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.