INTEREST RATES FOR TAX OVERPAYMENTS AND UNDERPAYMENTS (JULY 2009 QUARTER)

The IRS has announced the interest rates for tax overpayments and underpayments for the calendar quarter beginning July 1, 2009.

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. 2009-17

IRS PREVAILS IN COST SHARING CONTROVERSY

The 9th Circuit Court of Appeals reversed the Tax Court in an interesting case involving issues of Section 482 cost sharing, precepts of regulatory interpretation, and penalties.

The Section 482 cost sharing issue related to the question whether compensation expenses of a U.S. participant in a cost sharing arrangement relating to stock options can be allocated exclusively to the U.S. participant (thus fully reducing taxable income of the U.S. participant), or whether the Section 482 cost sharing regulations required that such compensation expenses are “costs” that had to be allocated in part to the (non-U.S.) cost sharing participant. This became an issue because two Treasury Regulations under Section 482 conflicted with each other.

The conflict was between the general Section 482 regulation that only costs that are normally shared between unrelated parties are subject to Section 482 adjustment, and a specific regulation relating to cost sharing that said that all costs had to be shared to be respected under Section 482. The Tax Court had found that stock option costs are not typically costs that are shared between unrelated parties in a cost sharing arrangement, and thus the general rule in the regulations precluded the stock option costs from being reallocated in part away from the U.S. participant under Section 482 .

The appellate court gave more weight to the specific cost sharing regulation, and less to the general statement of Section 482 principles. It based this weighting on the statutory and regulatory interpretative rule that a provision that is specific takes precedence over a more general provision. The appellate court also rejected as not applicable the principle that ambiguities in the tax law should be interpreted against the government.

The appellate decision is not as relevant to Section 482 cost sharing law as it might appear, since the IRS had already revised its Regulations to require the same result that the appellate court eventually reached. It made this change after it had lost in the Tax Court. Since Section 482 is a very short Code provision, with the meat on its bones being provided by extensive Regulations, the IRS has a fairly free hand to write the Regulations in any reasonable manner (unlike other areas of the Code where it may be more constrained by Code language) and thus set clear law for future tax years and taxpayers regardless of how the appellate court resolved the current case.

One area where the new Regulations might still be challenged is if a different interpretation of cost sharing arises in a treaty context. However, the appellate court opinion will likely constrain such challenges, since a treaty was involved in the case and the court did not feel it constrained them in its decision. Further, it noted that even if the treaty language did mandate a different result, the typical provision of a treaty that provides that it will not impact the taxation of taxpayer by its own taxing jurisdiction will act to negate the application of the treaty provision when it relates to U.S. taxpayers.

The one ray of sunshine for the taxpayer in the case related to the government seeking to impose accuracy related penalties on the taxpayer for not having allocated the stock option costs in part to the other participant. The appellate court noted that the Tax Court found for the taxpayer, and that the Treasury Department felt compelled to rewrite the Regulations to avoid the above conflict. As such, the court questioned whether the taxpayer should be subject to penalty when both the Tax Court and the IRS noted the uncertainty of the Regulations, and remanded the case for further action in regard to the imposition of penalties.

Xilinx, Inc. v Commissioner of Internal Revenue, 9th Circuit Court of Appeals, Case No. 06-74246 & –74269, May 27, 2009

EXTREME CARE NEEDED WHEN USING QUALIFIED INTERMEDIARIES IN SECTION 1031 EXCHANGES

Section 1031 of the Internal Revenue Code allows taxpayers to exchange real property and other types of property for property of “like-kind.” Since it is rare to find a buyer and seller with two properties that each is willing to exchange directly to the other, the Code allows for a deferred exchange where the seller sells his property, with the proceeds being used to buy a replacement property from a third party within certain time limits. As part of this exchange process, the seller cannot take into his or her own possession the sale proceeds from the sale of his property. One method of conducting such exchanges while keeping the sale proceeds out of the hands of the seller is to use a facilitator, or “qualified intermediary” (QI).  The QI usually takes title to the property from the seller, sells the property, holds the sale proceeds, and then acquires the replacement property which it exchanges back to the original seller.

The QI business is big business, with many millions of dollars of cash and properties passing through the hands of the QI’s each year. Like any business, a QI can fail and go under. What happens to the funds the QI is holding that are in the middle of an exchange if the QI goes into bankruptcy?

For customers of Landamerica, they are learning the hard way that their funds may be lost. Landamerica’s Section 1031 customers had $420 million with Landamerica that were in the middle of their swaps when the company went into bankrutpcy. The 450 customers claimed that their cash was held either in escrow or in trust, so they should be able to get all of their money back. The bankruptcy trustee argued that since no true escrow or trust was established to hold the funds, the customers are merely general, unsecured creditors of Landamerica. This means that they will be paid only after the secured creditors of the company are paid, and then only pro rata with all other unsecured creditors of the company.

In a ruling last year as to “segregated accounts,” and a ruling earlier this month as to other Section 1031 accounts, the Bankruptcy Court held that the funds of the customers were not held in trust or escrow, and that the customers are mere unsecured creditors. Therefore, it is unlikely that the customers will be made whole on their swap funds.

To make matters worse for these unfortunate customers, their swap funds were invested in auction-rate securities, which are difficult to value and may be substantially impaired in today’s poor credit market. Further, as time goes on, the attorney fees relating to the bankruptcy continue to further deplete the funds available for repayment to creditors.

The real tragedy here is that with proper structuring, as noted by the Bankruptcy Court itself, it should have been possible to both avoid these bankruptcy problems and still obtain Section 1031 deferred gain treatment. Further, contractual limitations could have been used to assure that the funds were invested in more conservative cash investments.

In re Landamerica Financial Group, Inc., 2009 WL 1269578
Bkrtcy.E.D.Va., May 07, 2009

JUNE 2009 APPLICABLE FEDERAL RATES

HSA CONTRIBUTION LIMITS ARE BUMPED UP

HSAs (health savings accounts) are a useful tax benefit in this day and age of increasing medical insurance premium costs. As with most insurance coverages, a higher deductible allows for lower premium charges. However, the higher deductible leaves the insured with higher out-of-pocket medical costs.

To assist taxpayers with paying for the portion of their medical costs that they have to pay for themselves due to a large deductible, the Code allows for a taxpayer to establish an HSA. The taxpayer (or his or her employer) can contribute amounts to the HSA without being subject to income tax on the contributed amounts. The earnings on HSA balances are also not taxed, and expenditures from the account for health and medical items do not result in income tax on the deferred income.

So that taxpayers don’t misuse the HSA and shelter too much income, there are annual limits for contributions. The 2010 limits have now been increased. For 2010, the individual contribution limit is $3,050 (up from $3,000). For family coverage limits, the limit in 2010 will be $6,150 (up form $5,950).

Only taxpayers who participate in “high deductible” medical insurance plans can have an HSA.

Rev.Proc. 2009-28

USE OF QPRT ALLOWS SALE OF REMAINDER

In the good old days, a taxpayer that owned a piece of property could sell the remainder interest, retain a term or life estate, and adopt a position that (a) no gift occurs, per the sale of the remainder for fair market value, and (b) at the end of the term interest or the death of the taxpayer, no estate tax applies to the retained term interest or life estate (which expired at death). Section 2702 of the Internal Revenue Code and the Regulations thereunder now impose a gift tax on the establishment of such an arrangement.

A recent private letter ruling effectively allows the old rules to operate in context of the transfer of a personal residence to a qualified personal residence trust (QPRT). Due to the special exception from the operation of Section 2702 to qualified personal residences, the IRS has confirmed that a simultaneous sale of the remainder interest in the residence with the transfer of the residence to a QPRT will not run afoul of Section 2702. So what does this arrangement accomplish?

First, unlike a typical QPRT setup, there is no taxable gift upon establishment (which would usually be measured by the value of the remainder interest in the QPRT).

Second, it allows the use of a life estate in the grantor, and not just a term of years as is typically required to avoid gross estate inclusion for estate tax purposes at the death of the grantor (assuming the grantor survives the term of the trust). Unfortunately, the PLR does not confirm that there is no estate tax exposure to this arrangement (and indeed specifically declines to address that issue), but many believe that Section 2036 would not operate to tax the arrangement since the remainder interest would be sold at fair market value.  This is an unresolved issue, with a split of opinion among the federal courts. More conservative planners desiring to avoid Section 2036 exposure can still use the ruling, but in more traditional QPRT manner with a term of years arrangement and with fingers crossed that the grantor outlives the term of years.

Third, it can facilitate the use of one QPRT for a married couple, instead of two separate QPRTs for their respective 1/2 interests.

Note, however, that there will be income tax consequences on the sale of the remainder interest. Also, the buyers will need funds to make the purchase – an existing funded trust for beneficiaries of younger generations than the grantor may be well suited to make such a purchase. Therefore, the transaction may not be viable for all situations.

PLR 200919002

IRS PROVIDES MORE GUIDANCE ON UNREPORTED OFFSHORE INCOME

Last month, the IRS announced that it was adopting consistent guidelines for voluntary disclosure requests of taxpayers that relate to offshore undisclosed accounts and foreign entities. Disclosure issues would be settled, with the taxpayer being subject to the imposition of taxes and interest for the prior 6 years, with the taxpayer filing or amending all returns for that period, including required FBAR returns. Late tax payments will still be subject to accuracy or delinquency penalties, and no reasonable cause exception will be allowed. However, all other penalties will be waived, and no criminal prosecutions will apply, other than a 20% penalty based on the highest aggregate foreign account or foreign asset value (or 5% in some circumstances).

The IRS has now issued written FAQ responses that flesh out the details of these offers. Highlights of the FAQs include:

A. The time limit for the offer is for six months only – through September 23, 2009;

B. The offer is open to all taxpayers that comply with IRS's terms, including corporations, partnerships and trusts. The offer does not apply if IRS has initiated a civil examination of the taxpayer, regardless of whether it relates to undisclosed foreign accounts or undisclosed foreign entities.

C. The settlement offer should not be used by taxpayers that have properly reported all of their taxable income but have not been filing FBARs in prior years to report a personal foreign bank account or to report the fact that taxpayers have signature authority over bank accounts owned by their employers. These taxpayers are advised to file the delinquent FBAR reports and attach an explanation of why the reports are being filed late. The FAQ indicates that no penalties will be imposed for the failure to file the FBAR.

The IRS has indicated that it will attempt to identify taxpayers that do not submit a voluntary disclosure offer, but instead simply file amended returns and pay related tax and interest under a “quiet" disclosure. Such taxpayers who follow the “quiet" disclosure route are at risk for civil examination and criminal prosecution. Taxpayers who have already taken the "quiet" disclosure route can still make a voluntary disclosure under the above guidelines.

SALE OR SURRENDER OF LIFE INSURANCE CONTRACTS

In today’s difficult financial times, more taxpayers than usual are cashing in or selling their life insurance policies. A recent Revenue Ruling addresses the IRS’ view of the income tax consequences of such transactions. The salient points are summarized below. Note that these rules apply to non-modified endowment policies (non-MEC) policies – results can differ for MEC policies.

A. SURRENDER OF POLICY TO THE INSURANCE COMPANY. In this circumstance the policy holder has income if and to the extent that the amount received on surrender exceeds his or her “investment in the contract.” Section 72(e)(5). The “investment in the contract” is the aggregate amount of premiums or other consideration paid for the contract before that date, less the aggregate amount received under the contract before that date to the extent that amount was excludable from gross income. It is the position of the IRS that any such income is ordinary income, and not capital gain.

B. SALE OF INSURANCE POLICY. While seemingly the same economic transaction occurs in a sale as under a surrender, different tax results obtain because a sale is taxed under the sale or exchange provisions of the Code, including Section 1001, while the above surrender treatment is addressed under the insurance – annuity rules of Section 72. In the case of a sale of a policy, the seller incurs a gain to the extent that the amount received exceeds his or her adjusted basis in the contract. Note that “adjusted basis” is not the same as “investment in the contract,” although premium payments are credited towards both. A key difference is that to the extent premium payments are allocable strictly to the cost of life insurance (and not the build-up of cash value to pay future premiums or benefits), that portion of the premium payment reduces basis, and will thus increase gain (or reduce loss) on the sale. In the case of a sale of term life insurance, the monthly premium amount is treated as the cost of life insurance through the date of sale. Not all practitioners are willing to concede that such a reduction in basis is proper. Notwithstanding sale or exchange treatment under Section 1001, the IRS nonetheless applies the “substitute for ordinary income” doctrine to tax the gain as ordinary income and not capital gain, to the extent the sales price is attributable to the inside build-up in the contract, with any remaining portion of the gain eligible for capital gain treatment.

Rev. Rul. 2009-13, 2009-21 IRB

DOCUMENTARY STAMP TAX LOOPHOLE ABOUT TO BE CLOSED [FLORIDA]

Florida imposes documentary stamp taxes on the transfer of real property. Since the tax typically applies only to transfers of real property and not interests in corporations and LLC’s that own real property, one planning method to eliminate the tax is for the seller to first transfer the real property to an LLC, and then sell the LLC interests to the buyer, free of documentary stamp taxes.

This planning was facilitated by case law and Department of Revenue concessions that transfers of real property could be made to a wholly owned entity without documentary stamp taxes being imposed.  Absent this change (or “clarification”) of the law, the first step of the above planning (the transfer of the real property to the LLC) could not be accomplished tax-free.

Likely in response to publicity regarding the planning technique, the Florida Senate has passed legislation that will impose documentary stamp taxes on such LLC transactions. The Florida House also passed legislation, but exempted from tax situations when the property was owned by the entity for at least 3 years prior to the transfer. Therefore, the Senate and House versions will need to be reconciled. We will also be interested to see the final language of the new law, to determine if and how it applies to entities other than LLC’s and whether any planning opportunities remain.