blogger visitor

Monday, April 26, 2010


Most organizations that are exempt from Federal income tax are required to file a Form 990 or some variation thereof on an annual basis. Previously, smaller organizations were exempt from the filing requirements. Smaller organizations can often still file with a short-form filing on an e-postcard Form 990-N.

The Pension Protection Act of 2006 requires that non-profit organizations that do not file a required information form for three consecutive years automatically lose their Federal tax-exempt status. This requirement has been in effect since the beginning of 2007. See IR-2010-10, Jan. 21, 2010.

These returns are generally due by May 15 of the year following the year for which reporting is due for those organizations that are on a calendar year reporting cycle. This means that a lot of returns are due soon.

The problem is that there are a tremendous number of non-profits with exempt status that have not been filing the required Forms 990. If they do not file (or extend and later timely file) by May 15, this will be the third year of nonfiling and will likely result in loss of exempt status. The New York Times, in an April 22, 2010 article, estimates that the number of organizations that are at risk of losing their exemptions is over 400,000.

Most larger organizations know of, and comply with, their filing obligations. Therefore, it is likely that most of the threatened organizations are smaller organizations. By reason of their small size, these are the organizations that can least afford the cost of preparing and submitting new applications to reinstate their exempt status.

The New York Times article opines that Congress should have only mandated that the exempt status of these organizations been suspended, and not revoked. This would make it easier to reinstate them. Arguably, however, the IRS should have regulatory authority for providing an expedited method of reinstating the status of these organizations short of a full application process.

Advisors who know of noncompliant small organizations would be doing them a great favor of reminding them to do their filings this year in a timely manner.

Sunday, April 25, 2010



Thursday, April 22, 2010


The Florida Bar Rules provide that "[a] lawyer shall not solicit any substantial gift, or prepare on behalf of a client an instrument giving the lawyer or a person related to the lawyer any substantial gift unless the lawyer or other recipient of the gift is related to the client." Rule 4-1.8(c). This prohibition is nothing new - it dates back to Roman law.

So what happens if a lawyer prepares a Last Will for client that violates this rule and that leaves him or her a substantial gift? A recent Florida case addresses this issue, when gifts were made both to an attorney and his paralegal.

The trial court noted that such an ethics violation does not make the gift void PER SE. However, it will be considered as evidence of undue influence if the Will is challenged. In the subject case, the trial court went on to find undue influence by the attorney and voided gifts of over $7 million to the attorney and his paralegal.

What if the client really wants to make a gift to the attorney, of his or her own volition? The Comments to the above ethics rule suggest that the attorney advise the client to seek advice of independent counsel on the gift. A further recommendation would be to have the other attorney draft the Will.

Carey v. Rocke, 18 So3d 1266 (Fla. 2d DCA 2009)

Sunday, April 18, 2010


Taxpayers often borrow funds from their life insurance policies. If the loans are not repaid, the insurance company may apply the cash surrender value of the policy to the loan balance (including accrued interest on the loans) when the total loan balance gets close to or exceeds the cash surrender value. This is often done in conjunction with a cancellation of the policy at that time. To the extent that the policy loan exceeds the owner’s “investment in the contract,” the owner will have to recognize income at that time.

This is what happened to Carolyn McGowen, and she had to recognize over $565,000 in income when her loan balance of over $1.065 million on a variable life policy exceeded the cash surrender value of the policy, prompting the carrier to cancel the policy and apply the cash surrender value to the loan balance.

Carolyn did not dispute that she had income from the surrender of the policy. She instead claimed that the income was “income from discharge of indebtedness,” and that she could then apply a special exclusion for income from discharge of indebtedness that was otherwise available to her under Code Section 108.

The Tax Court reviewed the situation and noted that the policy loan was in fact a genuine loan (which is how Carolyn was able to receive the loan advances without them being income to her at that time).  However, the Court noted that “income from discharge of indebtedness” occurs when the “debtor is no longer legally required to satisfy his debt either in part or in full.” This did not occur when the policy was cancelled – instead, the loan was actually paid in full through credit of the policy cash surrender value to the loan balance. Carolyn’s income was not from discharge of indebtedness, but arose directly under Code Section 72(e). Section 72(e) treats distributions from insurance policies to owners as income to the extent that the distributions exceed the investment in the contract. Thus, Code Section 108 (and its exceptions to income from discharge of indebtedness) could not be used by Mrs. McGowen.

Bill S. McGowen, et ux., TC Memo 2009-285

Thursday, April 15, 2010


In theory, it should be possible to use a properly structured domestic asset protection trust (DAPT) to receive assets from a settlor and have the assets protected from the settlor’s creditors, while also having completed gift treatment and no estate tax inclusion for the settlor, even though the settlor remains a discretionary beneficiary of the trust.

In non-DAPT jurisdictions, creditors of a settlor can typically reach the assets of a trust the settlor funds even if the settlor’s interest is wholly discretionary. This results in an incomplete gift. In a DAPT jurisdiction such as Nevada or Alaska, however, the assets are protected from the settlor’s creditors (subject to exceptions that vary from state to state). Thus, it has been argued that at the settlor’s death the assets of the trust are not included in the settlor’s estate and thus avoid estate tax. The settlor gets the best of many worlds – the assets grow outside of his taxable estate, the assets are protected from his creditors, and in a pinch the trustee can still apply trust assets for his or her benefit.

In Private Letter Ruling 200944002, the IRS gave much welcome recognition to this result. Based on this recognition, tax advisors are more likely now to proceed with this type of planning.

The lynchpin of this planning is that the local DAPT law of the state provides substantial limits on creditors of the settlor reaching the trust assets. This creditor protection is fairly likely to be respected by courts when the settlor is a resident of the state with DAPT law, and the trust is settled in that state with assets situated in that state. That is all well and good for settlors who reside in such states, but what if the settlor resides outside of such a state? Can the settlor establish a trust in a DAPT jurisdiction and still obtain these tax results?

The private letter ruling does not answer this question, since it involved a settlor who resides in the applicable DAPT jurisdiction. Presently, the law is unsettled as to the effectiveness of the creditor protection as to settlors residing outside of the DAPT state, including possible challenges to the application of such protection due to the Constitution’s Full Faith & Credit Clause. Therefore, while the private letter ruling does provide more authority for a favorable result, there is still a great deal of uncertainty in regard to the results for settlors residing outside the DAPT jurisdiction.

Saturday, April 10, 2010


A recent case family limited partnership case involved a partnership whose principal asset was publicly traded shares of stock of Dell. The highly liquid nature of those assets was used by the IRS and the reviewing courts to limit the amount of applicable discounts that were sought based on transfer restrictions in the partnership agreement and for lack of marketability.

In regard to transfer restrictions that were in the partnership agreement, the IRS claimed that these restrictions could not be used to reduce the value of gifted limited partnership interests pursuant to Section 2703(a)(2). Section 2703(a)(2) provides that “any restriction on the right to sell or use [the subject] property” are disregarded, unless the safe harbor requirements of Section 2703(b) are met. One of these safe harbor requirements is Section 2703(b)(1) which requires that the restriction “is a bona fide business arrangement.” The IRS argued that since the partnership owned only liquid shares of Dell, there was no “business” and thus no “bona fide business arrangement” under 2703(b). The Tax Court and the 8th Circuit Court of Appeals agreed. While the appeals court noted that at times shares of stock in a partnership can be a “business” for this purpose, such as where the stock is closely held and the arrangement is to maintain close control, this arrangement did not allow for a finding of a business. The courts found that the primary purposes of the arrangements were to protect the recipients of the gifts from dissipating the assets and to teach the children how to handle their money and did not relate to a business arrangement.

The second principal issue in the case related to the liquid nature of the Dell stock and the lack of marketability discount for the limited partnership interests. The IRS’ appraiser made an interesting argument that the fact that all the partners could agree to terminate the partnership, and that the partnership asset was a highly liquid asset, combined to put a limit on the lack of marketability discount since at some level of discounting the parties could find a mutual basis upon which it made sense to instead liquidate the partnership. This seems a little odd under the willing buyer – willing seller standard since who is to say when and why the other partners would consent to such a liquidation (that is, why it would ever be in their interests to consent to the liquidation), but both the Tax Court and the appellate court bought into the argument and thus limited the lack of marketability discount based on this theory.

HOLMAN v. COMM., 105 AFTR 2d 2010-XXXX, (CA8), 04/07/2010

Wednesday, April 07, 2010


New Code Section 1298(f) (recently enacted under the HIRE Act) requires shareholders of a passive foreign investment company (PFIC) to report such information as the IRS requires on an annual basis. Questions have been raised as to what and when taxpayers should now be reporting.

Even though this new provision is now in effect, the IRS is advising taxpayers that Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund, need only be filed under the old rules. New guidance will eventually be forthcoming that implements the new annual reporting requirements.

Notice 2010-34

Sunday, April 04, 2010


In the 2008 Supreme Court case of Knight v. Comm., investment advisory fees paid by a trust were held to be subject to the “greater than 2% of adjusted gross income” deduction limits of Code Section 67(a). Oftentimes, banks, brokers, and trust companies impose only one “bundled” fee for all services performed. Proposed regulations indicated that taxpayers would need to unbundle the fee somehow to allocate the fees among investment fees that are subject to the 2% limit and those that items that are deductible without regard to the 2% limit.

These regulations have not been finalized yet. In Notice 2008-32, the IRS provided interim guidance that for tax years before 2008, taxpayers would not be required to unbundle the fee to determine a portion of the fee that is subject to the 2% floor. It extended this guidance to tax years beginning before January 1, 2009 in Notice 2008-116.

The IRS has now extended the same guidance to tax years beginning before January 1, 2010, thus allowing full deductibility for bundled fees without regard to the 2% floor. This guidance applies to nongrantor trusts and estates.

Notice 2010-32

Friday, April 02, 2010


Capital, and all of its blessings, flows to where it is treated best. The recently passed Hiring Incentives to Restore Employment Act of 2010 (the "HIRE" Act) imposes new obstacles to the flow of capital into and out of the U.S. While ostensibly limited to "reporting" requirements to address offshore tax evasion by U.S. persons, at some point U.S. investors will balk at the level of reporting and forego profitable investments in the world at large, and foreign investors will simply move on to greener pastures and avoid the U.S. in making capital available. While such enforcement legislation may be considered to be tax revenue enhancing, the lost national revenue from reduced capital investment and tax compliance costs doesn't seem to be on anyone's radar screen – indeed, there is almost a complete absence of attention to the new rules in the national media. Once upon a time, U.S. tax policy was influenced by the impact of the tax code on U.S. economic growth and capital development – sadly for the U.S. economy, such concerns have taken a backseat in the ongoing campaign to root out tax dodgers.

I have prepared a general overview of the new provisions, which can be viewed here.

In addition to increasing the compliance burden of investors and businesses (including the imposition of foreign account disclosure requirements that essentially duplicate disclosures already required under FBAR reporting), the new provisions include several traps for the unwary. For example, U.S. persons that purchase stock of a U.S. corporation from a foreign entity are required to obtain certification regarding “substantial” U.S. ownership (or nonownership) of the foreign entity. If the U.S. person does not obtain the required certification, the U.S. buyer is obligated to withhold 30% of the purchase price from the foreign seller (at least that is how I read the new statute). If the U.S. buyer is not aware of these rules, the IRS can come after it for the 30% withholding even if the buyer has already fully paid the foreign seller. Tax and business counsel need to familiarize themselves with these rules to avoid the inadvertent application of these rules to their clients.