ESTATE TAX GROSS-UP OCCURS FOR GIFT TAXES PAID UNDER SECTION 2519 WITHIN 3 YEARS OF DEATH

[NOTE: This is a technical issue that is probably of interest to only a small subset of the readers of this blog. For more information on Section 2519, you can review my article from earlier this year entitled Tax Results of Settling Trust Litigation involving QTIP Trusts published in the January 2009 edition of Estate Planning, a WG&L publication. I will also be speaking on the same subject in January 2010 at the Heckerling Institute on Estate Planning.]

Section 2519 of the Internal Revenue Code imposes a gift tax when all or a portion of a QTIP trust (a specific type of marital deduction trust established by one spouse for another to reduce estate and/or gift taxes) is distributed during the lifetime of the beneficiary spouse to beneficiaries other than the spouse. The gift taxes are payable by the spouse – however, the spouse can “recover” the taxes from the beneficiaries who receive the assets of the trust that triggered the tax.

Section 2035(b) requires that any gift taxes paid by a decedent within 3 years of death be added to the gross estate of the decedent for purposes of computing estate taxes. In a recent Tax Court case, the issue arose whether gift taxes paid under Section 2519 are subject to this 3 year gross-up rule for the gift taxes paid within 3 years of the spousal beneficiary’s death.

The estate made a strong argument that the gross-up rule should not apply, at least when the spouse exercised her rights to recover the gift taxes arising under Section 2519 from the other trust beneficiaries. This is because the Section 2035(b) gross-up rule applies only to gift taxes of the spouse, and in this circumstance the substance of the transaction is that the other beneficiaries of the QTIP trust paid the gift tax.

The Tax Court was not persuaded by the estate’s argument, and held the gross-up ruled applied. The Court noted that under the Code, the gift tax is imposed on the spouse. The “right of recovery” of the spouse is just that – and is not technically a shift in who is primarily liable for the tax.

The Court noted that to rule otherwise would violate the policy of Section 2035(b) which is to prevent death bed transfers that would incur gift tax, and thus remove the gift taxes themselves from being subject to estate tax on the subsequent death of the grantor. The Court believed that if the gift tax incurred under Section 2519 was not covered by the gross-up rule, spousal beneficiaries of QTIP trusts would have the incentive to terminate the trusts prior to death (where death is foreseeable) so as to avoid estate taxes on the amount of gift taxes incurred.

Estate of Anne W. Morgens, et vir. v. Commissioner, 133 T.C. No. 17 (December 2009)

“GIFT OVER” FORMULA CLAUSE RESPECTED BY TAX COURT

Taxpayers often desire to make gifts of difficult to value property by using their available unified credit  to cover the value of the gift and thus avoid current gift tax. The problem they face is that if the IRS is successful in proving a higher value for the property than the taxpayer, this could put the taxpayer over the unified credit amount and thus incur current gift taxes.

To address this problem, taxpayers use “formula clauses” to limit the amount of the gift to the desired amount. The IRS typically contests these clauses, claiming they are against public policy since they reduce or eliminate the IRS’ incentive to auditing.

One type of clause used is known as a “gift over” clause. In this type of clause, the taxpayer gifts away the property, but provides that to the extent that the value of the gift exceeds a certain dollar amount, the remaining value goes to another recipient (typically one or more charities). Thus, any unexpected increases in value on IRS examination act to increase the amount going to charity – no additional gift tax results due to the charitable gift tax deduction.

In a taxpayer victory, the Tax Court has upheld the application of such a clause after the IRS successfully argued for a higher value for gifts made by a taxpayer than the value reported on the gift tax return. Facts and factors that assisted the court in reaching its decision included:

A. The Court noted this clause was not in the nature of a prohibited Proctor “savings” clause that returns property to the grantor to the extent of any finally determined increases in value. Instead, under this type of clause, no matter what the final valuation of the gifted property the taxpayer gifted away the same property, with the only uncertainty being who receives it (based on values finally determined).

B. The Court feels less comfortable in relying on public policy arguments than it has in the past. The Court cited Commissioner v. Tellier,  383 U.S. 687, 694 [17 AFTR 2d 633] (1966), where the Supreme Court warned against invoking public-policy exceptions to the Code too freely. The Court also noted the contrary public policy of encouraging gifts to charities, which gifts are supported by these types of clauses.

C. The Court noted that there were a number of facts that demonstrated fiduciary and legal obligations of various parties to respect the rights of the charitable beneficiaries, and thus limits the ability of the taxpayers to exploit the presence of the charities for tax planning purposes via low-ball valuations. Indeed, the charities were active in this case in negotiating the transfers and enforcing their rights. The case also presents useful guidance in regard to structuring the charity’s gifts in a manner that enhances these types of factors (e.g., by making the charities a full member in the LLC in which they received gifts instead of just holders of restricted transferee interests).

D. The Court also acknowledged that the Code and Regulations allow the use of formulas in various circumstances, so that formula clauses should not be preemptively declared to be against public policy in all circumstances. This is an argument often made by taxpayers and it is helpful that this argument was acknowledged, at least in part, by the Tax Court.

An interesting side issue in the case was whether the charitable deduction for the gift should be allowed in the original year of gift, even though the amount of the charitable gift was effectively increased by the IRS’ later higher valuation in a later year. The Court found that the charitable deduction occurred in the year of the original gift.

Petter, et al. v. Commissioner, TC Memo 2009-280

APPLICABLE FEDERAL RATES – JANUARY 2010

CONGRESS FAILS TO ACT ON ESTATE TAXES

Congress has had nine years to clean up the unusual situation of there being no federal estate taxes in 2010, and then a reversion to 2001 rates and exemptions in 2011 and thereafter. Last minute efforts this month to avoid the repeal of the tax in 2010 have failed, and for the first time in many years, there will be no estate taxes (but only for 2010).

It is likely that Congress will revisit the issue in 2010. What shape any resulting action takes is difficult to predict. Republicans may have the early edge to bargain down rates and increase the unified credit, but as the clock ticks towards 2011 with its built-in rate increases and substantial unified credit decrease, bargaining power may shift to the Democrats. Whether Congress will touch the political hot potato of a retroactive re-imposition of the tax is an interesting question.

Unfortunately, the repeal of the estate tax also brings in the abomination of carry-over basis. Presently, if someone dies, the adjusted basis in their property is adjusted to current value. In a carry-over basis regime, such adjustment does not occur, and the heirs receive the same basis the decedent had for calculating gain or loss on a future disposition and for other purposes. How the heirs are supposed to have basis information if the decedent is deceased and was not a good record keeper is anyone’s guess, and one of the reasons why carry-over basis is terrible tax policy from an administrative and compliance perspective.

SALE BY STATE OF UNCLAIMED STOCK TREATED AS A SECTION 1033 DISPOSITION

Many states have unclaimed property laws, which allow institutions and others that hold property on behalf of people that cannot be located to turn that money over to the state. After a given period, the state will typically then sell the property and add the funds to its general funds (if the property is already cash or bank account proceeds, no sale is needed).

A partnership had an interest in an escrow account that owned shares of stock of a publicly traded company. A successor escrow agent, out of lack of knowledge, did not know how to return such stock to the rightful owner (the partnership) and turned it over to a state under its unclaimed property law. The state later sold the stock. At a later date, the partnership found about the stock and was able to be paid the sales proceeds from the stock.

The sale of the stock generated gains for the partnership (even though that sale occurred without its knowledge or consent). The partnership requested the IRS to advise whether it could make use of Code §1033. Code §1033 always a taxpayer to defer gain in regard to property that is compulsorily or involuntarily converted by reason of its destruction, theft, seizure, requisition or condemnation, into similar property (either directly or by conversion into money and then acquisition of replacement property within 2 years).

In a favorable ruling, the IRS reached the following interest conclusions:

a. The transfer of the funds into the state’s control was considered a “seizure” by the government, within the meaning of the statute;

b. The conversion of the stock into money was determined to compulsory or involuntary – i.e., beyond the taxpayer’s control – because the taxpayer did not intentional fail to exercise its ownership rights;

c. The two year replacement period did not start when the state sold the stock, but at the later date when the state made the funds from the sale available to the taxpayer (thus giving more time to the taxpayer to acquire related property); and

d. Allowing the taxpayer to replace the stock with stock of another publicly traded corporation – equating the risks and activities of one publicly traded stock held for investment with other publicly traded common and preferred stock and stock in publicly traded mutual funds (but not debt instruments).

PLR 200946006

IRS GETS HAMMERED IN TRANSFER PRICING CASE

Transactions between related companies are subject to special scrutiny under Internal Revenue Code section 482, which requires that amounts paid between the companies be based on the "arms length" prices that unrelated companies would charge each other. Special rules exist under the Treasury Regulations for transactions involving the transfer of intangible property, and a further subset of those rules provides for a method where two related companies (typically one inside the United States and one outside the United States) engage in cost-sharing to jointly develop intangible property.

These cost-sharing rules were recently involved in a major Tax Court case. In the case, a US corporation entered into a cost-sharing arrangement with an Ireland affiliate. Since the US corporation had already developed some intangible property that was to be used in the venture, the Ireland affiliate was required to make a "buy-in" payment to the US corporation to compensate it for the existing intangible property that the US corporation brought to the venture. The US corporation and the Ireland affiliate constructed what they determine to be a reasonable "arms length" price of $166 million for the "buy-in" based on transactions that the US corporation entered into with unrelated parties.

The IRS challenge that price, and said that the buying payment should be an astounding 15 times higher at $2.5 billion and allocated income for the difference to the US corporation. The case eventually found its way into the US Tax Court for resolution.

Coming up with an arms length price for goods and intangibles is a conceptual exercise, with a lot of wiggle room in real-world implementation. This wiggle room also opens the door to reasonable disagreements between IRS and taxpayer experts as to what an appropriate arms length price should be in any particular situation.

Typically, these matters are negotiated and settled somewhere between the taxpayers position and the IRS' position, or when the court has to decide the issue it usually settles on a price somewhere between the two extremes.

In this case, however, the Tax Court completely sided with the taxpayer. Further, the Tax Court further embarrassed the IRS with a finding that the IRS's determinations were arbitrary, capricious, and unreasonable.

One take away from the case is that even if the taxpayer adopts a reasonable arms length price, the risk always remains that the IRS may challenge that price and that challenge may be entirely unreasonable. Another take away, however, is that the Tax Court has no difficulties in disregarding such unreasonable IRS activity and noting it on the public record.

VERITAS Software Corporation, Symantec Corporation (successor in interest), 133 TC No. 14 (2009)

2 WITNESS RULE FOR LEASES [FLORIDA]

In a recent Florida case, a landlord and tenant entered into a 10 year lease. Each signed the lease, but no witnesses signed. The landlord sought to void the lease because the signatures of the parties were not witnessed by two witnesses.

Fla.Stats. §689.01 reads in part "How real estate conveyed.--No estate or interest of freehold, or for a term of more than 1 year, or any uncertain interest of, in or out of any messuages, lands, tenements or hereditaments shall be created, made, granted, transferred or released in any other manner than by instrument in writing, signed in the presence of two subscribing witnesses by the party creating, making, granting, conveying, transferring or releasing such estate, interest, or term of more than 1 year, or by the party's lawfully authorized agent, unless by will and testament, or other testamentary appointment, duly made according to law; and no estate or interest, either of freehold, or of term of more than 1 year, or any uncertain interest of, in, to, or out of any messuages, lands, tenements or hereditaments, shall be assigned or surrendered unless it be by instrument signed in the presence of two subscribing witnesses by the party so assigning or surrendering, or by the party's lawfully authorized agent, or by the act and operation of law."

At first reading, there is no mention of a lease in the statute. However, since a lease is considered a transfer of an interest in land, the statute applies and leases for more than 1 year require two signatures.

The case does not make new law on this issue, but since it is a nonobvious issue, it bears mentioning, especially for those that don't practice regularly in the real estate area.

The case also held that the 2 witness requirement was not overridden by Fla.Stats. §608.4235, which authorizes a transfer of an interest in real property by a limited liability company on the signature of any member and makes no mention of required witnesses.

Skylake Insurance Agency, Inc. v. NMB Plaza, LLC, 3rd DCA, Case No. 3D07-454, October 28, 2009

LEGISLATION FINALLY PASSED TO AVOID REPEAL OF ESTATE TAXES

Since the early days of George Bush, Jr.’s administration, 2010 has been out there as the year in which there will be no federal estate tax. Also since that time, we have been predicting for our clients that this would never come to pass, and that sometime before then the repeal would be repealed, and higher unified credit and lower maximum tax rates would be made permanent.

Politics being what they are, what Congress had 8 years to deal with is now on the front burner, with only a few weeks left in 2009 to take action. Of course, Congress could act sometime in 2010 on a retroactive basis to the change the law, but many in Congress are adverse to retroactive tax legislation on major issues.

For the first time, legislation has cleared at least one house of Congress to repeal the repeal. Last Friday, the House of Representatives passed a bill that would repeal the repeal of estate taxes in 2010, make permanent the $3.5 million unified credit applicable in 2009, and also make permanent the 2009 maximum federal estate tax rate of 45%. The legislation would also repeal the one year of carryover basis that is presently in the law for 2010.

The Senate has not yet passed a corresponding bill. Issues likely to arise in the Senate include the amount of the unified credit equivalent, whether to index that credit for inflation, the maximum tax rate, bringing the gift tax unified credit back in line with the estate tax unified credit, and portability of the unified credit between spouses.

Whether any bill will clear both houses of Congress before year end is anyone’s guess.

IRS REFUSES TO GIVE UP ON OVERSTATED BASIS STATUTE OF LIMITATIONS ISSUES

We have previously reviewed two cases that have held that a reduction in gain arising from an erroneous overstated tax basis in an asset is NOT an omission from gross income that can give rise to an extended six year statute of limitations for gross income omissions of 25% or more. Salman Ranch Ltd. et al. v. U.S., 104 AFTR 2d ¶ 2009-5190 (CA FC 7/30/2009); Bakersfield Energy Partners, LP, Robert Shore, Steven Fisher, Gregory Miles and Scott McMillan, Partners other than the Tax Matters Partner, 128 TC No. 17 (2007). Nonetheless, the IRS has refused to be cowed by these decisions.

In September, the IRS issued new Temporary Regulations that will treat such basis overstatements as omissions from gross income for this purpose (Reg. § 301.6501(e)-1T(a)(1) ,  Reg. § 1.6229(c)(2)-1T(a)(1) ,  T.D. 9466, 09/24/2009).  The IRS has further signaled its enthusiasm for this issue by issuing a directive to IRS attorneys litigating these issues to contact the Office of Associate Chief Counsel (Procedure and Administration) to coordinate responses to the issue in light of the new Temporary Regulations.

Apparently, the IRS intends to pursue these issues, even in jurisdictions with court decisions hostile to the IRS’ position. The Temporary Regulations were crafted to take advantage of language in cases that had previously ruled in favor of the IRS on the issue. Whether the adoption of Temporary Regulations will now convince courts in those jurisdictions that were previously hostile to the IRS’ position remains to be seen.

Chief Counsel Notice 2010-001

INTEREST RATES FOR TAX OVERPAYMENTS AND UNDERPAYMENTS (JANUARY 2010 QUARTER)

The IRS has announced the interest rates for tax overpayments and underpayments for the calendar quarter beginning January 1, 2010.

For noncorporate taxpayers, the rate for both underpayments and overpayments will be 4% (unchanged).

For corporations, the overpayment rate will be 3% (unchanged). Corporations will receive 1.5% (unchanged) for overpayments exceeding $10,000. The underpayment rate for corporations will be 4% (unchanged), but will be 6% (unchanged) for large corporate underpayments.

Rev. Rul. 2009-37

IRS ALLOWS TAXPAYER TO COMBINE ACQUISITION INDEBTEDNESS AND HOME EQUITY INDEBTEDNESS

The Internal Revenue Code does not allow deductions for “personal interest.” Nonetheless, qualified residence interest, which includes interest on acquisition indebtedness and home equity indebtedness on a qualified residence, is deductible. Generally, acquisition indebtedness is deductible only on the first $1 million of acquisition indebtedness. Home equity indebtedness is generally deductible on $100,000 of home equity indebtedness.

What happens if a taxpayer borrows $1.1 million to buy a qualified residence? Can the taxpayer get interest deductions on $1 million of acquisition indebtedness, AND interest deductions on another $100,000 of the acquisition debt? Or is the full $1.1 million clearly acquisition indebtedness only, thus qualifying only $1 million of the debt for deductible interest?

In Pau,  TC Memo 1997-43  and Catalano,  TC Memo 2000-82 , the Tax Court limited interest deductions in this context to the acquisition indebtedness amount only of $1 million. Interestingly, the IRS has now reversed course and in a Chief Counsel Advice is now allowing interest deductions on $1.1 million - $1 million for acquisition indebtedness and another $100,000 as home equity indebtedness. Its a rare day that the IRS goes against court precedent to provide a favorable interpretation for taxpayers, instead of the IRS.

Chief Counsel Advice 200940030

APPLICABLE FEDERAL RATES – DECEMBER 2009

ORDINARY INCOME ON SURRENDER OF LIFE INSURANCE POLICY

Borrowing from a life insurance policy is a tax-advantaged method of obtaining funds. Generally, a policy owner can borrow against the cash surrender value of non-term life insurance policies. The receipt of the loan proceeds is not a taxable event to the owner, even though part of the cash surrender value was created by untaxed earnings that accumulated in the life insurance policy. If the owner dies while the loan is outstanding, the owner does not typically have to repay the loan, although the beneficiary of the life insurance will have its policy proceeds reduced by the outstanding loans. Note that loans do not always come from direct loans from a policy – sometimes loan balances arise when premiums are not paid on the policy and the life insurance company charges the cash surrender value as a loan to pay the premiums.

The policy owner will often incur tax consequences relating to the loan if the policy is surrendered back to the company. At that time, the loan balance is treated as having been distributed to the policy owner. If the amount of the deemed loan distribution, plus any cash paid out to the owner by the insurance company, exceeds the total premiums paid by the owner (his or her “investment in the contract”), gain results.

This is what happened to the taxpayer in a recent Tax Court case. The taxpayer did not object to this gain treatment, but the taxpayer was not too pleased to learn that the gain was taxed as ordinary income and not capital gain (which would have received the benefit of lower capital gains rates).

The Tax Court schooled the taxpayer in the surrender of life insurance contracts. While such contracts may be capital assets, the surrender of a contract is not considered a “sale or exchange,” so no capital gains treatment is allowed (although there are exceptions for terminally ill or chronically ill individuals).

The taxpayer might have done better by selling the policy to a third party, instead of surrendering it back to the insurance company. This would allow for capital gains treatment. However, two important limitations apply for such sales, at least in the IRS’ opinion. First, the taxpayer’s basis in computing gain would not be all premium payments made, but only premium payments made that were not paid for the cost of insurance (that is, premium payments made in excess of cost of insurance that were used to build-up cash surrender value). Therefore, there would be more gain in this scenario than in the surrender scenario. Second, the IRS would still tax the owner at ordinary income rates on the portion of the cash surrender value attributable to earnings that had built up in the policy that were not previously subject to income tax. Therefore, numbers would have to be crunched to see if a sale of the policy would yield better tax results for the owner.

Barr, TC Memo 2009-250

SUMMARYOF NEW TAX ACT PROVISIONS

Congress passed last week the Worker, Homeownership, and Business Assistance Act of 2009. President Obama is expected to sign the new Act. Below is a summary of key provisions:

A. Expansion of 5 Year NOL Carrybacks. The ability to carry back NOL’s for 5 years (instead of the normal 2 years) has been expanded to include 2009 losses  (previously the 5 year rule only applied to 2008).  The rule has been expanded to include most taxpayers, not just the small businesses it applied to before. Other than taxpayers who have already carried back 2008 NOLs, only one extended carryback is allowed. There is also a 50% of taxable income limit to the use of the carryback to the 5th carryback year.

B. Suspension of 90% NOL Limitation for Alternative Minimum Tax Purposes. For tax years ending after 2002, the Act suspends the 90% limitation on the use of any alternative tax NOL deduction attributable to the carryback of an applicable NOL for which the extended carryback period is elected.

C. Extension of Extra .2% FUTA Surtax. The 6.2% FUTA tax rate continues to apply through June of 2011, and the 6.0% rate applies for the remainder of calendar year 2011 and for later years.

D. Increased Late Filing Penalties for S Corporations and Partnerships. Once upon a time, there typically was no penalty for late filing of an S corporation or partnership income tax return. Now it is $89 per owner per month. Under the new law, it will now be $195 per owner per month. This is irksome. Clearly, the current increase is not being made due to a compliance problem that is sought to be reduced. Instead, it is only a hidden tax – increasing revenues through penalties instead of an outright tax increase.

E. First Time Homeowner Credit Extended and Expanded. This credit is now extended to principal residence purchases purchased before May 1, 2010 (or a purchase closed before July 1, 2010 if a contract is entered into before May 1, 2010). The credit phases out for higher income taxpayers. Taxpayers who have stayed in their residence for a 5 year consecutive period will be deemed “first time homeowners” if they acquire a new residence. A residence cannot exceed $800,000.

TAX INCREASES IN HEALTH BILL NOT INDEXED FOR INFLATION, AND WILL ALSO REACH CAPITAL GAINS AND DIVIDENDS

In 1960, only 3% of tax filers paid a 30% or higher marginal tax rate. By 1980, after the inflation of the 1970s, the share was closer to 33%. In 1981, Congress realized the inequity in these "stealth" tax increases by requiring tax brackets be indexed for inflation. Without such indexing, lower income persons are eventually subjected to higher marginal rates of tax as their income rises with inflation, even though they have not really increased their income on after-tax basis. Similar "bracket creep" has occurred in the context of the alternative minimum tax, which once-upon-a-time only applied to 1% of U.S. taxpayers.

The current House health bill has not indexed two main tax features for inflation: the $500,000 threshold for the 5.4-percentage-point income tax surcharge, and the payroll level at which small businesses must pay a new 8% tax penalty for not offering health insurance. Therefore, as time (and inflation) march on, more and more taxpayers will be subject to these new taxes without any real increase in income level.

Also worthy of note is that the surcharge will apply to capital gains and dividends. Thus, the capital gains tax rate that is now 15% would increase in 2011 to 25.4% with the surcharge and repeal of the Bush tax rates. The tax rate on dividends would rise to 45% from 15% (5.4% plus the pre-Bush rate of 39.6%).

The increase in taxes on capital gains and dividends is what it is, and is being discussed here only because this point is not widely known. The lack of indexing for the new taxes and penalties, however, is a dishonest method of raising taxes, since it effectively raises taxes each year without a new Congressional vote or presidential approval.

WILLFUL FAILURE TO PAY OVER WITHHOLDING TAXES APPLIES, EVEN THOUGH EMPLOYER DID NOT HAVE THE MONEY TO PAY IT OVER

A nursing home operator collected payroll taxes from his employees. Instead of paying the collected taxes over to the IRS, the operator spent them on other expenses. The IRS obtained criminal tax convictions under Code Section 7202.

The nursing home operator appealed the conviction, claiming he could not have “willfully” failed to pay over the taxes since he did not have the money to pay them even if he wanted to.  The taxpayer argued that willfullness required “bad faith or evil intent” - which had to be absent if he didn't have the funds to pay over the taxes.

The 9th Circuit Court of Appeals rejected his appeal in 2008. It did so by noting that prior precedent which had opened the door to this type of argument had been subsequently changed. It further noted that the taxpayer's argument was  "inconsistent with common sense, for we think it unlikely that even under [the prior case law], a defendant could succeed in arguing that he did not willfully fail to pay because he spent the money on something else."

Earlier this week, the U.S. Supreme Court refused to review the case. Consequently, it seems highly unlikely that criminal defendants can avoid convictions for failure to pay over withheld taxes simply because they spent the money elsewhere.

U.S. v. Easterday, 102 AFTR 2d 2008-5847 (2008, CA 9) , cert denied 11/02/2009

STATE AND LOCAL TAX ISSUES RELATING TO PASS-THROUGH ENTITIES

The U.S. allows pass-through treatment for partnerships and limited liability companies for federal income tax purposes. The issue remains how such entities and their owners will be taxed in those states and localities that impose income taxes. Most states and localities will respect the pass-through treatment of pass-through entities when applying their local income taxes. However, there are other state and local tax issues and consequences that relate to pass-through entities that can yield surprising or unexpected results. A recent article discusses some of these.

In regard to taxes imposed directly on the entity, some states will still impose entity level taxes on pass-through entities. Examples include the New Hampshire business profits tax, Tennessee corporate excise and franchise taxes, New York City taxes on ‘S’ corporations and unincorporated entities, and the Texas margin tax on limited liability entities.

States may also impose substantial fees on the entities. These may be based on dollar amounts per member, a percentage of income or assets, or a flat annual fee. At times, if the fees are material enough, they could be subject to challenge under Constitutional apportionment principles.

States and localities may impose estimated and/or withholding taxes on nonresident owners. These taxes may be imposed without regard to actual distributions from the entities, can create real cash flow issues for entities, could put entities at risk of violating loan covenants that restrict distributions or expenditures to or for the benefit of owners, and can create disproportionate distribution issues since such taxes are often not imposed on all owners.

A related and somewhat complex issue is state and local income taxes of owners on the income of the entity. Different regimes may impose different results based on residency of the owners, residency of the entity, types of income incurred, and may create double taxation issues when full credit for taxes imposed by other jurisdictions is not granted.

Clearly, tax planning for pass-through entities cannot be limited to federal taxes - applicable state and local tax issues also must be reviewed.

State Taxation of Taxation of Partnerships, Limited Liability Companies, and Their Owners, Business Entities (WG&L), Sep/Oct 2009 by Carolyn Joy Lee, Bruce P. Ely, and Dennis Rimkunas

NEXT IN THE IRS' SIGHTS - HIGH NET WORTH INDIVIDUALS

Basking in the glow of the recently completed offshore voluntary compliance program, IRS Commissioner Shulman in a recent speech revealed a new direction for IRS enforcement - high net worth individuals. The Commissioner noted the recent formation of a Global High Wealth Industry group housed in its Large and Mid-Size Business operating division. The IRS is concerned that the complicated legal structures of high net worth individuals often mask aggressive tax strategies.

Areas of possible abuse cover a large gamut of legal and tax structures, including trusts, real estate investments, royalty and licensing agreements, revenue-based or equity-sharing arrangements, private foundations, privately-held companies, and partnerships and other flow-through entities. For these purposes, the IRS may use taxpayers with a net worth in excess of $30 million as the target demographic of its scrutiny.

The Commissioner also indicated that the IRS will be continuing its international enforcement efforts. These efforts include increased scrutiny of annual FBARs or foreign bank and financial account reports, and updating definitions and instructions under the current FBAR rules. The IRS is also opening international Criminal Investigation offices in several new locations around the world - in Beijing, Panama City and Sydney, in addition to existing offices, such as Hong Kong and Barbados.

Remarks before the AICPA National Conference on Federal Taxation, October 26, 2009

SECTION 2053 REGULATIONS ADOPT "WAIT AND SEE" APPROACH

The IRS has issued final Regulations regarding the influence of post-death events on deductions under Code Section 2053 for claims and expenses. The Regulations intentionally adopt an interpretation under Section 2053 that events occurring after a decedent's death are to be considered when determining the amount deductible under all provisions of section 2053 and that deductions under section 2053 generally are limited to amounts actually paid by the estate in satisfaction of deductible expenses and claims.

This means that for claims against an estate that cannot be paid before the due date of the estate tax payment, estates will have to pay taxes without benefit of a deduction (except to the extent that the claims come within an exception to requirement of payment for deduction). This can have a substantial adverse effect on the estate. The ability to get a deduction LATER via a refund claim (with or without a protective refund claim if needed to keep the statute of limitations open) provides cold comfort for estates that may need to sell assets or otherwise position themselves so as to be able to make an estate tax payment that may ultimately have been needed.

The Regulations also provide guidance on other claim and expense deduction issues, including the weight to be given to court decrees, consent decrees, litigation settlements, and the like in regard to determining an amount and validity of claims against an estate, the deductibility of executor and attorneys fees, and interest on claims.

I have prepared a detailed outline of the new provisions. A Word version is available here or at http://tinyurl.com/yjz2277, and a mindmap version is available here or at http://tinyurl.com/yhfn7j6 (Adobe Reader or Adobe Acrobat is recommended to view the map).

APPLICABLE FEDERAL RATES – NOVEMBER 2009

INHERITED IRA DOES NOT RECEIVE CREDITOR PROTECTION [FLORIDA]

In an interesting creditor protection case, Florida's Second District Court of Appeals held that an "inherited IRA" is not subject to creditor protection under Florida law, unlike regular IRAs that are held for the original owner/participant. In the case, an individual inherited his father's IRA. A creditor of the new beneficiary sought to garnish the IRA account.

Fla.Stats. §222.21(2)(a) generally exempts from the reach of creditors of a participant/beneficiary assets owned in an IRA that are being held for such beneficiary. Finding that IRAs that are "inherited" from a decedent are factually different from a tax exemption standpoint from IRAs held for the original funding participant, the Court held Fla.Stats. §222.21(2)(a) inapplicable. Thus, the creditor of the beneficiary of the IRA could garnish its assets.

Personally, I don't believe the statute supports such a distinction between inherited and regular IRAs since both IRAs provide a continuing income tax exemption during their remaining term - but of course my opinion has no legal significance. The court appeared to be heavily influenced by several federal bankruptcy court decisions that likewise concluded that inherited IRAs did not receive creditor protection under similar statutes in other states and under the federal Bankruptcy Code.

Robertson v. Deeb and RBC Wealth Management, 2nd DCA, Case No. 2D08-6428 (August 14, 2009)

IRS ISSUES GUIDANCE ON EXPATRIATION

It has taken awhile, but the IRS issued extensive guidance this week on the operation of the revised expatriation rules under Code Section 877A.

Some highlights and items covered:

-The Code requires expatriates to recognize gain or loss as if they sold all their assets for fair market value on the day before expatriation. A $600,000 exemption against gain is provided (adjusted for inflation). The guidance confirms that the expatriate gets a full adjustment in basis for the gain or loss to be used in regard to future gain or loss computations for those owned assets, even for assets whose gain is reduced under the exemption. Losses will reduce basis (apparently even if losses are not deductible under the Code).

-The guidance confirms that assets owned under the grantor trust rules will be subject to the deemed sale rules.

-The $600,000 exclusion is allocated among all gain assets pro-rata to the built-in gain of such assets.

-Only one lifetime $600,000 exclusion will apply (that is, if an expatriate becomes a U.S. taxpayer in the future and then a covered expatriate again).

-Coordination with Section 367(a) gain recognition agreements is provided.

-The guidance warns about the application of Section 684 gain on trust assets if the expatriation converts the trust from a domestic to a foreign trust.

-Federal estate tax rules are invoked to determine what assets an expatriate is deemed to own (and thus have subject to the deemed sale) and for computing fair market value. Essentially, assets that would have been included in the expatriate's gross estate if he or she had died the day before expatriation are subject to the deemed sale rules. One has to wonder if there is some overeaching involved in this definition. There are policy reasons for including assets in a decedent's gross estate (e.g., under Code Section 2036-2038) where the decedent no longer owns a direct interest - those rules do not apply for income tax purposes so it should be inappropriate to tax them under the income tax rules upon expatriation. Further, the guidance provides that a taxpayer is deemed to own beneficial interests in trust that are not included in his or her gross estate under certain circumstances. To the extent that the guidance seeks to impose, under these extended ownership rules, an expatriate's interest in assets of a nongrantor trust, these rules should be invalid since the Committee Reports to Section 877A make clear that such trust assets are not subject to the deemed sale rules.

-Distributions from a nongrantor trust to the expatriate are subject to a 30% withholding tax post-expatriation to the extent the distribution would have been taxable if the expatriate was still a U.S. taxpayer. The trustee is liable for the tax - if not withheld, the taxpayer is liable for it. A conversion of a nongrantor trust to a grantor trust will result in a deemed distribution of the trust assets to the expatriate grantor. These rules will impose the 30% withholding tax even on capital gain income included in distributed fiduciary accounting income. The 30% tax will not apply if the expatriate is taxed as a U.S. person at the time of distribution. Reporting and notice rules are provided. For example, expatriates may need to provide a Form W-8CE to trustees of trusts of which he or she is a beneficiary.

-Persons becoming a resident may step-up their basis in assets owned for this purpose at the time they become a U.S. resident. The guidance provides exceptions, however, for U.S. real property interests and U.S. trade or business property. Query whether the IRS has the statutory authority for these exceptions.

-A procedure is provided for obtaining deferral of the tax on the deemed sale until the sale of the applicable asset. Interest is charged and security must be provided.

-Taxpayers report their deemed gain by filing a "dual status return" - that is, by filing a Form 1040NR for the period of the year after expatriation, with an attachment of a Form 1040 for the preexpatriation period. Such a dual status return will not be needed if the taxpayer expatriates on January 1 of a year.

-Expatriates will continue to file Forms 1040NR in future years, except if all of their U.S. source income is withheld at the source and they have no effectively connected income.

-Form 8854 is the principal expatriation filing that is filed with the Form 1040NR relating to the year of expatration. The Form is loaded with applicable elections and disclosures. Expatriates who are not "covered expatriates" by reason of not surpassing the threshold income or asset holdings requirements must still file the Form 8854 to make the required certification that they have complied with U.S. tax return filing requirements for the preceding five years - failure to make that certification will result in the expatriate being deemed to be a covered expatriate.

-The reporting requirements and taxes relating to estate and gift tax transfers are deferred, pending issuance of subsequent guidance.

Notice 2009-85

LLC INTEREST IS NOT THE SAME AS A LIMITED PARTNER INTEREST UNDER PAL RULES (ONCE AGAIN)

Code Section 469 provides that passive activity losses (PALs) cannot be used to offset nonpassive activity income, such as wages, dividends, or profits from nonpassive activities. A taxpayer will incur PALs as to losses from the conduct of a trade or business in which the taxpayer does not materially participate. The IRS provides a list of rules for finding when a taxpayer will be treated as "materially participating" in a business. Treas. Regs. §1.469-5T (a)(1) through (7).

Under Code Section 469(h)(2) and the related Treasury Regulations, a limited partner's interest in a limited partnership is presumptively considered to not have material participation, and thus triggers PAL treatment for partnership losses. Treas. Regs. §1.469-5T(e)(1). Under this rule, only some of the rules referenced above for finding "material participation" can be used to show material participation - not all of the methods described under Treas. Regs. §1.469-5T (a)(1) through (7) are available. For example, the "more than 100 hours of participation" rule of (a)(3) cannot be used by a limited partner to show material participation.

What if the taxpayer owns a member interest in a limited liability company instead of a limited partner interest in a limited partnership? The IRS has sought to equate the two, and thus apply the above presumption of non-material participation status and limited exceptions to that status, to LLC member interests.

However, a recent Tax Court opinion finds that a limited liability company interest should not be treated the same a limited partnership interest for this purpose. This ruling allowed the taxpayer to use the "more than 100 hours of participation" rule to avoid PAL status for its losses.

This is not the first time the IRS has lost on this issue. It had previously lost in both the Tax Court and the Court of Federal Claims. At this point, the IRS would be hard-pressed to continue to assert a position contrary to all 3 of these cases.

Hegarty, TC Summary Opinion 2009-153

HOW NOT TO SET UP AND USE A FAMILY LIMITED PARTNERSHIP

A recent Tax Court Memorandum decision provides another example of how not to set up and operate an FLP. In this case, the taxpayers managed to violate Section 2036(a), and also have an indirect gift of property contributed.

Go to http://tinyurl.com/y9dfj5z for a diagramed summary of the case [click on the '+' to expand the diagram sections].

Estate of Roger D. Malkin, et al. v. Commissioner, (2009) TC Memo 2009-212

AUTHOR ADVOCATES USE OF LLC'S TO HOLD NON-U.S. ASSETS

In a recent article in Estate Planning, Michael Galligan advocates for the use of U.S. LLC's to hold the non-U.S. assets of U.S. persons for estate planning purposes. For my easy-to-read summary of the article, including the benefits and possible drawbacks of that planning approach, go to http://tiny.cc/A4sum.

VOLUNTARY DISCLOSURE PROGRAM EXTENDED UNTIL OCTOBER 15

The IRS has extended until October 15, 2009 the deadline for entering the voluntary disclosure program for unreported offshore accounts from the current September 23 date. The IRS also announced that there will be no more extensions.

APPLICABLE FEDERAL RATES – OCTOBER 2009

COMMUNITY PROPERTY PRINCIPLES DID NOT ATTACH TO COUPLE'S PROPERTY WHEN THEY MOVED TO COMMUNITY PROPERTY COUNTRY

Noordin Charania owned substantial holdings in the stock of a U.S. corporation when he died. Even though he was a nonresident of the U.S., his estate was taxable on that stock for U.S. estate tax purposes based on the U.S. situs of stock of a U.S. corporation.

Mr. Charania's estate argued that only half of the stock was includible in his estate for estate tax purposes because the property was owned as community property with his surviving wife. Mr. Charania married his spouse in Uganda, which was at the time governed by British common law principles and was not a community property jurisdiction. Mr. Charania and his spouse eventually fled Uganda with little in the way of assets, and settled in Belgium, a community property jurisdiction, where the couple was living when he died. Mr. Charania acquired the subject assets while living in Belgium.

Mr. Charania's estate argued that the marital domicile was changed to Belgium, and community property principles applied to the stock. That is, it sought to apply the concept of a "mutable" marital domicile - one that moves with the couple (here, to Belgium). The IRS argued for an "immutable" marital domicile - one that does not move with the couple but that remains where the couple lived when they married.

The Tax Court undertook an extensive analysis on whether marital domiciles were mutable or immutable under British common law. That analysis, along with a finding that the Charanias did nothing under Belgium law to submit themselves to the local community property regime and did not otherwise evidence any intent to be part of that regime, led the Tax Court to conclude that the Charanias were not governed by Belgium community property law and the decedent's entire interest in the U.S. stock was subject to U.S. estate tax.

The case is of limited precedential value, per its reliance on British common law issues. Nonetheless, it demonstrates the difficulties that often arise in determining appropriate estate tax consequences when dealing with international taxpayers and/or international assets. This case was resolved only after integrating British common law rules, the obscure concepts of mutable and immutable marital domiciles, Belgium marital property rules, and international conflict of law provisions. For good measure and interesting reading, it included a dose of 20th century international politics, since the decedent was expelled from Uganda by its infamous dictator, Idi Amin.

Estate of Noordin M. Charania, et al. v. Commissioner, 133 T.C. No. 7

PROCEDURES FINALIZED FOR CHALLENGING SOME GIFT TAX DETERMINATIONS

If a gift is reported on a gift tax return, the IRS may challenge the value of the transferred property. If the IRS increases the value, but the taxpayer has adequate unified credit to cover any increase in tax, there is no increase in actual tax that results at the time. Previously, taxpayers had no way to obtain relief from such a change in value in Tax Court due to the absence of the imposition of current tax, even though the use of the taxpayer's unified credit may result in additional gift taxes or estate taxes due to later transfers.

In 1997, Code Section 7477 was enacted to provide a route to the Tax Court in circumstances such as these. The IRS has now issued Regulations providing when taxpayers can go this route to obtain a declaratory judgment from the Tax Court on the value of a reported gift.

There are a number of prerequisites/requirements before such relief is available:

a. The transfer must be shown or disclosed on a gift tax return, including a statement attached to a return;

b. The IRS must make a determination regarding the gift tax treatment of the transfer that results in an actual controversy in a situation where the adjustments do not result in a gift tax deficiency or refund. Thus, a taxpayer cannot initiate Tax Court review absent a dispute with the IRS. The IRS determination is deemed made by the mailing of a Letter 3569 to notify the taxpayer of the adjustments proposed by IRS;

c. The donor has to file a pleading seeking a declaratory judgment with the Tax Court before the 91st day after the mailing of the Letter 3569 by IRS (similar to 90 day letter procedures);

d. The taxpayer must have exhausted all administrative remedies. The Regulations list the various remedies and at what stage it agrees that they have been exhausted.

The new Regulations, which adopted fairly closely previously issued proposed regulations, are effective for Tax Court petitions filed after September 8, 2009.

HARDSHIP DISTRIBUTION FROM RETIREMENT PLAN DOES NOT AVOID 10% PENALTY

In today's economic hard times, many employees are seeking early distribution from their qualified retirement plans at work to help cover expenses. If the plan allows for it, a "hardship" distribution can be made if due to an immediate and heavy financial need of the employee and is in an amount necessary to meet the financial need.

Such distributions are not subject to the 20% withholding tax applicable to early plan distributions. They are still subject to income tax in the hands of the beneficiary.

A taxpayer who received a hardship distribution claimed that the distribution was not subject to the 10% penalty of Section 72(t)(1), which imposes a penalty on distributions from qualified retirement plans before age 59 1/2, due to the financial hardship involved. The Tax Court, noting that while some exceptions exist for imposing the 10% penalty tax, determined that there is no exception for mere financial hardship in the law.

There is an exception from the 10% penalty for "disability" distributions. However, the definition of "disability" is fairly strict. A taxpayer is considered disabled for this purpose only if he is unable to engage in any substantial gainful activity by reason of a medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued or indefinite duration. The Treasury Regulations provide that only medical conditions of a nature so severe as to prevent substantial gainful activity result in a taxpayer's being considered disabled for this purpose.

The taxpayer failed this definition of "disability" on numerous levels. His doctor indicated that he would fully recover from his mental illness (relating to post-traumatic stress disorder from his job). He also continued to work at the same job after his "disability" and also engaged in a business activity throughout the year that required him to travel a significant distance numerous times. Further, he later got another job full-time job with another employer.

Thus, avoiding the 10% penalty is not possible simply due to financial hardship. Taxpayers seeking to avoid the penalty based on "disability" will also have to overcome a high threshold to avoid the penalty.

Dollander, TC Memo 2009-187

OBAMA TO MAKE IT EASIER FOR EMPLOYEES TO SAVE FOR RETIREMENT

In an effort to boost savings by employees, President Obama is seeking to make several changes that will make it easier for employees to save for retirement. Some of the changes can be implemented immediately by the President - others will require Congressional law changes. The key changes are:

a. Taxpayers will be able to buy U.S. savings bonds with their tax refunds just by checking a box on their tax forms.

b. Employees will be allowed to contribute their pay attributable to unused vacation time to their 401(k) plans.

c. Workers would be automatically enrolled in workplace retirement plans, and would have to opt out if they do not want to participate. This is the opposite of current rules, where workers now have to opt in.

d. Legislation will be sought to allow workers without workplace retirement plans to have contributions made to IRAs through payroll deposit contributions at their places of work.

The voluntary nature of such measures is to be applauded. Methods of enhancing savings opportunities without unduly burdening employers is also good policy - so hopefully when formalized these rules will be implemented in a way that do not increase employer costs.

IRA FOUND NOT EXEMPT FROM CREDITOR CLAIMS

Federal bankruptcy law generally provides that an individual retirement account (IRA) that is exempt from income tax is an exempt bankruptcy asset that cannot be reached by creditors. However, such exemption is not bulletproof, much to the chagrin of Ernest Willis.

Mr. Willis owned a substantial IRA at the time he went into bankruptcy. Since the IRA was sizeable, his creditors did not "roll over" on the exemption issue (apologies for the IRA pun) but instead examined Mr. Willis' prior interactions with his IRA. Based on two sets of transactions that occurred many years in the past, the creditors were able to convince the court that the IRA was no longer exempt from tax due to Mr. Willis having engaged in prohibited transactions with his IRA. Under federal tax law, such prohibited transactions would cost the IRA its income tax exemption, and thus also resulted in the loss of bankruptcy protection. Such loss of IRA income tax exemption was successfully asserted, even though the IRS had never examined the IRA or Mr. Willis on the issue. The purported prohibited transactions related to borrowing from the IRA and improper distributions and contributions.

No analysis was undertaken of Florida's separate bankruptcy exemption for IRA assets.

Thus, the case opens up a possible avenue of challenge for creditors to reaching IRA assets, and a chink in the armor of protection for IRA owners and beneficiaries.

In Re: Willis, 104 AFTR 2d 2009-5669 (Bktcy Ct FL 2009)

VALUATION DISCOUNTS ALLOWED FOR DISREGARDED ENTITY INTERESTS

Under the "check the box" Treasury Regulations, an individual owning an interest in a single member LLC will be treated by default as owning the assets of the entity directly (absent an election to have the LLC taxed as a corporation). The Regulations provide that such disregarded entity treatment will be for all Federal tax purposes.

The issue then arises whether such an owner will value interests in the LLC that are gifted as if the owner owned and gifted the underlying assets directly, or whether usual entity interest valuation principles can be applied based on the property law attributes of the ownership interest in the LLC. If the latter treatment is correct, the taxpayer can value the transferred interests with due regard for discounts for lack of marketability or lack of control - if the former treatment is applied, such discounts are likely unavailable.

This was the issue raised in a recent Tax Court case. In the case, the owner of the LLC transferred various percentage interests in the LLC by gift, and also sold some of those interests. The taxpayer sought to apply lack of marketability and lack of control discounts, for gift tax valuation purposes and the IRS argued that the above disregarded entity/"check the box" rules did not allow for such discounts.

In an opinion favorable to taxpayers (and notwithstanding a lengthy dissenting opinion), the Tax Court sided with the taxpayer and allowed the application of discounts. The Court applied gift tax law which provides that in valuing a gift, State law principles are applied to determine the characteristics of the transferred property. The federal "check the box" rules are not State law rules, and thus should not enter into determining the character of transferred property.

Under the applicable State law (New York), the taxpayer did not have a property interest in the underlying assets of LLC, since under New York law the LLC is recognized as an entity separate and apart from its members. Therefore, there was no State law legal interest or right in the underlying LLC assets that could be gifted - instead, the gift was of the ownership interest in the LLC, applying valuation principles relating to interests in entities.

Notably, the gifts involved in the case were of multiple smaller pieces of the LLC, and not one gift of the taxpayer's entire interest or a gift of a majority interest in the LLC. Presumably, if the gift had been of the taxpayer's entire interest or a majority interest, under entity valuation principles, it is likely that little or no discount would have been available.

Suzanne Pierre, 133 TC No. 2 (2009)

APPLICABLE FEDERAL RATES – SEPTEMBER 2009

HIGHLIGHTS OF UBS SETTLEMENT

The Internal Revenue Service and the Department of Justice have entered into an agreement that will result in the IRS receiving an unprecedented amount of information on United States holders of accounts at the Swiss bank UBS. Highlights of agreement include:

--Pursuant to a treaty request, the IRS will receive information on accounts of various amounts and types, including bank-only accounts, custody accounts in which securities or other investment assets were held and offshore company nominee accounts through which an individual indirectly held beneficial ownership in the accounts.

--If the results are not satisfactory to the IRS, it may resume other judicial remedies to gather additional information.

--The Swiss government will direct UBS to notify account holders that their information is included in the IRS treaty request. It is expected that these notices will be sent on a rolling basis with some being sent over the coming weeks and others over the coming months. Receipt of this notice will not by itself preclude the account holder from entering the IRS' Voluntary Disclosure Program.

--The Swiss government will also entertain requests for similarly situated accounts at other Swiss banks.

--Individuals whose information is obtained by the IRS through this process will not be eligible for the Voluntary Disclosure Program.

IR 2009-75

© 2009 Thomson Reuters/RIA. All rights reserved.

WATCH OUT - DEADLINES APPROACHING FOR EXTENDED NOL CARRYBACKS

Net operating losses (NOLs) generally may be carried back 2 years and forward 20 years. However, for NOLs arising in tax years ending after Dec. 31, 2007, the American Recovery and Reinvestment Act of 2009 permits an eligible small business (ESB) to elect to increase the NOL carryback period for 2008 NOLs from 2 years to 3, 4, or 5 years. The benefits of the extended carryback include (1) offsetting the loss against income earned in up to five prior tax years, (2) getting a refund of taxes paid up to five years ago, and (3) getting the benefit of part or all of the loss now, rather than waiting to claim it on future tax returns against future income.

ESBs are businesses (whether corporations, partnerships or sole proprieterships) that have no more than an average of $15 million in gross receipts over a three-year period ending with the tax year of the NOL. The carryback election is made either by making it on a timely filed tax return for 2008 or by filing the appropriate refund forms.

The deadline for calendar year taxpayers to elect to carryback is approaching. For corporations, the election must be made by September 15, 2009, and for noncorporate taxpayers by October 15,2009. Taxpayers who believe they are eligible for the carryback should consult with their tax preparers to make sure that the deadline is not missed.

FBAR FILING DATE EXTENDED FOR SOME FILERS

The area of FBAR filings (Report of Foreign Bank and Financial Accounts, Form TD F 90-22.1) has been a hotbed of activity recently, for practitioners, taxpayers, and the IRS. In October 2008, the IRS revised the FBAR and the accompanying instructions. On June 5, 2009, the IRS issued Announcement 2009-51, 2009-25 I.R.B. 1105, which stated that the IRS is temporarily suspending the filing requirement of the FBAR for those persons who are not U.S. citizens, residents, or domestic entities. On May 6, 2009 and June 24, 2009, the IRS posted questions and answers (Q&As-9 and -43, respectively) on its public website that provide relief to certain persons who only recently learned of their obligation to file an FBAR by setting forth conditions and procedures for filing Form TD F 90-22.1 by September 23, 2009.

The announcements continue. The IRS has now announced that two categories of filers can wait until June 30, 2010 to file FBAR's for 2008 and prior years (FBARs are usually due by June 30 of the calendar year after the reporting year). The purpose of the delay is to give the IRS time to provide more guidance as to who and how much file for these categories.

The two categories of filers who can take advantage of the deferred filing date are (i) persons with signature authority over, but no financial interest in, a foreign financial account, and (ii) persons with a financial interest in, or signature authority over, a foreign commingled fund.

Notice 2009-62, 2009-35 IRB, 08/07/2009

POP QUIZ - FLORIDA APPORTIONMENT

BACKGROUND FACTS:

Decedent dies, and his estate is subject to federal estate taxes. Part of his taxable estate assets pass under his Last Will and through his probate estate, and part of the assets consist of life insurance that passes outside of the probate estate. Thus, part of the federal estate taxes are attributable to the life insurance.

Florida law provides that the default allocation and apportionment of estate taxes is that the recipient of insurance and other nonprobate assets pay their share of the estate taxes attributable to those nonprobate assets, absent a proper allocation of those taxes to probate property.

The decedent's Last Will provides:

"I direct my Personal Representative TO PAY OUT OF THE property which would otherwise become a part of the RESIDUARY ESTATE, ALL ESTATE, inheritance, transfer and succession TAXES, including interest and penalties thereon, WHICH MAY BE LAWFULLY ASSESSED BY REASON OF MY DEATH. I WAIVE on behalf of my estate ANY RIGHT TO RECOVER any part of SUCH TAXES, interest or penalties FROM any person, including ANY BENEFICIARY OF INSURANCE on my life and anyone who may have received from me or from my estate any property which is taxable as part of my estate." (emphasis added)

Fla.Stats. § 733.817(5)(h)(4), relating to when a direction in a Last Will to pay taxes on nonprobate property from probate property will be respected, provides:

"For a direction in a governing instrument to be effective to direct payment of taxes attributable to property not passing under the governing instrument from property passing under the governing instrument, the governing instrument must expressly refer to this section, or expressly indicate that the property passing under the governing instrument is to bear the burden of taxation for property not passing under the governing instrument. A direction in the governing instrument to the effect that all taxes are to be paid from property passing under the governing instrument whether attributable to property passing under the governing instrument or otherwise shall be effective to direct the payment from property passing under the governing instrument of taxes attributable to property not passing under the governing instrument."

THE QUESTION:

Does the insurance in the decedent's estate bear estate taxes, or will the insurance beneficiaries receive the proceeds tax-free while the probate estate and its beneficiaries have to pay the estate taxes attributable to the insurance?

THE ANSWER:

According to the recently decided appellate case of Boulis v. Estate of Boulis, 34 Fla.L.Weekly D1567b, (4th DCA, August 5, 2009), the tax apportionment clause is NOT effective to shift the taxation of the insurance proceeds to the probate estate, so the insurance beneficiaries will have to bear their share of the estate taxes.

Doesn't the apportionment clause in the Last Will direct to "pay out of the residuary estate...all estate taxes?" Yes, it does. But per Fla.Stats. § 733.817(5)(h)(4), for such a direction to be effective, such a direction must either refer to that section of the law (which was not done in the Last Will), or "expressly indicate that the property passing under the governing instrument is to bear the burden of taxation for property not passing under the governing instrument."

To the appellate court, a direct expression to pay all estate taxes out of the probate estate is not the same as the requisite direct expression to have nonprobate property bear the burden of the estate taxes. Presumably, some direct reference to "nonprobate property" is needed. But wasn't there such a reference when the Last Will expressly provides that the estate waived any right to recover estate taxes from insurance beneficiaries?

Did you get the answer right? Don't be upset if you didn't - reasonable minds clearly will differ on whether the appellate court was correct on this one.

LESSONS TO BE LEARNED:

Don't mess around with apportionment. If you want to have estate taxes paid by the probate estate on nonprobate assets, stick closely to the statutory language. This means either make a direct reference to Fla.Stats. § 733.817(5)(h)(4), or use the "safe harbor" language in that statute ("all taxes are to be paid from property passing under the governing instrument whether attributable to property passing under the governing instrument or otherwise") or something very close to it.

BASIS OVERSTATEMENT DOES NOT TRIGGER 6 YEAR STATUTE OF LIMITATIONS

Under the Internal Revenue Code, the statute of limitations imposed on the IRS for assessing additional income tax is 3 years after the later of the date the tax return was filed or the due date of the tax return. However, a 6-year period of limitations applies when a taxpayer omits from gross income an amount that's greater than 25% of the amount of gross income stated in the return.

In a recent case before the Court of Appeals for the Federal Circuit, the taxpayer had overstated its adjusted basis in reporting gain from a disposition of property. This overstatement of basis resulted in less gain being reported then was determined to be due. The issue before the Court was whether an understatement of gain relating to an overstatement of basis is an "omission from gross income" giving rise to the extended 6-year period of limitations. Similar rules apply in regard to partnership audits, which rules applied in this case.

Reversing the Court of Claims, the Court of Appeals held that the 6-year statute of limitations did not apply. The Court relied on the U.S. Supreme Court case of Colony Inc. v. Comm., 357 US 28 (1958) wherein the U.S. Supreme Court had indicated that the statutory language refers to the specific situation where a taxpayer actually omitted some income receipt or accrual in his computation of gross income, and not more generally to errors in that computation arising from other causes.

The Ninth Circuit Court of Appeals ruled similarly in 2009, so the IRS will likely have to concede this point in the future.

Salman Ranch Ltd. et al. v. U.S., 104 AFTR 2d ¶ 2009-5190 (CA FC 7/30/2009)

DISCOUNTING VOIDED VIA STEP TRANSACTION DOCTRINE

Oftentimes, taxpayers contribute assets to partnerships or LLCs, and then make a gift of ownership interests in the partnership or LLC and seek to apply a valuation discount to the gift. A recent District Court case voided the application of the discounts through the use of the step transaction doctrine.

In the case, there was some uncertainty whether the gift of interests in an LLC occurred simultaneously with the contribution of assets to the LLC, or sometime after. Nonetheless, the court addressed what result would occur even if the funding to the LLC occurred prior to the gift of LLC interests.

The court noted that there are three different tests under which the step transaction can be applied. The binding commitment test, which is the narrowest alternative, collapses a series of transactions into one “if, at the time the first step is entered into, there was a binding commitment to undertake the later step.” The end result test stands at the other extreme and is the most flexible standard, asking whether the “series of formally separate steps are really pre-arranged parts of a single transaction intended from the outset to reach the ultimate result.” The interdependence test inquires whether, “on a reasonable interpretation of objective facts,” the steps were “so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series” of transactions. The interdependence test focuses on the relationships between the steps, rather than on their end result. The question is whether “any one step would have been undertaken except in contemplation of the other integrating acts.”

The court found that the transaction flunked all three tests under the facts of the case. By applying the step transaction doctrine, the court determined that the assets contributed to the LLC were an indirect gift to the recipients of the LLC interest gifts, and thus not entitled to a valuation discount based on LLC attributes.

In discussing similar cases where the step transaction was NOT applied, the court provided guidance for avoiding its application. The court noted in those other cases (Holman v. Comm'r, 130 T.C. 170 (2008); Gross v. Comm'r, 96 T.C.M. (CCH) 187, 2008 [TC Memo 2008-221] WL 4388277 (2008)) the assets contributed to the entity had the potential to materially fluctuate in value prior to the subsequent gifting of the interests in the entity. Also, in those other cases, the donor/contributor had made an affirmative and clear decision to delay the gifting of the interests until some time after the contribution of assets to the entity (even though the delay was only a few days). Practitioners seeking to avoid the application of the step transaction doctrine should be mindful of these types of facts.

Linton v. U.S., 104 AFTR 2d 2009-5176, 07/01/2009

CASH FOR CLUNKERS [FLORIDA]

If you are fortunate (unfortunate?) enough to qualify for the cash for clunkers program, the federal government will provide a $3,500 or $4,500 voucher toward the purchase or lease of a new, more fuel efficient vehicle when the purchaser or lessee surrenders an eligible trade-in to a participating dealer.

In a break to participants, the Florida Department of Revenue has advised car dealers that they should consider the voucher itself as a trade-in for purposes of Florida sales tax purposes. This means that the amount of the voucher will be taken off the sales price in computing sales tax due on the new vehicle purchase.

Tax Information Publication No. 09A01-11, July 16, 2009

IRS CONFIRMS PRECIOUS METAL ETF'S CAN GENERATE COLLECTIBLES GAINS

Many investors purchase gold, silver, and other precious metals through exchange traded funds (ETFs). Since shares in ETFs are usually traded through stock exchanges, the question has arisen whether any long term gains on sale of such ETF metal shares will be subject to the standard 15% maximum income tax rate long term capital gains, or the 28% "collectibles" maximum tax rate that would otherwise apply to direct gains in such metals.

The IRS has recently released a 2008 Chief Counsel Memorandum that confirms that as far as it is concerned, if the ETF is structured as a "trust" for income tax purposes and the fund purchases physical metal, then the gain will be collectibles gains, and thus long term gains will be subject to the 28% maximum rate.

Interestingly, in earlier private letter rulings (PLRs 200732026 & 200732027), the IRS adopted a somewhat contrary opinion when it ruled that the acquisition of shares of a publicly traded investment trust invested in gold or silver by either an IRA or an individually-directed account under a qualified retirement plan would not be considered the prohibited acquisition of a collectible under Code Section 408(m)(1).

Office of Chief Counsel Memorandum, CC:ITA:B01:LAAyres, May 2, 2008

APPLICABLE FEDERAL RATES – AUGUST 2009

CASUALTY LOSSES AND CHINESE DRYWALL

Many homeowners are suffering with damages to their residences from purportedly tainted Chinese drywall. The IRS has provided guidance on if and when damages may give rise to a casualty loss deduction under Code Section 163(h). The IRS Associate Chief Counsel indicates that such damages will meet the casualty loss requirements of being sudden, unexpected, or unusual, if the Environmental Protection Agency or the Consumer Safety Product Commission determines that such drywall emits chemical fumes that causes the extreme or unusual damages.

In computing such losses, taxpayers need to keep certain things in mind. First, casualty losses generally are subject to a $100-per-casualty floor and the 10%-of-AGI limitation. Second, the taxpayer will need to prove the amount of the loss, which is the loss in fair market value (but no greater than the taxpayer's adjusted basis in the residence).

In computing this loss of value, the taxpayer will need to separate out (and not deduct) loss in value relating to market declines in value. Since the U.S. residential market has undertaken a general decline in recent years, this separating of loss between drywall damage and market loss may be difficult to prove. Taxpayers may instead want to avail themselves of Treas.Reg. § 1.165-7(a)(2)(ii) which, if met, will allow the loss to be computed instead based on the cost of repairs.

The IRS also noted that costs incident to a casualty, such as temporary alternative housing, are nondeductible personal expenses and not casualty losses.

Taxpayers must also take the deduction in the proper year, which is generally the year the loss is sustained, or when a determination is made that the loss will not be fully reimbursed.

IRS PROVIDES MORE GUIDANCE (AND REQUIREMENTS) FOR COST SHARING DEVELOPMENT OF INTANGIBLES

Section 482 of the Internal Revenue Code requires arms-length pricing for transactions occurring between commonly controlled taxpayers. A principal objective of these rules is to assure that a fair amount of income and thus tax occurs within the U.S. taxing jurisdiction - that is, it seeks to prevent the shifting of income out of the U.S., or deductions into the U.S., through the use of overcharging or undercharging for items between related entities situated in different jurisdictions. To assure proper payments for use of intangible property, arms-length pricing generally requires that the pricing be commensurate with the income generated from the intangible.

Use of intangibles outside of the U.S. by non-U.S. entities can often allow the non-U.S. entity to generate income that is not immediately (or ever) subject to U.S. tax. If a U.S. entity develops the intangible, but then transfers it outside the U.S. to a related entity, Section 367 and/or 482 can operate to create income for the U.S. entity. To avoid this income, taxpayers often enter into joint development arrangements with related entities. Such "cost sharing" arrangements allow the U.S. and non-U.S. entities to jointly develop, own, and then use the developed intangibles. Since they jointly developed the intangible, there is no need to transfer ownership or license use of the intangible from one entity to the other, so the impact of Sections 482 and 367 can be minimized.

Prior regulations under Section 482 acknowledged cost sharing as a valid planning mechanism. However, the regulations did not provide a lot of detail on what cost sharing arrangements would be respected by the IRS.

In recently issued regulations, the IRS has now put a lot of "meat on the bones" of its prior regulations. The regulations are a two-edged sword. On the one hand, they provide a lot more guidance on how to put together a cost-sharing arrangement that the IRS will respect. On the other hand, taxpayers that do not follow the new rules risk having their cost-sharing arrangements challenged.

For those that are interested but haven't had a chance to review the regulations yet, below are some of the highlights.

GENERAL RULE. The IRS will respect a cost-sharing arrangement if (1) cost sharing transactions (CST) are entered into, (2) platform contributions are compensated for, and (3) various compliance requirements are met.

CST TRANSACTIONS. This obligation requires that commonly controlled taxpayers have to contribute to intangible development costs (IDCs) in proportion to their shares of reasonably anticipated benefits (RAB shares) from the developed intangibles by entering into cost sharing transactions (CSTs). In plain English, this means that the commonly controlled participants involved in developing an intangible, must each contribute via cash or property a pro rata share of the costs of development, in proportion to each of their anticipated benefits from the intangible asset. IDCs include all costs, including cash-based compensation, that are identified with or reasonably allocable to the development of the intangible asset. IDC's exclude land and depreciable property acquisition costs, and also exclude interest costs and income taxes. If a cost relates to the development of an intangible and also to other business activities, then it must be reasonably allocated between the two activities.

DIVISION OF BENEFITS. The future benefits from the intangible must be divided up among the commonly controlled participants in only certain ways. First, they can divide up the benefits via allocation of various nonoverlapping geographical divisions of use. Second, and this is new, the division can be made by allocating various "fields of use" among the participants. Third, and also new, the IRS will allow for other division methods established by taxpayers if they meet certain requirements such as clear and unambiguous division, that the method is verifiable, the benefit allocations are non-overlapping, perpetual, and exclusive, and the results are reasonably predictable.

COMPENSATION FOR PLATFORM CONTRIBUTIONS. As noted above, participants must contribute to the cost of IDC development in proportion to their anticipated benefits. However, sometimes participants will make noncash contributions to the development by contributing resources, capabilities, or rights that were acquired outside of the development of the subject IDC. For example, one of the controlled entities may provide its own research scientists or intellectual property to the IDC development process. The cost-sharing rules require that the contributors of such "platform contributions" receive arms-length payments for such platform contributions from the other participants. The arms-length payments are computed using traditional Section 482 arms-length computation methods and principles, with some special rules thrown in for good measure. Note that platform contribution payments must commence shortly after they are incurred.

ADMINISTRATIVE REQUIREMENTS. In addition to meeting the above substantive requirements, a qualified cost-sharing arrangement must (a) have a cost-sharing written contract, entered into within 60 days of the parties incurring their first intangible development cost, that provides various terms set out in the regulations, (b) meet additional documentary requirements, (c) meet specified accounting and books & records requirements, and (d) file required disclosures with the IRS, including one within 90 days of the first incurred IDC, and then annually. Note that the above 60 day requirement under (a) is a trap for the unwary. Taxpayers that start work on jointly developing an intangible, but don't enter into their agreement within the required 60 day period, risk having their cost-sharing arrangement not being respected by the IRS.

The IRS has done a good job in fleshing out the requirements for cost-sharing arrangements for taxpayers. This will provide more comfort and certainty for taxpayers engaging in these type of arrangements. At the same time, it has imposed various obligations, including proper payments for platform contributions and misc. administrative requirements that must be complied with, so the certainty that is provided comes with compliance costs, and risks for those that don't fully comply with the new rules.

Treas.Regs. Section 1.482-7T

IRS MAY ISSUE RELIEF FOR SWAP PARTICIPANTS WITH BANKRUPT QUALIFIED INTERMEDIARIES

On May 24 of this year, I discussed how some taxpayers suffered economic losses in a Section 1031 exchange when funds or property were held for them by Qualified Intermediaries that went bankrupt. In letters sent by the IRS to a Senator and a Congressman, the has IRS indicated that even though like-kind exchanges run through such Qualified Intermediaries could not be completed due to the bankruptcy of a Qualified Intermediary and not through any fault of the taxpayers, the taxpayers still need to recognize gain (if there is gain) if the property they contributed to the exchange was disposed of by the Qualified Intermediary.

The IRS noted that losses for lost funds and/or replacement property may be allowable under Section 165(a) in the year the loss is sustained. Thus, there may be an available offset for any gain that arises, depending on when the loss is evidenced by closed and completed transactions and fixed by identifiable events. However, if the loss occurs in a different tax year, a mismatch of gain and loss can occur.

The IRS did indicate, however, that it is "considering the tax policy implications of current law and evaluating the scope of [its] authority in this area to issue administrative guidance.” Therefore, it is possible that some direct relief may ultimately be issued by the IRS (presumably including the ability of the taxpayer to not have to recognize gain on the initial disposition, or at least measure gain and loss by the actual consideration received back).

IRS CAN LEVY ON STOCK OPTIONS

In a recent Chief Counsel Advice (CCA), the IRS determined that it may enforce a levy by seizing and selling a taxpayer's executive stock options. That the options had restrictions on transferability was found not to impede seizure and sale.

In the CCA, the taxpayer owned vested nonqualified stock options (NQSOs) and qualified stock options (ISOs) in a corporation. Under the option terms, the taxpayer could only transfer the options only to certain named persons or under certain circumstances (e.g., death).

In regard to the NQSOs, the IRS noted that the transfer restrictions were contractual, not statutory. The IRS determined that the Code Section 6331 levy provisions superseded private contractual restrictions.

In regard to the ISOs, the restrictions on transfer were statutory, per Code Section 422. Nonetheless, the IRS concluded that Code Section 6334(c) trumps the ISO restrictions. That provision reads “not withstanding any other law of the United States ... no property or rights to property shall be exempt from levy other than property specifically made exempt by subsection (a).” Since there is no statutory exemption for stock options, the IRS determined it could levy on, seize, and sell the options.

This result is not unexpected. There are other areas of the law under which third party creditors cannot reach a property interest of a taxpayer, but the IRS can. Two of these are a taxpayer's interest in an ERISA-qualified retirement plan, and state law homestead protections.

While the CCA noted that there was a contractual agreement between the taxpayer and the company that opened the options up to the tax authorities, it went on to say that it was not relying on that contractual agreement in reaching its conclusion.

Chief Counsel Advice 200926001

UNDUE INFLUENCE PERMISSIBLE FOR TRUST REVOCATIONS [FLORIDA]

If an individual exercises undue influence in regard to the creation of a trust, the trust can be voided. Interestingly, if an individual exercises undue influence to convince a grantor to revoke his or her revocable trust, no challenge to the revocation is allowable.

Both situations involve improper influence that results in a change in a grantor’s estate planning disposition. Nonetheless, Florida’s 4th District Court of Appeals recently asserted that one type of influence is subject to challenge, while the other is not.

This unusual state of affairs was premised by the appeals court by the Florida Supreme Court case of Florida National Bank of Palm Beach County v. Genova, 460 So.2d 895 (Fla.1984). Genova provided that a grantor’s right to revoke his or her revocable trust should not be subject to challenge on undue influence grounds. Many believed that this case could be limited to situations when the grantor was still alive – that is, no challenge on undue influence grounds would lie while the grantor was living. However, the 4th DCA rejected the argument that Genova was so limited, and instead also applied its rule to reject an undue influence challenge to a revocable trust revocation after the grantor was deceased.

MacIntyre, ex rel. Wedrall Trust v. Wedell, --- So.3d ----, 2009 WL 1393375, Fla.App. 4 Dist., 2009.

REVISED “INVERSION” REGULATIONS

NOTE: The following discussion relates to a narrow area of tax law relating to the transfer of a U.S. corporation or its business to a foreign corporation, so it may be of interest only to a small segment of readers.

Section 7874 was enacted to foreclose many tax benefits from the transfer of a U.S. corporate business to a foreign corporation or the insertion of a foreign holding company as owner of U.S. corporations. The rules also apply to similar partnership transfers. Two different sets of rules apply, depending on the percentage ownership in the foreign entity that is acquired by former owners of the U.S. entity. The IRS has now issued additional regulations regarding the application of these rules, which regulations apply to acquisitions completed after June 9, 2009.

The following is a summary of the items covered in the new regulations:

1. The use of two or more entities to acquire the U.S. entity as a method of avoiding the anti-inversion rules is prohibited;

2. Guidance on how the rules apply when the foreign corporation is acquiring more than one U.S. entity is provided;

3. Publicly-traded foreign partnerships may be treated as a foreign corporation under the rules, even if public trading does not being in the two-year period after the acquisition;

4. Treating interests in entities as equity interests under the rules if they are economically equivalent to equity;

5. Clarification of how the rules apply when the acquisition is not of a U.S. entity, but of  a foreign entity that owns a U.S. entity;

6. Guidance as to when interests of creditors may be treated as equity interests under the rules;

7. The taking away of a safe harbor and guidance as to what constitutes substantial business activities for purposes of the exception to the rules where the foreign corporation has substantial business activities in its home country; and

8. Expansion of when stock of the foreign entity is treated as acquired “by reason of” holding interests in the domestic entity (for purposes of determining whether Section 7874 will apply), to include taxable and nontaxable distributions and other transactions.

JULY 2009 APPLICABLE FEDERAL RATES

IRS COMMISSIONER JOINS WITH TREASURY SECRETARY TO CHANGE PERSONAL USE OF BUSINESS CELL PHONE RULES

Numerous employers provide cell phones to their employees for business use. Unsurprisingly, such phones are often used by employees for both business and personal use.

Code Section 132 provides that an employee may exclude from gross income the value of the cell phone use allocable to business use. However, personal use by the employee is a taxable fringe benefit. Further, since such phones are listed property under Code Section 280F, strict substantiation requirements are required to determine what portion of use relates to business use.

Such rules are a nuisance and an accounting nightmare. Recognizing this, Treasury Secretary Geithner previously called upon Congress to remove any tax consequences from personal use of employer provided cell phones. In a statement issued by the IRS Commissioner, he is also joining in the request. Hopefully, Congress is listening.

FOREIGNERS RELEASED FROM FBAR OBLIGATION

We previously wrote about how the instructions to Form TD F 90-22-1 (Report of Foreign Bank and Financial Accounts) (commonly referred to as the “FBAR”) were recently revised to include some non-U.S. persons in the reporting net. Likely due to public concerns that requiring non-U.S. persons to report their foreign accounts to the U.S. government would adversely affect foreign investment in the U.S., the IRS is now backpedaling. In a recent announcement, it is indicating that in regard to FBAR forms due on June 30, 2009, the OLD definition of a reporting person will continue to apply – the old definition does not include foreign persons or entities.

The announcement indicates that this limitation only applies for the June 30, 2009 filings. Therefore, a wait-and-see approach is needed to determine if this revision will be made permanent.

Announcement 2009-51