INTERESTING DISREGARDED ENTITY CASE

A recent tax case involving a disregarded entity was interesting to read – not so much for the result but for the business of the taxpayer.

First, about the case. The taxpayer in the case was the sole member of a Connecticut limited liability company. As a single member LLC, the LLC was "disregarded" for federal tax purposes. As such, its individual member was required to report on its own tax return the tax income and expenses.

The LLC did not pay its federal payroll taxes. Due to that failure, the IRS assessed those taxes against the sole member since the LLC was a disregarded entity. The owner claimed he was not responsible for the LLC payroll tax obligations based on provisions of Connecticut law that a member of an LLC is not responsible for the obligations of the LLC.

The 2^nd District Court of Appeals predictably held that the member was responsible for the taxes. The Court noted that the member "could have had the benefit of limited personal liability if he had simply elected to have his LLC treated as a corporation; he chose not to do so and thereby avoided having the LLC taxed as a separate entity. We know of no provision, policy, or principle that required the federal government to allow him both to escape personal liability for the taxes owed by his sole proprietorship and to have the proprietorship escape taxation as a separate entity." The Court also noted that courts have already recognized other areas of tax law where tax obligations of an entity may be imposed on an owner notwithstanding limitation of liability provided under State law.

So what was interesting about the business of the taxpayer? It was an accounting firm – probably the last people you would expect to believe that a member could have disregarded status for computation and payment of some federal taxes while having no personal liability for other federal taxes of the entity.

McNamee v. Dept of Treasury, 2007 U.S. App. LEXIS 12016 (2nd Cir. 2007).

JUDICIAL REVIEW OF INTEREST ABATEMENT REQUESTS

While the Internal Revenue Code allows for the avoidance of penalties at times (e.g., if the taxpayer acted reasonably), interest on late payment of taxes generally cannot be removed or abated. An exception exists if the IRS, in its discretion, determines to abate interest for a tax deficiency or a delay in making a tax payment to the extent such failure or delay is attributable to an officer or employee of the IRS. IRC Section 6404(e).

In 1996, under the Taxpayer Bill of Rights II, Congress gave the Tax Court jurisdiction to review interest abatement denials for abuse of discretion. Since then, various courts have been split on whether the Tax Court is the exclusive court for such reviews, or whether federal district courts or the Claims Court can also review such denials. Due to the split, the U.S. Supreme Court took on the issue to resolve the uncertainty.

In Hinck v. U.S., 99 AFTR2d 2007-986 (2007), the Supreme Court has indicated that the Tax Court is the ONLY court with jurisdiction to review such interest abatement determinations for abuse of discretion.

TAX PROVISIONS HIDDEN IN MINIMUM WAGE LEGISLATION

In passing an increase in the federal minimum wage, Congress also enacted some new tax law provisions. The Small Business and Work Opportunity Tax Act of 2007 includes provisions on the following subjects:

• An expansion of the kiddie tax rules to apply to children age 18, and children over age 18 but under age 24 who are full-time students—if their earned income doesn't exceed one-half of the amount of their support. The kiddie tax can result in such children being taxed at the effective tax rate of their parents on their unearned income.
  
• Expensing under Section 179 is increased from a maximum of $100,000 to $125,000.
  
• Significantly increases the penalties on tax return preparers if the return contains an "unreasonable position" or "willful or reckless conduct."
  
• A qualified joint venture conducting a trade or business that is owned solely by a husband and a wife in which they both materially participate can avoid partnership classification and instead be effectively treated as a disregarded entity.
  
• Interest expense that is paid or accrued on debt incurred to acquire S corporation stock is taken into account in determining the income of the S portion of an Electing Small Business Trust (ESBT) under Subchapter S. Thus, the deduction for interest on the debt incurred to acquire the S stock is taken into account in determining the taxable income of the S portion of the ESBT.
  

A modification to the qualified Subchapter S subsidiary rules that limits the gain that the S corporation shareholders take into account on sales of more than 20% interests in QSubs to the gain on the percentage sold, rather than the gain on 100% of the QSub stock.

IDENTITY THEFT – THE NEW FRONTIER

Most of us are aware of the modern scourge of identity theft – either as victim or by the numerous articles and consumer alerts on the subject. What many may not be aware of is the new frontier of identity theft – stealing the identity of deceased persons.

Identity thieves purportedly watch the obituary pages, looking for enough information to open credit card accounts or otherwise engage in identity theft. Since the decedent isn't around, the responsibility for protecting the decedent's estate from such theft falls to the decedent's executor or personal representative.

There are some things that the executor/personal representative (or the attorney for the estate) can do to reduce the risk or effects of identity theft. These include:

• Closing all known charge card and credit card accounts as soon as possible;
  
• Advise the applicable state Department of Motor Vehicles of the death, and request that no duplicate drivers' licenses be issued;
  
• Send copies of the decedent's death certificate to the big three credit reporting bureaus (Experian, TransUnion, and Equifax);
  
• Limit personal information in the obituary that is useful to identity thieves, such as addresses and dates of birth.
  

When identity theft is suspected, obtaining a credit report from the credit reporting bureaus will confirm most instances and provide information to limit damages.

APPLICABLE FEDERAL RATES - JUNE 2007

June 2007 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.78% (4.79%/May -- 4.84%/April -- 5%/March)

-Mid Term AFR - Semi-annual Compounding - 4.59% (4.57%/May -- 4.56%/April -- 4.8%/March)

-Long Term AFR - Semi-annual Compounding - 4.85% (4.84%/May -- 4.75%/April -- 4.95%/March)

DIRECTION OF RATES: Mixed

TRUST INTEREST IMMEDIATELY VESTS [FLORIDA]

Trusts regularly provide for who will succeed to trust assets at the death of the current beneficiary. What happens if the named recipient of the trust assets lives to the event giving rise to his or her interest (such as the death of the prior trust beneficiary), but dies before he or she receives all of the trust assets?

In a recent Florida case, the dispositive provision read: "Distribution to Grandson: Upon my death, the then balance of principal and accumulated income remaining in the trust fund shall be distributed to my Grandson, ROBERT R. BIZZELL, if he is living at the time of distribution. If he is not living at the time of distribution then the said trust fund shall be divided into equal shares and distributed, one share to each child who survives me and one share for each child who may then be deceased, leaving descendants then surviving, to be distributed to such descendants, per stirpes." The grandson, Robert Bizzell, survived the settler of the trust, and thus was entitled to receive the remaining trust assets at the death of the settler. However, the grandson himself passed away before all the trust assets were distributed out to him.

A dispute then arose as to who should receive the undistributed trust assets. One of the disputants was a person who would receive the grandson's assets from his estate, treating the undistributed assets as owned by him for this purpose and applying the intestacy rules (which person was Bizzell's half-sister). The other disputants were those who would have received the assets under the above clause as if the grandson had not survived the settler at all (which persons were lineal descendants of the settler). The half-sister argues that the grandson's interest vested immediately at the death of the settler, and thus his estate and his heirs under the estate were entitled to the trust assets that were due to be distributed to him when he died. The lineal descendants of the settlor instead argued that only the trust assets distributed through the date of death belonged to the grandson's estate, and no vested interest arose in the undistributed assets.

The trial court ruled in favor of the half-sister. The appeals court, in reviewing the law, noted that the law favors early vesting of estates. It further indicated that any doubt as to whether an interest is vested or contingent should be resolved in favor of vesting. Applying these rules, the appellate court upheld the trial court ruling, and held the undistributed trust assets vested at the death of the settlor with the grandson, and thus the grandson's heirs succeeded to those undistributed trust assets at his death.

The result in the case is not remarkable. However, it is always comforting to see a case confirm a common understanding of the law, especially as to an issue such as this that comes up regularly in trust drafting and administration.

Bryan v. Dethlefs, 34d DCA ,Case No. 3D06-2360.

NO PARTIAL DEDUCTION FOR PREPAID SERVICES

Accrual basis taxpayers can generally deduct liabilities incurred when (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability. For taxpayers that prepay a liability for services before services are actually provided, the requirement of economic performance can be a bar to deductibility until those services are actually performed.

This rule is softened by the 3 ½ month rule and 8 ½ month rule. The 3 ½ month rule provides that a taxpayer is allowed to treat services or property as provided to it as the taxpayer makes payment to the person providing the services or property, if the taxpayer can reasonably expect the person to provide the services or property within 3 ½ months after the date of payment (per Treas. Reg. §1.461-4(d)(6)(ii) ). Under the 8 ½ month rule, if the liability is recurring in nature, economic performance occurs on or before the earlier of (i) the date that the taxpayer files a return (including extensions) for the tax year, or (ii) the 15th day of the ninth calendar month after the close of the tax year (i.e., 8 ½ months), and certain other requirements are met, the liability can be deducted before economic performance occurs (Code Sec. 461(h)(3) ; Treas.Reg. § 1.461-5(b)(1))

Some taxpayers have deducted expenses relating to prepaid services that are only partially performed within the requisite 3 ½ month or 8 ½ month period. The IRS Chief Counsel has now indicated that this is inappropriate, and that the two special rules are all or nothing rules. If the services are fully performed within the requisite time period, the deduction is allowed. If they are only partially performed, then no deduction (and not a partial deduction) will be allowed.

EMISC 2007-009

IRS PROVIDES GUIDANCE ON CIRCULAR 230 PENALTIES

Circular 230 is a set of rules for attorneys, CPA's, and other tax practitioners, relating to tax shelter issues, tax opinions, and standards for issuing tax advice. These rules aim to reduce the practice of issuing aggressive tax opinions that taxpayers can then rely upon to avoid penalties.

Practitioners who violate these rules may be suspended or disbarred from practice before the Internal Revenue Service. They may also be subject to monetary penalties.

In Notice 2007-39, the IRS provided some guidance on the monetary penalties. The Notice provided:

• The MAXIMUM monetary penalty that the IRS may impose is the collective gross income derived by the practitioner and the employer, firm, or other entity in connection with the prohibited conduct
  
• The Secretary has discretion to impose a monetary penalty in an amount less than the amount allowed by statute;
  
• In general, the Service will not impose monetary penalties in cases of minor technical violations, when there is little or no injury to a client, the public, or tax administration, and there is little likelihood of repeated similar misconduct.
  
• The IRS may also impose monetary penalties against an employer, firm, or other entity, if the practitioner was acting on its behalf in connection with the prohibited conduct giving rise to the penalties and the employer, firm, or other entity knew, or reasonably should have known, of the prohibited conduct.

The Notice provides details on when an employer will be liable to penalty for violations by an employee. Since taking reasonable steps to ensure compliance with Circular 230 by employees can help insulate the employer from penalty, all employers should be instructing their employees on Circular 230 particulars and monitoring compliance to minimize their exposure to penalty.

FORM 990-T PUBLIC DISCLOSURE RULES

Section 501(c)(3) organizations generally must make copies of their federal tax return available to members of the public. Under the Pension Protection Act of 2006, this public disclosure has been extended to their Forms 990-T, relating to reporting of unrelated business taxable income incurred by Section 501(c)(3) organizations.

In Notice 2007-45, the IRS has advised taxpayers how to comply with the new requirement. Highlights of the Notice include:

· All charities that file Form 990-T are required to make the return public. For example, although churches are not required to file Form 1023 or Form 990 with the IRS, they are required to file the Form 990-T with the IRS to report unrelated business taxable income. Thus, churches are required, under this notice, to disclose Form 990-T to the public.

· Forms 990-T should be disclosed in the same manner as required under existing rules for Forms 990.

· Proper internet posting of the Form 990-T will absolve the organization from having to provide copies directly to persons that request a copy.

VACATION!

For anyone wondering if something was amiss on this blog last week, the answer is no – I was away on vacation, including a vacation from all things tax. Looking over the tax news of the week, it was fairly quiet, so it doesn't look like anything significant went unreported.

FORM MATTERS

Section 1035 of the Internal Revenue Code allows a taxpayer to swap an annuity contract for another annuity contract without incurring income or gain. The contracts exchanged must relate to the same insured and the obligee(s) under both contracts must remain the same.

The statute works fine when the taxpayer directly swaps one contract for another, even though the cash value of one contract is applied to the new annuity. Such swap will often be accomplished by an assignment of the old annuity contract to the company issuing the new annuity. Alternatively, the cash value of the old contract may be directly transferred by its issuing company to the issuer of the new annuity.

In Rev.Rul. 2007-24, the owner of an annuity requested that the issuer of his annuity send funds directly to the issuer of a new annuity from his old annuity contract. The first issuing company refused, and instead mailed the owner a check for the value of his annuity contract. The owner, seeking to come within Section 1035, did not deposit the check into his own account. Instead, he endorsed it over to the new issuing company.

The IRS ruled that this indirect swap was ineffective for purposes of Section 1035. Instead, since the owner received a check for the value of his old contract, this will be taxable to him as an annuity distribution under Code Section 72(e).

You never know when the IRS will be lenient when a taxpayer follows the substance of an exemption or reduction provision, but doesn't quite exactly follow the form. Nonetheless, it is generally true that for exemptions from gain or loss on exchanges of items to apply, the IRS usually does not like to see cash pass through the hands of the exchanging party, and thus will hold the taxpayer to the exact form of their transaction instead of applying a more liberal "substance over form" argument.