APPLYING SUBSTANTIAL ECONOMIC EFFECT RULES WITH PASS-THROUGH PARTNERS

Under Code §704(b), allocations of partnership items of income, gain, loss, deduction and credits must have "substantial economic effect" to be respected for federal income tax purposes. The economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Further, the allocations cannot be "transitory" or "shifting."

In testing for substantial economic effect, issues arise how to apply the tests if a partner is a pass-through entity for income tax purposes. Proposed regulations issued in 2005 relating to examining the tax effects on the ultimate owners of pass-through partners were recently finalized.

Generally, the regulations require that the tax consequences are examined at the owner level of the pass-through entity (or the beneficiary level, for trusts and estates). Pass-through entities for these purposes include partnerships, S corporations, estates, trusts, and qualified Subchapter S subsidiaries. Treas.Regs. §1.704-1(d).

Look through treatment will also apply for controlled foreign corporations (CFCs) also, but only if U.S. shareholders of the CFC own in the aggregate (directly or indirectly) at least 10% of the capital or profits of the partnership. If the look-through rules apply, the U.S. shareholders are the ones examined, as to income that passes through or would pass through under Code §951(a). Treas.Regs. §1.704-1(d)(3).

T.D. 9398, 05/16/2008; Reg. § 1.704-1

WAIVER OF DIVIDENDS

Generally, a taxpayer entitled to income cannot simply say "don't pay me" and avoid being taxed on the income. In that situation, under the doctrine of constructive receipt the taxpayer will have to report the income, and then further account for the disposition of the income that they should have received - for example, such forfeited income could be treated as a gift.

A recent private letter ruling illustrates an exception to this rule that is not widely known or applied. This relates to the waiver of corporate dividends.

In the ruling, a corporation desired to increase its dividends to its public shareholders. However, if it had to pay the increased dividends to the nonpublic shareholders, then there would not be enough cash available to bring the dividend to the desired level for the public shareholders. The other shareholders agreed to waive the payment to them of the dividend to the extent it exceeds the current dividend level. A private letter ruling was sought that the waiving shareholders would not have to report the unpaid dividend income under the constructive receipt doctrine.

Going back to 1953, the IRS has provided guidance to the effect that a waiver of dividends by a majority shareholder would be respected if the resulting increased dividend to minority shareholders was not payable to shareholders who had a direct family or business relationship with the waiving shareholder, and a valid business purpose existed for the waiver. In Rev.Proc. 67-14, 1967-1 CB 591, the IRS listed four "safe harbor" criteria that must be met before the IRS will issue a favorable ruling on a dividend waiver. The criteria are:

(1) A bona fide business reason must exist for the waiver;

(2) The relatives (e.g., brothers, sisters, spouse, ancestors, and lineal descendants) of the waiving shareholder must not be in a position to receive more than 20% of the total dividends distributed to the nonwaiving shareholders;

(3) The ruling is not effective if any change in stock ownership (other than death) enables nonwaiving relatives to receive more than 20% of the dividend; and

(4) A ruling issued on a proposed waiver won't be effective for a period longer than three years from the date of the ruling.

The IRS ruled favorably in the private letter ruling. The ruling is helpful by providing examples of business reasons that are sufficient for the IRS. In the ruling, the IRS noted the waiver will enhance the market value of the corporation and will thus will provide it with greater access to capital markets for future equity offerings, and will further permit the corporation to maintain adequate capital to support its operations and expand its business.

PLR 200820019

CHARITABLE DEDUCTION AVAILABLE FOR SPECIAL LICENSE PLATES

While not a big dollar item, the IRS has released a letter it issued to a member of the U.S. House of Representatives regarding the ability of a constituent to deduct amounts paid to the State of Minnesota for a special license plate relating to the conservation of natural habitats. In the letter, the IRS noted that Minnesota charges an extra $30 over the regular license plate fees for such habitat license plates, and that the $30 is used to buy and manage habitats for public uses, such as hiking and hunting.

The letter goes on to conclude that when a taxpayer, with the intention of making a gift, purchases an item from a qualified charity, the excess of the payment made over the value received is a charitable contribution for the excess. Since many states offer special license plates whose fees are dedicated to charitable causes, the extra fees should thus be eligible for income tax charitable contribution deductions.

While the letter does not give any cites to the Internal Revenue Code, the statutory support for this deduction is presumably IRC Section 170(c)(1), which includes as a deductible charitable contribution payments to a state for exclusively public purposes.

APPLICABLE FEDERAL RATES - JUNE 2008

May 2008 Applicable Federal Rates Summary:

SHORT TERM AFR - Semi-annual Compounding - 2.07% (1.63%/May -- 1.84%/April -- 2.24%/March -- 3.09%/February )

MID TERM AFR - Semi-annual Compounding - 3.20% (2.72%/May -- 2.85% /April -- 2.95%/March -- 3.48%/February)

LONG TERM AFR - Semi-annual Compounding - 4.46% (4.17%/May -- 4.35%/April -- 4.23%/March -- 4.41%/February)

DIRECTION OF RATES: Up

RECENT GIFT TAX FLP CASE

Family limited partnership cases typically involve the valuation of partnership interests for estate tax purposes. The same valuation principles are generally involved for gift tax purposes when the subject of a gift is a limited partnership interest.

In Astleford, the Tax Court in a memorandum decision addressed limited partnership valuation issues, in the context of gift taxes. While the case has no groundbreaking precedents, it did address some valuation issues that often come up in the partnership context.

One issue that came up was whether a transferred general partnership interest (which was transferred by the taxpayer to a limited partnership controlled by the taxpayer), should be valued as a partnership interest or as a less valuable "assignee" interest which is valued at less than a full interest due to lack of management rights. The partnership agreement suggested that an assignee had less than full management rights, but nonetheless the Court applied a substance over form analysis to hold that the successor owner (a family limited partnership) held all or almost all of the ownership rights of the transferred general partnership interest and thus should not be valued as a mere assignee interest.

The Court noted that the taxpayer effectively retained the control rights over the transferred interest because the taxpayer was general partner of the transferee partnership. However, if the interest itself did not have control attached to it, under the willing buyer - willing seller valuation standard presumably a buyer would have paid less for the missing control element so this reasoning may be questionable.

Also questionable is that the Court also noted that the transfer documents for the partnership interest did not refer to the transferred interest only as an "assignee" interest. Since the transferee could only receive what the transferee received, and that is what is being valued, the fact that the assignee nature was not specified by the parties should not really impact value.

The Court also allowed a "tiered" discount. First, it allowed a discount for value for the general partnership interest that was transferred to the limited partnership. Then, it allowed a further discount for the value of the limited partnership interests transferred by the taxpayer. Such tiering of discounts is often sought after as a method of creating larger value reductions through a multiple partnership ownership structure than would be the case with only one partnership involved. However, the general partnership had been in existence for more than 20 years before the transfer to the limited partnership - there is a reasonable likelihood that the Tax Court if faced with a similar arrangement but with recently created multiple tier partnerships would not be so generous in allowing for tiered discounts.

Astleford, TC Memo 2008-128.

LATE FILING RELIEF FOR FIRPTA TAX AND WITHHOLDING ISSUES

Code Section 897 imposes U.S. income tax on foreign persons disposing of U.S. real property interests (including the disposition of interests in U.S. corporations owning significant real property interests - USRPHC's). Code Section 1445 imposes withholding obligations on buyers and transferees of such U.S. real property interests (USRPIs).

Sections 897, 1445, and the regulations thereunder provide for various exceptions to tax and withholding, provided that documentation is provided to the buyer/transferee, and where required, to the IRS, in a timely manner. If such documentation is not timely provided and filed, the parties can seek relief through a private letter ruling (with concomitant ruling fees and professional fees). The IRS has now provided a mechanism to obtain late filing relief on many of these issues without the submission of a private letter ruling request.

The late filings covered by these new rules are those provided in Treas.Regs. §§ 1.897-2(g)(1)(ii)(A), 1.897-2(h), 1.1445-2(c)(3)(i), 1.1445-2(d)(2), 1.1445-5(b)(2), and1.1445-5(b)(4). These provisions relate to the provision of:

a. documentation that stock being transferred is not stock in a USRPHC (relating to both tax under Section 897 and withholding under Section 1445); and

b. documentation advising that a nonrecognition provision of the Internal Revenue Code applies to the transfer of a USRPI.

Upon application, the IRS will advise the taxpayer whether relief is granted within 120 days. Relief will be granted if the taxpayer had "reasonable cause" for the nonfiling.

Rev. Proc. 2008-27, 2008-21 IRB, 05/13/2008

IRS UPDATES LIEN PRIORITY REGULATIONS

Like any lien on property, federal tax liens on property of a delinquent taxpayer raise questions of priority of payment against other lienholders. Under Code Section 6323, the holder of a security interest (including a mortgagee or pledgee) is protected against a general tax lien if, before the IRS files notice of lien, the security interest is in existence, even if it came into existence after the tax lien arose. The holder of a security interest is protected even if the holder had actual knowledge of the tax lien before acquiring the interest.

The IRS has not updated its lien priority regulations in many years. It recently issued proposed regulations, that will be effective if and when final. Highlights of the new regulations include:

--A Form 668, Notice of Federal Tax Lien, may be filed either in paper form or electronically;

--With regard to a Notice of Federal Tax Lien that includes a certificate of release, failure to timely refile the Notice in any jurisdiction where it was originally filed would extinguish the lien;

--A purchaser of property in a casual sale is protected against a filed tax lien if the sale price is less than $1,000 (adjusted for inflation - $1,320 in 2008);

--A holder of a mechanic lien is protected against a filed tax lien with respect to residential property in an amount up to $5,000 (adjusted for inflation - $6,600 in 2008);

--Household goods are exempt from levy to the extent they don't exceed $6,250 in value (indexed for inflation - $7,900 in 2008);

--The regulations indicate that there is generally a 10-year period (reflecting the period in Code Sec. 6502 ) for instituting a proceeding in court or serving a levy to collect a properly assessed tax.

Preamble to Proposed Regulations 4/16/08; Prop Reg § 301.6323(b)-1 , Prop Reg § 301.6323(c)-2 , Prop Reg § 301.6323(f)-1 , Prop Reg § 301.6323(g)-1

IRS ALLOWS SEPARATE ENTITY TREATMENT FOR SERIES LLC

A series limited liability company is an entity that allows for the creation of separate ventures ("Portfolios") as part of one LLC. Each Portfolio will typically have separate liabilities, assets, management, and members. Since there is only one entity filed with the applicable state, costs for forming new entities are avoided, administrative fees and costs are reduced, and one filing with the SEC possibly can be used for multiple Portfolios (as compared to forming a separate LLC for each venture). Delaware was the first to allow for SLLCs, and a few other states now provide for them.

SLLCs are not widely used. One reason for this is that the IRS has never provided any direct guidance on how the separate Portfolios would be treated for income tax purposes. This dearth has ended - the IRS has issued a private letter ruling dealing with the subject.

Under the ruling, the IRS has indicated that each Portfolio will be treated as a separate entity for tax purposes. While the IRS did not come out and specifically say that the Portfolios within each Series LLC are to be treated as separate entities, it implied this when they said that each can make its own entity characterization selection under the check the box rules and entity characterization rules.

Perhaps similar to the way that LLCs exploded in popularity once the federal income tax consequences of their use was ruled on by the IRS, this ruling may result in broader use of SLLCs. In this regard, it would be helpful if the IRS issued guidance in the form of a Revenue Ruling or Regulations, since taxpayers other than the recipient of a private letter ruling are technically not permitted to rely on private rulings issued to others.

PLR 200803004

AVOIDING PENALTIES ON LATE IRA ROLLOVERS

Individuals may transfer funds from one qualified retirement plan or IRA into another without triggering income tax if the transfer is completed within 60 days. If the rollover is not completed by the 60th day, bad things can result - principally, the potential income taxes on the transferred amount, with applicable penalties and interest, the potential loss of deductions and exemptions due to the phase-outs based on resulting increase in adjusted gross income, and a 10% penalty on early withdrawal for taxpayers under age 59 1/2.

Internal Revenue Code Sec. 408(d)(3)(I) grants the power to the IRS to waive the 60-day requirement if penalizing the taxpayer would be against equity or good conscience. The Code specifically lists casualty, disaster, or other events beyond the reasonable control of the individual subject to the requirement as good reasons.

The following summarizes the automatic waiver and the discretionary waiver provided by the IRS, and how these are applied in practice. This summary is based in large part on an article by Linda Nelsestuen And Wesley Austin in December 2007 issue of Practical Tax Strategies.

1. Automatic Waiver - If the taxpayer's situation meets all of the criteria in Rev Proc 2003-16, 2003-1 CB 359 , the 60-day rule is automatically waived. To qualify, among other criteria the following must apply:
   1. The financial institution receives the funds within the 60 day period;
   2. The funds are not deposited into an eligible retirement plan within the 60-day rollover period solely because of an error on the part of the financial institution; and
   3. The funds are properly deposited within one year from the beginning of the 60-day rollover period.
2. Facts and Circumstances Waiver - Rev Proc 2003-16 provides that the Service will issue a ruling waiving the 60-day rollover requirement for cases in which the failure to waive such requirement would be against equity or good conscience. This consists of casualty, disaster, or other events beyond the reasonable control of the taxpayer. Facts the IRS consider include:
   1. Whether the errors were caused by the financial institution;
   2. Whether the taxpayer was unable to complete the rollover due to death, disability, hospitalization, incarceration, or restrictions imposed by a foreign country or postal error;
   3. Whether the taxpayer used the amount that was distributed;
   4. How much time has passed since the date of distribution.
3. IRS Denial of Discretionary Facts and Circumstances Waivers in Practice.
   1. In practice, many waivers are denied because the taxpayer used the funds with the expectation of replacing them within the 60 days, or taxpayers originally had no intent to roll over the proceeds until they became aware of the tax consequences.
   2. Taxpayers using ignorance of the law as an excuse have not received favorable rulings.
   3. Relying on the advice of counsel has been an appropriate reason.
   4. Taxpayer intent is very important. If the original intent was something other than rolling the money over into another IRA, the Service will most likely rule against the taxpayer. However, if the taxpayer has a documented medical or mental condition that precluded him or her from transferring funds in a timely manner, the original intent does not appear to be an issue, and the IRS will most likely rule in favor of the taxpayer.
   5. The use of the funds as a short-term loan is not viewed favorably unless the taxpayer has a debilitating illness and was physically or mentally unable to complete the transaction within the required time.
   6. A lack of understanding of the law, reliance on the advice of non-financial advisors, and a belated realization as to the adverse tax consequences have not been found to be acceptable reasons to grant a waiver.