NO NOL CARRYOVER TO SUBCHAPTER ‘S’ ESBT TRUST

A trust that owns stock in a Subchapter S corporation can elect to be taxed as an "electing small business trust" or "ESBT." Such an election is one method of avoiding the prohibition on trust ownership of Subchapter S corporation stock.

After making the ESBT election, the portion of the trust that owns the Subchapter S stock is taxed separately from the remaining portion of the trust. Code Section 641(c)(2)(C) limits the deductions and losses of the ESBT share to those that pass through to it as a shareholder of an 'S' corporation, losses from the disposition of the 'S' corporation stock, and a share of trust administration expenses.

What happens if the trust had a net operating loss attributable to the pass-through of 'S' corporation stock as of the time of its ESBT election? The Code is not entirely clear on whether the ESBT can deduct that NOL.

Code Section 642(h)(1) indicates that on the termination of a trust, the net operating losses of the terminating trust carry over to the beneficiaries receiving the assets of the terminating trust. Arguably, then, such losses should carry over to the ESBT trust as successor to the pre-ESBT trust. Since the losses came from the 'S' corporation, the limits under Code Section 641(c)(2)(C) on losses that are deductible by an ESBT perhaps should not apply.

In a recent Chief Counsel Advice, the IRS has indicated that the NOL cannot be carried over to the ESBT (although it can be used by the non-ESBT portion of the trust). The rationale of the Advice is that the Code Section 641(c)(2)(C) list of allowable ESBT deductions is the exclusive list of deductions, and that a Code Section 642(h)(1) NOL carryover is not included in that list (even though one could argue that it is included via Code Section 641(c)(2)(C)(i), relating to Subchapter S items described in Code Section 1366)).

Unless they feel strongly that the Advice is erroneous, practitioners should count as a "cost" to electing ESBT status the possible loss of prior NOL's attributable to the 'S' stock, unless those losses can effectively be used by the non-ESBT portion of the electing trust.

CCA 200734019 -- 08/24/2007

ENFORCEABILITY OF COHABITATION AGREEMENTS IN FLORIDA [FLORIDA]

A recent article in the Estate Planning Journal provides some recommendations on drafting cohabitation agreements for unmarried couples (Goffe, Wendy S., Preparing Effective Cohabitation Agreements for Unmarried Couples). Such agreements are similar to the prenuptial and post-nuptial agreements entered into by their married counterparts. Such cohabitation agreements typically address expense sharing, how income will be shared or separated, how assets will be titled, and what happens to property upon termination of the relationship.

As noted in the article, what may come as a surprise to many is that cohabitation between unmarried persons, if there is a sexual relationship involved, is illegal in the State of Florida. More particularly, Florida Statutes Section 798.02 provides: "If any man and woman, not being married to each other, lewdly and lasciviously associate and cohabit together, or if any man or woman, married or unmarried, engages in open and gross lewdness and lascivious behavior, they shall be guilty of a misdemeanor of the second degree…"

This raises the question whether a cohabitation agreement is enforceable in Florida, since arguably it is void as against public policy or because it is based on illegal consideration (the illegal relationship described in the above law).

This issue has not been fully resolved in Florida. The principal case in the area is Poe v. Levy's Estate, 411 So2d 253 (4^th DCA 1982). That case holds that if there is valid consideration (promises or other amounts paid) for an agreement between cohabitating parties aside from sexual relations, then the agreement will not be void. Therefore, if a Florida cohabitation agreement includes consideration outside of the sexual arena, then enforceability should not be an issue. However, there are not a lot of cases on the issue, so even though Poe supports this rule, if it comes up in other Florida appellate districts, a different result is possible.

NEVADA ENACTS CHARGING ORDER PROTECTION FOR CORPORATE STOCK

Nevada recently enacted unique legislation that will enhance the use of its corporations for asset protection purposes. More particularly, it became the first state to enact legislation that provides that a charging order will be the sole remedy for creditors of stockholders of certain Nevada corporations in regard to those shares.

The concept of a "charging order" comes from the partnership and LLC arena. If a debtor owns an interest in a partnership or LLC, and a creditor of that debtor obtains a "charging order" against that interest to collect its debt, the creditor does not become a full owner of the interest. Instead, the creditor's interest is limited to receiving distributions from the entity to the extent that the entity otherwise makes distributions to its owners. If other persons control the entity, this wait for a distribution can be quite lengthy. Further, once the creditor is paid off with distributions, its interest in the entity terminates and the debtor owner thereafter receives back its full ownership rights. Therefore, obtaining a charging order is not as good a remedy for a creditor as being able to force a judicial sale of the interest of the debtor. If the creditor can force a judicial sale, the creditor immediately gets the sale proceeds from the interest – or if it purchases the interest with its debt, it gets full ownership rights forever in the entity and the debtor loses all rights.

Some jurisdictions limit a creditor's rights to a charging order. By doing so, debtors receive creditor protections because the creditor can no longer force

Until the new legislation in Nevada, the charging order remedy had no application to stock in a corporation. By providing that a charging order will now be the sole remedy for creditors of Nevada corporation stockholders as to their shares, Nevada is now providing a significant (and presently unique) method of asset protection.

The new legislation does not apply to all Nevada corporations. For example, the corporation must have more than 1 stockholder and less than 75 stockholders. It cannot be a subsidiary of a publicly traded entity, nor a professional corporation. It will also not apply to any liabilities arising from an action filed before July 1, 2007. Contractual remedies offered by a stockholder to a creditor will not be overriden by the new law.

What happens if the debtor stockholder lives outside of Nevada – will the protection apply? The question of whether the law of Nevada or the law of the residence of the debtor stockholder will apply is unknown – indeed, this is an issue that applies to all the various asset protection statutory protections offered by the various states. Until the issue is resolved, a reasonable approach for persons outside of Nevada is to adopt the attitude of "what do I have to lose" by using a Nevada company, since the possibility that it could work will provide negotiating leverage with creditors. The answer to what is lost by using a Nevada corporation instead of a corporation in one's home state is mostly just the increased costs involved, such as payment of registered agent fees for a local Nevada registered agent, the costs of a service to assist with formation, other Nevada fees, and possibly the need to register the company to do business in a different state.

APPLICABLE FEDERAL RATES - SEPTEMBER 2007

September 2007 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 4.76% (4.94%/August -- (4.91%/July -- 4.78%/June)

-Mid Term AFR - Semi-annual Compounding - 4.73% (5.03%/August -- (4.89%/July -- 4.59%/June)

-Long Term AFR - Semi-annual Compounding - 5.03% (5.24%/August -- (5.09%/July -- 4.85%/June)

DIRECTION OF RATES: Down

WHEN DISREGARDED ENTITIES ARE NOT DISREGARDED

Under the check-the-box rules, entities owned by one person can often elect (or by default may be treated as) a disregarded entity for tax purposes. This generally means that the income and expenses of the entity are not taxable or reportable by the entity but are instead treated as being incurred directly by the owning person or member. Qualified subchapter S subsidiaries are similarly treated.

The IRS has had problems with this in the employment tax area in regard to wage withholding and FICA and FUTA taxes. In 1999, the IRS announced that these liabilities can either be met by the disregarded entity under its own name and taxpayer identification number, or by the owner under its name and taxpayer identification number. In 2005, it issued proposed regulations that would ignore the disregarded entity rules in this area, thus imposing the obligations solely on the disregarded entity.

The IRS has now issued final regulations, putting the 2005 proposed regulations into action. They will apply to wages paid on or after January 1, 2009, so they are not immediately applicable. A disregarded entity that is subject to these rules is treated as a corporation for purposes of applying the withholding tax rules.

Under these rules, an individual who is the owner of a disregarded entity treated as a sole proprietorship will not be treated as an employee, but as self-employed for purposes of the employment tax rules.

New regulations now will also treat these disregarded entities as separate entities for certain excise taxes reported on Forms 720, 730, 2290, and 11-C, as well as for excise tax refunds or payments claimed on Form 8849, and excise tax registration on Form 637. These rules are effective January 1, 2008, a year before the employment tax rules.

T.D. 9356 ; Reg. § 1.34-1 ; Reg. § 1.1361-4 ; Reg. § 301.7701-2

VIRTUAL ADOPTION [FLORIDA]

A child is given over by his natural parent to adoptive parents. The adoptive father raises the child, and then passes away without a last will. The child seeks to receive his intestate share of his adoptive father's property, but finds out that no formal adoption occurred. The child asserts that even though he was never actually adopted, he was "virtually adopted" and thus should receive his intestate share. Florida statutes make no mention of the concept – does the child have any rights?

A recent Florida case confirms that virtual adoption does indeed exist in Florida. Reviewing the case law on the unusual subject, the appeals court laid out the five necessary elements that need to be present to make a case for "virtual adoption" in regard to inheriting property from a deceased adoptive parent:

1. an agreement between the natural and adoptive parents (regarding the transfer of custody and providing for the adoption);
   

   
   

2. performance by the natural parents of the child in giving up custody;
   

   
   

3. performance by the child by living in the home of the adoptive parents;
   

   
   

4. partial performance by the foster parents in taking the child into the home and treating the child as their child; and
   

   
   

5. intestacy (dying without a last will) of the foster parents.
   

If virtual adoption is found, the child's rights to property are based on contract principles.

In the instant case, one of the elements was missing, so virtual adoption was held not applicable.

In re Estate of Ladislav Louis Musil, deceased. GERALDINE DOUGLASS, Appellant, v. ROSA FRAZIER, as Curator of the Estate of Allen Frazier, deceased, Appellee. 2nd District. Case No. 2D06-2114. Opinion filed August 15, 2007.

USING RETROACTIVE EFFECTIVE DATES IN AGREEMENTS

Tax effects flow from the date transactions occur. For example, in a recent Tax Court case, a dispute arose in regard to a change in ownership of interests in a limited liability company (LLC). For LLC's taxable as a partnership, the members are of the LLC are taxable directly on their percentage share of the income and losses of the LLC. Therefore, a transfer of an interest will result in changes to the shares of income (or loss) to be allocated to the involved members, effective as of the date of transfer.

Oftentimes, the documentation for such a transfer does not get completed until after the date the transfer occurred. Therefore, the documentation will often indicate a date the documents are signed, and a retroactive "effective date" for the transfer. In the case mentioned above, the taxpayers had such a retroactive effective date. However, they did not report their ownership as being changed as of the retroactive effective date in filing their tax returns. The IRS sought to apply the retroactive date – and the taxpayers argued that such a retroactive date would be an unenforceable backdating of a document and should be ignored. In the end, the IRS position was upheld. It is interesting that this is the opposite of what you would expect – normally it is the taxpayer that wants to use the prior effective date and the IRS seeking to ignore it.

The case was instructive of several principles that apply to retroactive effective dates. These include:

-impermissible "backdating" generally involves an effort to make it appear that the document in question was executed on a date prior to its actual execution date; i.e., there is an effort to mislead the reader. Therefore, if one is seeking a retroactive effective date for tax purposes, the first requirement is that the document be above board as to what is going on. Thus, showing the true date the agreement is signed, along with an earlier "effective as of" clause, is advisable. What is not advisable is to date an agreement as being signed on a date that is earlier than the date of actual signing.

-To be effective, a retroactive effective date must be allowable under applicable state law. In the case, the Tax Court noted that this was the case in Georgia, the state involved.

-The purpose of the retroactive dating cannot be to obtain an unwarranted tax benefit. In the case at issue, the IRS didn't really care which members picked up the income – changing the percentage ownership among them did not avoid tax it just shifted it among the members. While one could see a situation where the IRS would care (based on relative tax rates, or available losses) which member picked up the income, the fact that the parties are acting at arms-length also goes a long way to protect against a "tax benefit" objection by the IRS.

-The Tax Court will be more willing to accept a retroactive effective date if it can be shown that the later written documents is merely a memorialization of a prior oral agreement. Therefore, if this is the case, it would probably be helpful to recite this in the documentation.

Barry E. Moore, et ux., TC Memo 2007-134

IT DOESN’T ALWAYS PAY TO MAX OUT ON RETIREMENT PLAN CONTRIBUTIONS

The conventional wisdom is that taxpayers should contribute all that the law allows (but of course, no more than they can afford) to tax-deferred retirement plans. This allows for a current income tax deduction for the contribution (and thus instant savings on income taxes), and deferred income taxes on growth on the contributed assets.

However, the conventional wisdom is not always correct. Some number crunching CPA's have confirmed that older workers may be better off not contributing everything they can. This is due to the confluence of several factors, including (a) mandatory minimum distribution requirements that require distributions to made soon after retirement, which distributions will be taxable, and (b) the fact that under current law, the current rates of income tax are slated to materially increase in 2011. Thus, current income tax deductions at today's lower rates will result in higher taxes when paid out of the retirement account at later higher rates.

For this to occur, however, the assets not transferred to the retirement plan would need to be invested in a low tax investment, such as long term investments in securities that are taxable only on sale. Otherwise, the tax benefits of deferring current investment income in the retirement plan will again swing the computation in favor of making a deductible contribution to the retirement plan.

Of course, if a taxpayer loses out on employer-matching of contributions to a retirement plan by not making their own contribution, then the balance will also swing in favor of making the retirement plan contribution.

Source: Baxendale, Sidney J. & Levitan, Alan S., Reduce Pre-Tax Retirement Contributions For More After-Tax Wealth, Practical Tax Strategies (July 2007)

AUDIT TRIGGERS - TRYING AGAIN!

My experiment to link to a descriptive summary map (a "mindmap") didn't work out so well - some of you had trouble opening the linked .pdf file. I am trying a new service that looks like it will work better.

To download or read the summary of audit triggers, click on the link for the summary of Common Estate Tax Audit Triggers and How to Avoid Them by Jill Miller from the August 2007 issue of Estate Planning Journal (after clicking the link, click the Download button on the webpage, and then you can either "open" or "save" the file).

http://www.box.net/shared/t7rupdua7c

I like to use mindmaps to visualize summarize things that contain a lot of information - hopefully this will work out and I can use them for blog posts. Feel free to send me an email at crubin@floridatax.com if you have any problems or comments, and my apologies to anyone who had trouble with the link.

AVOIDING ESTATE TAX AUDITS

Estate tax audits can be costly, both in regard to professional fees and increased taxes. A recent article summarizes a number of audit triggers that can usually be avoided when the estate tax return is carefully prepared.

Click on the link to see the highlights of Common Estate Tax Audit Triggers and How to Avoid Them by Jill Miller from the August 2007 issue of Estate Planning Journal (after clicking the link, click the Download button on the webpage, and then you can either "open" or "save" the file).

http://www.box.net/shared/t7rupdua7c

FLORIDA ESTATE TAX RETURNS NO LONGER REQUIRED (UNTIL 2011) [FLORIDA]

The requirements for estates that file a Florida Estate Tax Return for Residents, Nonresidents, and Nonresident Aliens (Form F-706) with no tax due have changed.

Effective July 1, 2007, Florida law no longer requires the estate of a decedent who died after December 31, 2004, to file a Florida estate tax return (Form F-706) if a state death tax credit or a generation-skipping transfer credit is not allowed by the Internal Revenue Code.

This is welcome news – until now, Florida has required the return even though Florida no longer imposes an estate tax.

However, this provision does not apply to estates of decedents dying after December 31, 2010.

PERMISSIBLE LLC NAMES [FLORIDA]

Sections 608.406 and 608.407, Florida Statutes, were amended during the 2007 legislative session. Effective July 1, 2007, the name of a new limited liability company and the new name of an existing limited liability company must be distinguishable from the names of all other filings filed with the Division of Corporations, except for fictitious name registrations and general partnership registrations. The name must also contain the words "limited liability company," the abbreviation "L.L.C.," or the designation "LLC" as the last words of the name. "Limited Company," the abbreviation "L.C.," and the designation "LC," are no longer acceptable suffixes.