructive to note some of the facts that the IRS relied upon in denying Section 501(c)(3) status to the applicant:

-over 40% of activities were related to debt consolidation and management activities, for which the consumer being helped is charged a fee;

-there was significant advertising expenses for the sale of such debt management services;

-services are not limited to lower income persons, but are "sold" to the general public;

-while the organization claimed it would provide courses and seminars focusing on money management and budgeting, it failed to substantiate an educational methodology. Further, it did not provide specific information about its seminars (i.e. agenda, literature describing the seminars, and dates and times of the seminars), as well as how it would integrate these seminars into its operations. It also failed to budget funds for educational materials, workshops, or other educational, thus creating doubt whether it would really undertake such activities;

-creditors may make fair-share "contributions" to the organization, in reality because they benefit from the activities of the organization since it effectively helps them get paid on their consumer loans and credit (that is, the counseling organization acts as a debt collection agency);

-no evidence was presented that the organization received contributions from disinterested members of the public;

-there is a risk that private individuals will inure benefits from the organization, due to (a) high compensation paid to officers, and (b) a related entity for back office debt processing and software services.

There are a number of these organizations out there. With the ruling, the Services is reminding taxpayers that unless such organizations restrict their activities to education, and/or providing services at free or low-cost to low-income taxpayers, and do not seek to find methods of providing economic benefits to founders or related parties, obtaining exempt status for these types of consumer credit counseling services will be difficult.

Private Letter Ruling 200649035. See also Private Letter Ruling 200649033.

LEGISLATION PASSED TO ALLOW TAX COURT REVIEW OF EQUITABLE INNOCENT SPOUSE CLAIMS

There are a number of ways that a spouse can get relief from tax liabilities arising from a joint tax return. One method relates to a separate liability election under Code Section 6015(c). Another relates to qualifying for innocent spouse relief under Code Section 6015(b). Lastly, a spouse can seek equitable relief from the IRS under Code Section 6015(f).

Due to statutory changes made in 2001, the IRS has argued that its denial of equitable relief under Code Section 6015(f) is not subject to Tax Court review if no deficiency assessment was made in the particular case. A spouse may want to seek this equitable relief even in the absence of a deficiency assessment - for example, if the spouse was liable for tax declared on a joint tax return but which was not paid. There is case law support for the IRS' position of no Tax Court review in such circumstances.

To allow for review, on December 5 the House of Representatives passed by voice vote H.R. 6111, a bill allowing the Tax Court to review claims for equitable innocent spouse relief, and suspending the running of the limitations period while such claims are pending. This bill is identical to S. 3523, which was passed by the Senate by unanimous consent on Sept. 30, 2006. As a procedural matter, H.R.6111 will have to go back to the Senate for approval. Since the text is identical to S. 3523, it should easily be approved in the Senate and then sent to the President for his signature.

CHARITABLE CONTRIBUTIONS THROUGH PAYROLL DEDUCTIONS

To assist in charitable fundraising, many companies have payroll deduction programs. Under these programs, amounts are withheld by an employer from employee pay, and the funds are then paid over directly to the charity.

The Internal Revenue Code, as modified by the 2006 tax act, requires that a contributor obtain certain written forms of substantiation before a charitable deduction is allowed for the contributor. The IRS has issued rules that provide an acceptable method of substantiation for employee contributors who make their contributions through a payroll deduction plan.

A. Two items of substantiation, if both are obtained, will meet the statutory requirements. The first is a pay stub, Form W-2, or other document furnished by the employer that sets forth the amount withheld during a taxable year by the employer for the purpose of payment to a donee organization. The second item is a pledge card or other document prepared by or at the direction of the donee organization that shows the name of the donee organization.

B. If the amount paid over exceeds $250, the pledge card or other document prepared by the donee organization also must include a statement to the effect that the organization does not provide goods or services in whole or partial consideration for any contributions made to the organization by payroll deduction. This additional information is needed because of the additional substantiation requirements imposed on charitable gifts of $250 or more. Treas. Regs. Section 1.170A-13(f)(11)(ii) provides that the contribution amount withheld from each payment of wages to a taxpayer is treated as a separate contribution for purposes of applying the $250 threshold.

Notice 2006-110, 2006-51 IRB, 12/01/2006

9 GOOD REASONS FOR BUYING LIFE INSURANCE

Opinions on life insurance are all over the board. Some thing it is the greatest invention ever, while others are convinced it is a scam purely for the enrichment of life insurance agents and companies and refuse to consider it even when the facts cry out for it.

The truth lies somewhere inbetween. In the estate planning process, life insurance can provide substantial benefits at times, and at other times it is a waste of money and can actually be injurious to overall wealth planning and protection.
In defense of life insurance, here are 9 situations where life insurance can be a boon in the estate planning or family wealth management process:

1. REAL LACK OF LIQUIDITY IN THE CLIENT’S ESTATE. If a client’s assets are all tied up in illiquid assets, such as closely-held businesses, real estate, IRAs or deferred annuities, surviving family members will need the life insurance proceeds to pay estate taxes and for post-death living expenses. While the family can always sell those assets, adverse tax or economic consequences can result. Planning should be undertaken to avoid estate taxes on the insurance proceeds, and in selecting the proper beneficiary.

2. YOUNG COUPLE WITH CHILDREN AND PERHAPS SUBSTANTIAL DEBT. So as to assist in the repayment of debt, payment of education expenses, payment of child care expenses, and to allow for a comfortable existence for the survivor.

3. FUNDS TO REPLACE A VALUABLE EMPLOYEE. Both in your business, or perhaps within the family, such as a caregiver for an elderly family member.

4. PROVIDE CASH FOR A BUY-SELL AGREEMENT. Most co-owners of a business do not want to end up being partners with the spouse or children of a deceased co-owner. Insurance provides cash to buy out the interest of the deceased co-owner, and simultaneously provides funds to live off for the surviving spouse or family members.

5. PROVIDE REPLACEMENT FUNDS FOR CHARITABLE GIFTS MADE AT LIFETIME OR AT DEATH. Oftentimes, if the charitable gift occurs during lifetime, income tax savings can be used to fund the cost of the insurance. This is a win-win - more assets for charity without cost to the family (although the government loses out on tax dollars!).

6. USING LIFE INSURANCE TO DIRECTLY BENEFIT CHARITY.

7. PROVIDING FOR CHILDREN OF A PRIOR MARRIAGE. This type of gift to prior children may be easier to swallow for the surviving spouse since it doesn’t involve the transfer of assets in which the spouse may have developed an emotional or economic investment, especially if he or she does not have a great relationship with the children of the prior marriage. This type of gift also allows for the passage of assets to a spouse to obtain tax benefits (e.g., estate tax marital deduction, deferred IRA or pension plan payout options) while still providing for the children of the prior marriage.

8. TO COVER LIMITED ESTATE TAX EXPOSURE DURING TERM OF YEARS PLANNING DEVICES SUCH AS A QUALIFIED PERSONAL RESIDENCE TRUST OR GRANTOR RETAINED ANNUITY TRUST. These type of trusts provide estate tax benefits only if the grantor survives the term of the trust. To cover the risk of estate taxes for death before the end of the term, insurance can help.

9. A TAX-DEFERRED PRIVATE RETIREMENT POLICY. Value accumulates tax-free in a life insurance policy, similar to an IRA or pension plan. There are also ways to access the funds in the policy without current income taxes. Therefore, a properly structured policy can operate as a persona retirement plan.

Much of the foregoing was adopted from the presentation of L. Howard Payne of Sarasota, Florida for the Florida Bar CLE program "Something Old, Something New... Estate and IRA Planning in the 21st Century."