Expanded Methods to Determine Public Charity Status

The Pension Protection Act of 2006 imposed important limitations on private foundations that make grants to public charities that are Section 509(a)(3) supporting organizations. Prior to these limitations, such grants were qualified distributions under Code Section 4942 (and thus such grants helped the foundation meet its minimum distribution requirements) and were not taxable expenditures under Code Section 4945 (which would be subject to a penalty excise tax). This may not be the case now, depending on the type of supporting organization that is involved and other factors. Many private foundations now seek to avoid distributions to supporting organizations entirely, to avoid running afoul of the new provisions. Distributions to supporting organizations from donor advised funds can also run into similar problems.

The IRS has made it a little easier for a private foundation to find out whether a recipient organization is a supporting organization. Previously, the IRS allowed a grant making private foundation to determine the supporting organization of a grantee by reviewing:

1. The IRS determination letter of the recipient organization can be reviewed. If one is not available, an updated one can be obtained from the IRS (1-877-829-5500)
   
2. The IRS Business Master File (BMF) can be reviewed online.
   

However, it is not easy to use the IRS BMF. In recognition of this, the IRS now allows taxpayers to acquire this information from third parties who access the IRS database. If a grant making organization receives a written report that contains required information from a third-party provider, the organization is allowed to rely on that report.

One major provider of these reports (for a fee, of course) is Guidestar (http://www.guidestar.org).

IRS EO Update , Issue Number 2007-8

GUIDANCE COMING ON DEDUCTIBILITY OF INVESTMENT FEES BY TRUSTS

Since the early 1990's, taxpayers and the IRS have been battling over the issue whether investment advisory fees paid by a trust are fully deductible, or deductible only to the extent that they exceed 2% of the trust's adjusted gross income (AGI). Taxpayers assert that the 2% limitation does not apply, due to Code Section 67(e)1) which provides that costs paid or incurred in connection with the administration of a trust that would not have been incurred if the property was not held in the trust are fully allowed as deductions in arriving at adjusted gross income.

The IRS and various court opinions are at odds as to the proper interpretation of the law. Acting in its role as arbiter of these conflicts, the U.S. Supreme Court agreed on June 25 to take on the issue, and hopefully provide the final word.

William L. Rudkin Testamentary Trust u/w/o Henry A. Rudkin, Michael J. Knight, Trustee (CA 2 10/18/2006), cert granted 6/25/2007

ATTRIBUTING A TRADE OR BUSINESS FROM A PARTNERSHIP OR LLC FOR SECTION 355 PURPOSES

Usually, if a corporation distributes the stock of a corporation it owns, it will be taxed on any appreciation in the value of that stock over its basis for tax purposes. The shareholders of the distributing corporation may also recognize income or gain on the receipt of the distributed stock. However, Code Section 355 will allow a corporation to distribute a controlled corporation to its shareholders without either the distributing corporation or its recipient shareholders from recognizing gain.

One of the requirements for nonrecognition treatment is that the distributing corporation and the controlled corporation must each be engaged, immediately after the distribution, in the active conduct of a trade or business that has been carried on for the previous 5 years. In circumstances when the active trade or business is owned in a partnership or limited liability company (LLC) taxable as a partnership, under certain circumstances, the active trade or business will be imputed to the distributing or controlled corporation for purposes of meeting the 5 year active trade or business test. Under prior rulings and proposed regulations, a "look-through" for this purpose is allowed if (a) the corporation has a significant interest in the partnership (which means it owns at least 1/3 of the partnership or LLC interests), AND (b) the corporation performs active and substantial management functions for the partnership or LLC with respect to the trade or business assets or activities.

Under a recently issued Revenue Ruling, the IRS has liberalized the look-through rules. Under the new rules, there are now two different ways to qualify for look-through treatment. First, a corporation can impute the trade or business activities of the partnership or LLC if it has a "significant interest" in the partnership or LLC – for this purpose, a "significant interest" is a 1/3 or greater ownership interest. The second way is if the corporation owns less than a significant interest, but performs active and substantial management functions for the partnership or LLC.

The new Revenue Ruling applies to an LLC that is taxable as a partnership. There is no reason that these rules should not also apply to an actual partnership.

These concepts appear to have been borrowed from the continuity of business enterprise rules in the corporate reorganization area, which apply similar requirements of "significant interest" and/or active and substantial management functions in regard to qualifying the continuity requirements by reason of a look-through for a partnership or LLC.

Rev Rul 2007-42, 2007-28 IRB

SCHOOL SUPPLY SALES TAX HOLIDAY RENEWED [FLORIDA]

Floridians enjoyed a sales tax exemption on hurricane supplies earlier this month. The Florida has renewed another favorite holiday, this time for school supplies. The exemption will save a few dollars for students, their parents, and people who like to buy school supply items.

The holiday will run from August 4, 2007 through August 13, 2007. Sales tax will not be collected on the sale of books, clothing, wallets, or bags (including: handbags, backpacks, fanny packs, and diaper bags, but excluding briefcases, suitcases, and other garment bags) having a sales price of $50 or less per item. The sale of school supplies having a sales price of $10 or less per item is also tax exempt during this period. the exemption will not apply to sales within: (1) a theme park or entertainment complex; (2) a public lodging establishment, such as a hotel or motel; or (3) an airport.

APPLICABLE FEDERAL RATES - JULY 2007

July 2007 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.91% (4.78%/June -- 4.79%/May -- 4.84%/April)

-Mid Term AFR - Semi-annual Compounding - 4.89% (4.59%/June -- 4.57%/May -- 4.56%/April)

-Long Term AFR - Semi-annual Compounding - 5.09% (4.85%/June -- 4.84%/May -- 4.75%/April)

DIRECTION OF RATES: Up

LOTTERY CASE ILLUSTRATES GROSS ESTATE ANNUITY INCLUSION RULES

Lottery cases are often interesting for how they illustrate the application of various tax provisions in an unusual context. A recent tax case relates to the valuation of lottery payments at death.

Mildred Lopatkovich and Mary A. Susteric jointly won a lottery with one other person in Ohio. Their luck ran out and each died about 10 years later when 15 payments remained. Their estates converted the lottery payment obligations into one lump sum payment based on the rules of the Ohio Lottery Commission, and reported the value of the lottery assets at the conversion value.

The IRS audited the returns, and instead valued the lottery assets using the IRS annuity tables. This resulted in over a 20% increase in the reported values, with resulting higher estate taxes. The estates disagreed, and the case ended up in U.S. District Court.

There is a split in the federal Circuit Courts of Appeal as to whether the IRS annuity tables have to be used to value annuity-type payments, or whether other valuation methods are permissible. The District Court noted that the tables must be used to value the lottery payments unless it is shown that the result is so unrealistic and unreasonable that either some modification in the prescribed method should be made, or complete departure from the method should be taken, and a more reasonable and realistic means of determining value is available. The court emphasized that a lack of transferability of an annuity could affect its value. Given that the Ohio rules impacted the value that could be received for the lottery assets, the court found that the estates successfully demonstrated that the value ascribed by the annuity tables was “unrealistic and unreasonable.” The court ordered further proceedings to give the estate an opportunity to show that there was a more reasonable and realistic means to determine the fair market value of the remaining lottery payments.

Negron v. U.S., (DC Oh 6/4/2007)

ESTATE TAX ON RETAINED TRUST INTERESTS – PROPOSED REGULATIONS ISSUED

Section 2036 subjects the estates of trust grantors to federal estate tax when those grantors transfer interests to a trust and retain income or other distribution interests, and then die before such interests expire. For many types of trusts, there is some uncertainty on how much of the trust property is subject to estate tax in the estate of the deceased grantor.

The Treasury Department has now issued proposed Treasury Regulations that provide a mechanism for computing how much of the trust assets are subject to estate tax under these circumstances.

The rules apply to numerous special types of trusts used by estate planners. These include charitable remainder annuity trusts (CRATs), charitable remainder unitrusts (CRUTs) grantor retained annuity trusts (GRATs), grantor retained unitrusts (GRUTs), and various other forms of grantor retained income trusts (GRITs), qualified personal residence trusts (QPRTs) and personal residence trusts (PRTs). The proposed Regulations generally adopt the methodology previously provided by Revenue Ruling that addressed such inclusion for CRATs and CRUTs. The proposed Regulations would include in the grantor's gross estate so much of the trust assets as would be needed, using applicable interest rates at the date of death, to yield the annual payment due to the grantor under the trust.

The proposed Regulations also make reversionary interests in GRATs less attractive (that is, provisions which require that if the grantor dies during the term of the GRAT the GRAT assets are paid to the grantor's estate) - since such a reversion will likely result in 100% gross estate inclusion for a death during the term of the GRAT, and a nonreversionary interest GRAT can use the Regulations to exclude a portion of the appreciation from estate tax inclusion, reversionary interests are now less favored.

Prop Reg § 20.2036-1 , Prop Reg § 20.2039-1

ALIMONY ALLOWED WITH LEGAL OBLIGATION TO PAY

Ex-spouses making payments to their former spouse like to have them characterized for tax purposes as "alimony." If qualified as alimony, the payor gets to deduct the payment, and the recipient has to include the payment in income.

Under prior law, to be qualified as alimony, a payment had to be paid pursuant to a legally enforceable obligation. In a recent Tax Court case, Daniel Webb was subject to a court order that any payments he made would be includible in the income of his former spouse, but he was not obligated to make any payments under the order. Daniel did make payments, and deducted them as alimony. The IRS objected, claiming that since the payments were not a legally enforceable obligation, they did not qualify as alimony and he could not deduct them.

The Tax Court sided with Daniel and found the payments to be alimony. The Court noted that the "legally enforceable obligation" requirement had been removed from the law in 1984. Further, that requirement was also removed from the regulations issued by the Treasury Department. Thus, there no longer is any requirement for a legally enforceable obligation.

Note that another prerequisite for alimony treatment is that the payment is made under a divorce or separation instrument. The Tax Court found that the order described above qualified as this instrument, presumably since it referred to payments that might be made. Therefore, purely voluntary payments from one ex-spouse to the other that are not referenced at all in such an order or agreement may not be able to take advantage of the Tax Court's pronouncement in this case. Also, since the case is only a summary opinion, it has limited precedential value.

Webb, TC Summary Opinion 2007-91

SATISFYING A PARTNERSHIP GUARANTEED PAYMENT OBLIGATION WITH APPRECIATED PROPERTY

Under Code Sec. 731(b) , no gain or loss is recognized to a partnership on a distribution to a partner of property, including money. Well, not all the time, apparently.

In Revenue Ruling 2007-40, a partnership owed its partner a guaranteed payment of $800,000. To satisfy its obligation, it transferred a parcel of property worth $800,000, but with an adjusted tax basis of $500,000 to the partner. The IRS held that the partnership incurred $300,000 in gain on the transfer, applying the general income tax principle that a taxpayer recognizes gain when it satisfies an obligation with appreciated property.

Rev Rul 2007-40, 2007-25 IRB

WHEN IS A COOPERATIVE UNIT CONSIDERED HOMESTEAD? [FLORIDA]

Well, that depends whom you ask. Or maybe it depends on for what purpose.

Florida homestead law has three general applications. First, homesteads may qualify for an exemption from ad valorem taxes. Second, they may be protected from forced sale by creditors. Third, there are specific rules governing the descent and devise of homestead.

Florida does treat cooperatives as homestead for ad valorem tax purposes.

Thirty years, ago, the Florida Supreme Court held in Re Estate of Wartels v. Wartels, 357 So. 2d 708 (Fla. 1978), that a cooperative apartment may not be considered homestead property for the purpose of subjecting it to Florida Statutes regulating the descent of homestead property. However, the 5^th District Court of Appeals subsequently held that a cooperative apartment would be considered homestead for purposes of the protection against forced sale. S. Walls, Inc. v. Stilwell Corp., 810 So. 2d 566 (Fla. 5th DCA 2002) . This result was reached even though the definition of homestead for both descent and distribution purposes, and for the protection against forced sale, is found in the same provision of the Florida Constitution.

In a recent case before the Second District Court of Appeals, the issue again came up as to whether a cooperative apartment is homestead for purposes of descent and distribution. The argument was raised that subsequent change in Florida statutory law in regard to cooperative units necessitated a change in status from the determination in Wartels. The 2^nd DCA found itself bound by Wartels and held the cooperative apartment was not homestead for descent and distribution purposes.

Nonetheless, the court did certify the issue to the Florida Supreme Court for its consideration as being in conflict with the Walls decision. While the current case dealt with homestead for descent and distribution purposes, and Walls dealt with the exemption against forced sale, since both provisions rely on the same constitutional definition of homestead, the court stated that the definitions cannot be different and thus finds its decision to be in conflict with Walls.

PEGGY ANN PHILLIPS, et al., Appellants, v. JANICE HIRSHON, etc., et al., Appellees. 3rd District. Case Nos. 3D05-620 and 3D05-619. L.T. Case Nos. 04-0429, 03-2199, 04-0430. May 2, 2007