GIFT TAX GROSS-UP DOES NOT APPLY TO NONRESIDENTS

Under Code Section 2035(b), if a U.S. person makes a gift and pays gift tax within 3 years of his or her death, the amount of the gift tax is included in his or her gross estate for federal estate tax computation purposes. In an interesting ruling, the IRS has indicated that such inclusion will not apply if the decedent is a nonresident alien of the U.S. for transfer tax purposes.

Code Section 2104(b) generally applies Code Sections 2035 through 2038 to the estates of nonresidents.  However, Code Section 2104(b) by its language only applies to “property of which the decedent has made a transfer.” The IRS is interpreting this language to require a “gratuitous transfer,” and further believes that the payment of gift tax is not such a gratuitous transfer. Thus, Code Section 2035(b) will not apply.

Nonresidents have various transfer tax planning opportunities that are not available to U.S. citizens and residents. Add this to the list!

CCA 201020009

HOMESTEAD CAN STILL BE SUBJECT TO FRAUDULENT CONVEYANCE WHEN IRS INVOLVED [Florida]

A transferee of an insolvent debtor that receives property from the debtor may be required to disgorge the received property or its equivalent value to the debtor’s creditors, if the transfer to the transferee was a “fraudulent conveyance.” However, a fraudulent conveyance only applies to a transfer of property of a debtor. Property of a debtor for this purpose does not include property that is “generally exempt under nonbankruptcy law.”

In a recent case, an insolvent debtor transferred his homestead property to his transferee. The creditor sought to recover the homestead property from the transferee as a fraudulent conveyance. Per the above rules, the transferee defended the creditor’s claim per the homestead property being exempt from creditor claims under Florida law – thus, it was not “property” of the debtor for this purpose so that the fraudulent conveyance laws did not apply.

A strong argument, but the twist in this case was that the creditor was the Internal Revenue Service. The IRS is a supercreditor in that, as a matter of federal supremacy, it is not bound by state law homestead protections. Since the IRS could have levied on the transferred homestead prior to its transfer and regardless of its homestead status, the Tax Court held that the transferred homestead was not “generally exempt under nonbankruptcy law” (at least as to the IRS) and thus was an asset of the transferor that could be reached by the IRS under Florida’s fraudulent transfer laws.

Scott E. Rubenstein, et al. v.  Commissioner, 134 T.C. No. 13 (2010)

DESIGNATED BENEFICIARY COULD NOT BE CREATED THROUGH A POST-DEATH TRUST REFORMATION

Individual retirement account (IRA) assets can be made payable to a trust at the death of the account owner. If the trust has a “designated beneficiary” under the Code and Regulations, the payout from the IRA can typically be spread (and tax deferral maximized) over the lifetime of the designated beneficiary.

In a recent private letter ruling, a beneficiary trust of an IRA did not have a designated beneficiary. The trustee undertook a reformation action in state court to modify the trust so that after the reformation the trust then had a designated beneficiary.

In the ruling, the IRS rejected the attempt to create a designated beneficiary. The IRS indicated that a retroactive modification to the date of death of the account owner would not be respected for federal tax purposes. While the IRS will respect state court orders in many circumstances, it will respect it in regard to a reformation only if reformation is specifically authorized by the Code.  For example, Code §2055(e)(3) specifically allows parties to reform a charitable split interest trust to make the charitable interest eligible for the charitable deduction. Since there is no applicable Code provision authorizing a reformation so as to qualify a trust as having a designated beneficiary, the reformation would not be given effect.

Private Letter Ruling 201021038

SALE RESTRICTIONS AND FORFEITURE RISK DID NOT INHIBIT CONSTRUCTIVE RECEIPT

In a recent District Court case, a taxpayer sold a partnership interest in exchange for shares of stock. The stock had significant restrictions, including limits on the ability to sell the received stock for up to 5 years, and the taxpayer would have to forfeit shares if they went into competition with the buyer of the partnership interests, if they quit working for the buyer, or were fired for cause or poor performance.

The taxpayer claimed that he did not have to recognize gain on the value of the received shares, since he could not realize anything from the shares upon receipt and they could be forfeited in the future.

In analyzing the situation, the court noted that “constructive receipt” occurs under Section 451 Regulations if as to a taxpayer an amount is “credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.” Income is not constructively received “if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.”

The court found that a number of facts combined to indicate there was sufficient “control” in the taxpayer to find constructive receipt. These facts included that the seller would eventually benefit from any appreciation that occurred in the shares while they were subject to restrictions, the seller would receive the dividends from the shares during the restriction period, and the seller could direct how the shares were voted. The court also took into consideration that the transaction was specifically structured to result in full taxation in the year of sale and not a later year, because the taxpayers anticipated future appreciation (in this case, the taxpayer changed his mind and sought to “defer” the tax because the stock actually ended up going down in value, so that the taxpayer picked up income in the year of sale that would never have arisen if the stock was taxable only when the restrictions lapsed).

Given the number of factors cited by the court, it is difficult to tell which ones were more critical than the others in the finding of constructive receipt. Further, if the transaction had not been carefully structured with one tax result in mind, but with the taxpayer then adopting the opposite characterization when the stock value went down instead of up, perhaps a more sympathetic hearing by the District Court may have resulted.

U.S. v. Fort, 105 AFTR 2d 2010-XXXX, (DC GA), 05/20/2010