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