blogger visitor

Thursday, January 31, 2008


A number of States, including Florida, provide valuable creditor protection for homesteads, and such protections can act to exempt a homestead from the reach of creditors in a bankruptcy proceeding. Because of perceived abuses of these protections, Section 522(p)(1) of the Bankruptcy Code was enacted. This provision caps the portion of a homestead exemption allowable  in a bankruptcy proceeding at $125,000 (now $136,875 per inflation adjustment) for interests in real property that a debtor acquires within the 1,215-day  period immediately preceding bankruptcy.

Clearly, then, if a debtor purchases a homestead in Florida and files a petition within 1,215 days, only the first $136,875 in value will be protected, and not the entire value if it exceeds $136,875. What happens if the debtor owned the property more than 1,215 days before filing for homestead, but only made the property his or her homestead within the 1,215 period?

According to a recent Bankruptcy Court case, this conversion of status within the 1,215 day period does not trigger the $136,875 limitation. Such a conversion was held not to be an acquisition of an "interest" within that time period.

The Bankruptcy Courts have been inconsistent on this issue. In Nevada, a Bankruptcy Court held that the dollar limitation was triggered under similar facts. However, courts in Texas and Massachusetts have ruled similarly to Florida.

In re Reinhard, 377 B.R. 315 (Bankr.N.D.Fla. 2007)

Monday, January 28, 2008


A hot topic today in estate planning is the use of formula clauses to avoid unexpected gift or estate taxes. Such clauses aim to reduce tax exposure based on uncertainty in valuation of transferred property. That is, when property is gifted or passes at death, the amount of gift or estate tax depends on the valuation. While a taxpayer may obtain an appraisal of value to determine how much is being transferred and thus subject to tax, the IRS may later object to the value and if a higher value is finally determined, unexpected or undesired taxes result.

To avoid such undesired taxes or to reduce the uncertainty involved in the transfer of difficult to value property, planners seek to use various clauses and dispositive schemes that seek to avoid tax on any increases in value that ultimately result. The IRS does not like these clauses and arrangements, and there is some uncertainty on their legal effectiveness, including questions about whether the Procter case from the 1940's has any application to voiding such arrangements.

In a recent Tax Court case, a decedent left assets at death to an heir. The heir executed a partial disclaimer that left a portion of the assets to a charitable foundation to the extent that the value of the assets exceeded a fixed value. The object of the disclaimer was to avoid additional estate taxes if assets were revalued upward, since increased assets would then pass to the charitable foundation and would qualify for an increased charitable deduction. The IRS audited the estate tax return, and found that the assets on the return were undervalued, and increased their value by approximately 50%. The estate, using the disclaimer clause, sought an increased charitable deduction to cover the valuation increase. The IRS challenged the increase in charitable deduction.

The Tax Court held for the taxpayer, allowing the increased charitable deduction. First, the Court held that the amount passing to charity was not "contingent" at death - the value at death was the value at death, even though the IRS and the taxpayer had not yet agreed on what that value was. Second, the Court rejected the "public policy" objections of the IRS. The Court did note that such clauses may discourage the IRS from challenging valuations. However, at least in regard to the situation when disclaimed property passes to charity, the Court noted that such clauses in fact encouraged charitable contributions, which are obviously favored from a public policy standpoint. The Court also noted that there were other checks on the estate to fairly value the property other than just the IRS' ability to audit - such as the fiduciary obligations of the fiduciaries of the estate and the oversight of the charity itself. The Court also distinguished Procter, noting that unlike Procter, the operation of the clause did not undue a transfer but only reallocated where transferred property passed, nor did it have the Court opine on a moot issue or upset the finality of any Court decision.

There was also another disclaimer in the case, this time to a charitable lead trust where the disclaiming beneficiary was a remainder beneficiary. That charitable deduction was disallowed because the disclaimer was ineffective based on the beneficiary's remainder interest in the recipient trust.

Conservatively, the case could be limited to disclaimer clauses and charitable recipients. Planners will need to review the case to determine their comfort in applying its principals to nondisclaimer-type formula clauses and noncharitable scenarios.

Christiansen v. Commissioner, 130 T.C. No. 1 (2008)

Friday, January 25, 2008


The IRS has released information in regard to its 2007 audit and enforcement activity. The information shows a clear trend towards more audits.

Audits of individuals with more than $1 million in income increased 84% over the prior year. 1 out of 11 of such taxpayers were audited in 2007. For all taxpayers, audits were up 7%. The IRS filed 3.8 million levies and 700,000 liens.

In the business arena, the IRS has stepped up its activities for flow-through entities, such as S corporations and partnerships. Audits of those entities were up 26% and 25%, respectively. Audits of large corporations were down slightly.

Some other miscellaneous info:

-57% of all taxpayers now file their returns electronically;

-the IRS accuracy was 91 percent on tax law questions answered through its toll-free telephone service (good news, except for the 9% getting wrong answers!);

-the IRS online system for tracking refunds was accessed 32.1 million times.

Tuesday, January 22, 2008


Losses from business activities undertaken by a trust or estate may be suspended under the passive activity loss (PAL) rules, and thus may not be available to offset other non-passive income of the trust or estate just as if the trust or estate is an individual. Generally, "passive activity" status and the PAL rules can be avoided if a taxpayer "materially participates" in the business. Minimum participation will be found to exist if the taxpayer participates in the business in a regular, continuous, and substantial basis, or if certain minimum participation hour requirements are met.

Many trustees engage third parties to assist them in running businesses under their control, especially since they are often not well suited to business management. Therefore, the question comes up whether the activities of such assistants will count towards determining whether material participation exists. At first review, such hired persons may need to be ignored since the Treasury Regulations, in the case of individual taxpayers, will not allow the activities of employees of a taxpayer to be counted for material participation purposes.

In Mattie K. Carter Trust, 91 AFTR 2d 2003-1946, 256 F Supp 2d 536 (DC Tex., 2003), a Federal District Court in Texas held that the focus should be on the participation of the trust itself, not just the trustee. As such, persons who conducted business operations on behalf of the trust should be included in the measure of the trustee's material participation.

Per a recent Technical Advice Memorandum, it is now clear that the IRS has not acceded to the analysis in the Carter Trust case. In TAM 200733023, the IRS indicated that the focus of material participation is on the trustee itself. Activities of third parties acting on behalf of the trust (or an estate) will not be counted towards material participation. In the TAM, the IRS concluded that activities of certain "special trustees" who were appointed to manage a business investment were not trustees themselves because they did not have power to bind the trust (even though they were trustees under state law). Therefore, since they were not acting as trustee, their activities were not counted towards material participation.

Therefore, the state of the law on this issue is uncertain. The Carter Trust case is helpful in avoiding the PAL rules. However, the above TAM, and the Regulations themselves that address employees of taxpayers and the disregard of their activities, suggest it will be difficult for any trust or estate to escape the PAL rules when the assistance of any third parties is involved in running the business.

Saturday, January 19, 2008


February 2008 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 3.09% (3.16%/January -- 3.84%/December -- 4.07%/November)

-Mid Term AFR - Semi-annual Compounding - 3.48% (3.55%/January -- 4.09%/December -- (4.34%/November)

-Long Term AFR - Semi-annual Compounding - 4.41% (4.41%/January -- 4.67%/December -- (4.83%/November )


Thursday, January 17, 2008


The question of whether trust expenses for investment advisory fees are fully deductible or may be deducted only to the extent they exceed 2% of adjusted gross income has been resolved by the U.S. Supreme Court. The Court ruled that such expenses will usually be subject to the 2% floor.

The controversy came from an exception to the 2% floor for expenses "paid or incurred in connection with the administration of the estate or trust...which would not have been incurred if the property were not held in such estate or trust" and whether investment advisory fees fit within that exception. Several Circuit Court of Appeals had differed on the question.

The benchmark test adopted by the Court is whether the expense at issue is "commonly" or "customarily" incurred outside of trusts and estates - if yes, then the 2% floor applies and the exception does not. Since investment advisory fees are commonly incurred by individuals (and not just trusts and estates), they do not come within the 2% floor exception.

The Court did note that it is possible that some types of advisory fees may exclusively relate to trusts and estates, in which case the 2% floor would not apply. However, incurring advisory fees simply to comply with fiduciary "prudent investor" rules is not enough to escape the 2% floor.

While the taxpayer here did not benefit, the Court was helpful to taxpayers since it adopted a less rigorous test than that applied by the lower court in determining whether the trust and estate exception from the 2% floor applies. The lower court indicated that trust expenses would escape the 2% floor only if they were of a type that COULD NOT be incurred by an individual. The Supreme Court test is less narrow than that, and thus more expenses should qualify for the exception to the 2% floor.

Note that the IRS had issued proposed regulations that were patterned on the lower court test, essentially allowing deductions to avoid the 2% floor only if they were unique to trusts or estates. Since the Supreme Court adopted a broader test for the exception to the 2% floor for trusts and estates, revised regulations should be forthcoming.

Knight, Trustee of William L. Rudkin Testamentary Trust, Case No. 06-1286 (2008)

Thursday, January 10, 2008


Creditors of a deceased person generally must submit a written claim against the estate within 3 months of publication of a notice of administration, or 30 days of service of the notice if service is required, their claim will typically be barred. Such claims are usually submitted on a Florida Bar approved form after the commencement of the probate proceeding.

In a recent Florida case, the decedent entered into a contract to sell real property, but he died before the closing. The buyer filed a Petition for Administration for the decedent since the family did not commence a probate proceeding. In his petition, the buyer included the details of the contract and its claim to enforce the contract. After the estate was opened, the buyer did not submit a formal claim against the estate. Subsequent in the administration, the appointed personal representative sought to sell the real property pursuant to the original contract. One of the beneficiaries objected, claiming that the creditor's rights under the contract were barred because he did not timely file a claim. The trial court agreed, and denied the petition to sell the property.

The appellate court reversed the trial court. The court noted that almost all of the elements of what must go into a claim were included in the buyer's Petition for Administration. Since the law does not require a particular form of claim, the Petition for Administration was held to be a qualified (and timely claim).

The appellate court also noted pursuant to changes in the law, a claim filed BEFORE the notice of administration is published is timely filed.

In re Estate of Walter J. Koshuba, 2nd DCA, Case No. 2D06-5500, October 10, 2007

Tuesday, January 08, 2008


As promissed, here are some additional summaries of year-end tax law changes:
  • A $250,000 gain exclusion applies for sales of a principal residence - $500,000 can be excluded for married couples. Since the $500,000 exclusion requires a joint return, if one spouse died and the house was sold in a later tax year, the surviving spouse could only use his or her $250,000 exclusion. Now, for sales after 12/31/07, a surviving spouse can obtain the full $500,000 exclusion if the exclusion requirements were met immediately before the spouse's death, and the surviving spouse does not remarry before the sale, and the house is sold within 2 years of the first spouse's death.
  • For 2007, qualified mortgage insurance premiums are deductible as if they are home mortgage interest. This provision has now been extended through 2010. Note that the deduction is phased out at higher levels of adjusted gross income.

Sunday, January 06, 2008


Mrs. Lee passed away. Her husband then died about 45 days later. However, under the terms of Mr. Lee's estate planning documents, Mrs. Lee was deemed to have survived him and thus a distribution was made to her estate. Mr. Lee's estate sought an estate tax marital deduction for the transfer.

Mr. Lee's estate argued that Section 2056(b)(3) authorized the marital deduction, even though Mrs. Lee did not survive Mr. Lee. Section 2056(b)(3) reads:

"(3) Interest of spouse conditional on survival for limited period.—For purposes of this subsection, an interest passing to the surviving spouse shall not be considered as an interest which will terminate or fail on the death of such spouse if—

(A) such death will cause a termination or failure of such interest only if it occurs within a period not exceeding 6 months after the decedent's death, or only if it occurs as a result of a common disaster resulting in the death of the decedent and the surviving spouse, or only if it occurs in the case of either such event; and

(B) such termination or failure does not in fact occur."

Not so fast, says the Tax Court. Noting that Section 2056(b)(3) exists to permit a marital deduction even if the passing of an interest to a surviving spouse is conditioned upon the spouse's surviving the decedent by a period not exceeding 6 months if the spouse in fact survives the requisite 6 months, the Court held that neither Section 2056(b)(3) nor the provisions of Mr. Lee's Last Will can change the plain language that a marital deduction is available only for a transfer to a SURVIVING spouse.

Estate Of Kwang Lee, TC Memo 2007-371

Friday, January 04, 2008


Earlier this week we discussed some dynamics regarding the new tax return preparer penalties. Subsequent to that posting, the IRS issued several Notices regarding the expanded penalties.

Notice 2008-13 has the key provisions. One provision notes that persons who give advice on a return position can be penalized - not just traditional return preparers. Thus, for example, an attorney who advises the taxpayer or a preparer on how to prepare a return may be subject to the penalty.  However, such a person will be subject to these rules only if the item(s) advised on represent a significant portion of the tax liability reported on the tax return. 

That Notice also provides some relief to preparers and advisors in regard to items for which there is a reasonable basis for a position, but not enough of a basis to meet the "more likely than not" standard of correctness. As discussed in the previous blog post, preparers are encouraged to seek qualified disclosure of the issue to protect themselves from penalties, even though such disclosures are not needed to protect the taxpayer from penalties due to lower standards. The Notice allows a preparer to obtain the same protection as actually disclosing the issue on the tax return without doing so, by providing required notices to the taxpayer regarding penalties and the need for disclosure. This helps eliminate a conflict of interest that might otherwise arise between the taxpayer and the preparer.

For more information on the new rules, I have posted a brief summary at (after clicking the link, click the Download button on the webpage, and then you can either "open" or "save" the file).

Tuesday, January 01, 2008


Applying tax laws to existing facts is not always a black and white affair. Many times there is uncertainty as to how the law should apply in a given situation. This creates issues for taxpayers and tax return preparers as to how to report such items, and penalty risks if an incorrect position is adopted.

In the past, the standards for imposing penalties on preparers were less strict than the standards for imposing penalties on the taxpayers. Recent law changes have flipped this - now preparers labor under more strict standards than the taxpayers.

The standards for imposing penalties are and were:

-FOR PREPARERS UNDER OLD LAW - "unrealistic positions", or an enhanced penalty for "wilful or reckless" conduct (IRC Section 6694);

-FOR TAXPAYERS - "no substantial authority" (IRC Section 6662(d)); and

-FOR PREPARERS UNDER NEW LAW - "no reasonable belief that the position would more likely than not be sustained", or an enhanced penalty for "wilful or reckless" conduct (IRC Section 6694).

Also, the penalties on preparers were previously only $250, or $1,000 if the preparer was wilful or reckless. Now, the penalties are the GREATER OF $1,000 (or $5,000 for wilful or reckless conduct) and 50% of the fees earned by the preparer. For many returns, including estate tax returns, this 50% penalty can run into the tens of thousands or even hundreds of thousands of dollars. Also, in addition to monetary penalties, preparers who incur penalties may also be referred to the Director of Practice.

With this new setup, preparers may now face return reporting positions which pass muster under the "no substantial authority" standard, and thus should not incur penalties for the taxpayer if the IRS disagrees, but for which the preparer is uncertain will fly under the "more likely than not" standard under which the preparer labors. This can create a conflict of interest between the preparer and the taxpayer - the preparer may need to be more conservative to protect its own interests than would be necessary to protect the interests of the taxpayer. The conflict of interest issues can be further exacerbated when the return preparer is also a fiduciary of the taxpayer - e.g., corporate fiduciaries for estates and trusts often prepare income tax returns and estate tax returns for the estate or trust.

Note that both taxpayers and preparers can avoid these penalties if they disclose the issue in a prescribed manner on the tax return. Of course, taxpayers often are concerned about disclosure as a "red flag" to the IRS to audit the return or examine the particular issue.

A preparer caught in this situation has the following basic alternatives:

a. Prepare the return with the uncertain position, and run the risk of incurring the preparer penalty;

b. Obtain a covered tax opinion that meets the Circular 230 requirements, thus substantiating the preparer's reasonable belief that the position is more likely than not to be sustained by the IRS (assuming that this is a valid belief and a tax practitioner is willing to provide the opinion). This takes time and generates the additional expense of obtaining the opinion; or

c. Provide adequate disclosure on the tax return to the IRS. This raises the "red flag" concerns addressed above.

Interestingly, by increasing the penalties and standards of the preparers, Congress has in effect increased the standards for taxpayers who need the services of a return preparer.

Special thanks to my partner, Marvin Gutter, for his analysis of these issues.

IRC Sections 6662; 6694.