THE PROS AND CONS OF MAKING GIFTS IN 2010

With a year without estate tax, and reversion to 2001 rules in 2011, 2010 surely goes down as one of the most challenging years in transfer tax planning. One of the big issues in 2010 is whether taxpayers should be making taxable gifts. As with most planning issues, there is no cut and dried answer - the circumstances of the taxpayer need to be considered. Below are some of the key pros and cons of making taxable gifts in 2010.

PROS

-With lower stock market and real estate values, the transfer value (and thus transfer costs) are likely lower than in the past.

-The maximum gift tax rate is only 35% in 2010, returning to 2001 rates in 2011. If the transferor survives three years from the date of the gift, any gift tax paid escapes transfer tax, thus reducing the maximum effective rate to below 26%.

-If the Bush tax cuts are allowed to expire, income tax rates will increase. Therefore, gifting strategies that allow income to accrue in lower rate taxpayers will be more valuable than in the past.

-With a low interest rate environment, many gifting strategies produce lower gifts than in high interest rate years.

-Direct gifts to lower generations, as opposed to gifts to generation skipping trusts, may be more favored in 2010 than in other years due to uncertain availability of generation skipping tax exclusion ratio benefits for transfers to trusts.

CONS

-If the transferor dies in 2010, no gift tax would apply. Therefore, unnecessary transfer taxes are incurred. However, this risk can be minimized by waiting to complete gifts until very close to the end of the year. This also allows for more flexibility should Congress change the transfer tax laws prior to the end of 2010.

PREPAID FORWARD CONTRACT TREATED AS A SALE

Prepaid forward contracts were a popular item in the early 2000’s. Such arrangements would allow the holder of substantially appreciated public stock (such as a founder whose stock had run up substantially in the bull market) to receive a payment of 75%-80% of the value of his or her shares, have an upside if the stock appreciated in value thereafter in the next few years, have no downside risk, and be able to defer income taxes on the funds paid until the transaction closed a few years later. A principal issue regarding such transactions was whether the upfront payment constituted a taxable sale in the initial year, or whether deferral existed until the transaction completely closed in a later year. Something of a sweet deal, Revenue Ruling 2003-7 allowed for nonsale treatment for prepaid forwards, at least under the facts of that ruling.

Taxpayers who participated in those transactions could typically receive a better financial deal if as part of the transaction they also lent the shares that were subject to the transaction so that the investment entity involved could sell those shares short or otherwise hedge their risks. This is what the Anshutz Company did in the prepaid forward contracts it entered into in the early 2000’s.

The Tax Court has now determined that the Anshutz Company was not entitled to defer its gain, but instead had income upon entering the prepaid forward contract. The court noted that the prepaid forward, in combination with the share lending transaction, resulted in almost all incidents of ownership having been given up by the taxpayer, and thus it was appropriate to trigger gain in the year the taxpayer received the cash proceeds.

Since many of these transactions occurred awhile ago, of those older ones only those that are either under audit, in litigation, or for which the taxpayers have extended the applicable statute of limitations, will be affected by the new decision. Presumably, those whose transactions did not include the stock lending element will not be as adversely impacted by the Tax Court’s analysis, but it remains to be seen how the IRS will interpret the precedential value of the case in those situations.

Anschutz Company v. Commissioner, 135 T.C. No. 5 (2010)

APPLICABLE FEDERAL RATES – AUGUST 2010

DOES A TAX FRAUD GUILTY PLEA AUTOMATICALLY RESULT IN AN FBAR PENALTY?

A taxpayer through a company had Swiss bank account. He did not report the income from the accounts on his federal income tax return. The taxpayer also did not file the required FBAR disclosure form for the accounts.

The taxpayer eventually plead guilty to tax fraud, conspiracy to defraud the United States and criminal tax evasion in connection with the Swiss bank accounts. The IRS sought to use his guilty plea as requiring an automatic finding of willful failure to file the required FBARs and sought to automatically impose FBAR penalties.

Not so fast, says the U.S. District Court for the Eastern District of Virginia. In denying the government’s motion for summary judgment, the court noted that there may still be valid defenses available to the FBAR penalty even though the taxpayer admitted guilt on the above tax charges. More particularly, the court noted the following issues still remain and thus allowed the case to proceed to trial:

-The taxpayer contends that U.S. authorities were already on notice of the accounts, and indeed, the assets in the accounts had already been frozen.  Thus, according to the taxpayer, he did not have the requisite intent to “willfully” fail to disclose the accounts by filing the Form TDF 90-22.1 because he believed their existence had already been disclosed.

-The taxpayer contends he had no knowledge that Form TDF 90-22.1 existed, nor had his attorneys advised him as to its existence or significance, and thus could not “willfully” have failed to file the Form.

-Lastly, the taxpayer contends he had no “signatory or other authority over” the accounts as required by 31 C.F.R. § 103.24 because the accounts were frozen.

Whether the taxpayer will prevail remains to be seen, but at least he will have his day in court as to these issues.

U.S. v. Williams, 106 AFTR 2d 2010-XXXX, (DC VA), 03/19/2010

PREPAYING INDEBTEDNESS AT A DISCOUNT DOES NOT ALWAYS GIVE RISE TO CANCELLATION OF INDEBTEDNESS INCOME

Oftentimes, a debtor is able to negotiate with a creditor to pay off a debt at a discount. The debtor pockets the savings – however its not a total win since the debtor may have to share some of the savings with the IRS. This is because the reduction in the amount due will often be characterized as cancellation of indebtedness income, which is subject to income tax. This harks back to a case that tax people may remember from their school days – U.S. v. Kirby Lumber Co. In that well-known case from 1931, the U.S. Supreme Court held that a taxpayer who purchased back its own bonds at a discount realized income to the extent of the savings since the taxpayer had increased its net wealth in the transaction.

However, not all obligations are treated the same in this area. A recent private letter ruling reminds us that if the debtor’s obligation is contingent only and not fixed, a negotiated prepayment reduction will NOT generate cancellation of indebtedness income. In issuing the favorable ruling, the IRS relied on another old case, Corporacion de Ventas de Salitre y Yoda de Chile v. Comm., 29 AFTR 1074  (CA 2 1942). That case was very similar to Kirby Lumber in that a taxpayer purchased back its own bonds at a discount. However, since the bonds were payable only of future profits, the obligation was contingent. The Second Circuit there held that no cancellation of indebtedness income due to the contingent nature of the obligation.

PLR 201027035

30-DAY LETTERS VS. 90-DAY LETTERS IN ESTATE TAX AUDITS

In estate tax audit situations, the IRS only has a 3 year statute of limitations to assess additional taxes. If the IRS takes too long to initiate an audit, or the audit drags on too long, the taxpayer may lose an opportunity to have unagreed audit issues reviewed by an Appeals Office prior to the issuance of a 90-day letter.

When audit items are unagreed, the normal course of operation is for the IRS to issue a 30-day letter of the IRS’ findings. The 30-day letter asks the taxpayer to agree to the IRS’ findings. The taxpayer can either agree, go over the examiner’s head and take the issue up with the IRS Appeals Office, or do nothing (in which case the IRS will then send a notice of deficiency). Thus, the 30-day letter is the taxpayer’s ticket to the Appeals Office where the taxpayer may receive a more favorable result than at the agent level, especially since appeals officers can factor into settlements the likelihood of IRS success if an issue is litigated.

If there is not enough time before the statute of limitations expires, the IRS will skip the 30-day letter and instead issue a 90-day letter (notice of deficiency). The 90 -day letter indicates a deficiency in tax. The taxpayer that wants to fight on can either pay the tax and sue for a refund in District Court, or file a petition for review in the Tax Court without paying the tax. There is no effective opportunity for Appeals Officer review prior to taking one of those two steps (although the taxpayer can file in the Tax Court and then go to Appeals).

Recent guidance to auditors provides that Appeals will need to at least 180 days left on the statute of limitations before a case should be referred to them. Adding the 30 days provided under a 30-day letter, examiners are directed to skip the 30-day letter and issue a 90-day letter if there are less than 210 days remaining on the statute of limitations on the day that the taxpayer communicates disagreement with the proposed adjustments.

If there are more than 210 days, the examiner need not automatically issue a 30-day letter. Instead, the examiner should examine all the facts and circumstances to see if a 30-day letter is appropriate. The factors to be reviewed include:

-how much time is needed for the examiner to  issue the 30-day letter, receive the taxpayer's response, and then consider that response;

-how likely is it that the taxpayer will request an extension of the initial 30 day response period;

-a minimum of 30 days to process the case file to Appeals;

-a minimum of 10 days to account for time needed to process the case filing from the date of closing to review and closing by the Group Manager;

-the nature of the issues and the complexity of the facts involved; and

-the applicable legal authorities.

Throughout the audit process, taxpayers and their representatives that anticipate going to Appeals should endeavor to move the case along as quickly as possible so as to not lose the opportunity to go to Appeals under a 30-day letter.

SB/SE Division's Interim Guidance On Issuance of Statutory Notice of Deficiency  (June 24, 2010)

CHARGING ORDERS AS EXCLUSIVE REMEDIES IN LLC’S – PART ONE

A recent Florida Supreme Court case addressing whether a charging order is an exclusive remedy for a creditor of a member of an LLC as to the LLC interest is creating a stir. This posting addresses the case. A future posting will address the question of whether the exclusive remedy of charging orders issue should be garnering so much attention.

First, some background. Assume that Owner O is a member of an LLC, and owes $1 million to judgment Creditor C. O has no assets other than his LLC interest. The LLC owns substantial assets, so that O’s share of the LLC exceeds $1 million in the underlying assets.

C can obtain a “charging order” against O. This requires that if and when the LLC makes distributions to its members, the amount due to O has to be paid to C instead to the extent of its $1 million judgment. C does not become a member of the LLC and obtains no voting or other rights as to the LLC. O remains the member. Once C is fully paid, O can then begin again to receive member distributions from the LLC.  Thus, a charging order does not provide a lot of leverage to C – it cannot force a distribution so it has to wait around until the members decide to vote a distribution. This could involve a very long wait for C.

In most states, in the absence of a specific statutory provision that a charging order is an exclusive remedy for a creditor, a creditor could alternatively judicially foreclose on a debtor’s interest. This would require the sale of O’s member interest either to third parties or to C. If this happens, then C loses his member interest permanently. 

If C can only obtain a charging order as his sole remedy, this is generally perceived to be favorable to debtors like O.

The purpose of the charging order remedy is to protect the other members of the LLC. This avoids innocent co-members from having their entity hijacked or interfered with by a third party creditor of a debtor member that succeed to the ownership interest of a debtor member. Instead, the creditor has to stand by on the outside of the entity awaiting distributions and cannot interfere with LLC operations.

So what happens if the LLC is only owned by one person? Since there are no other members of the LLC to protect, the question arises whether a creditor should be limited to charging order remedies only. This was the question raised in the recent Florida case.

The Florida Supreme Court held that even though Florida law provides for a charging order as a remedy as to LLC interests, a charging order is not the exclusive remedy for a creditor. When one considers that the purpose of the charging order remedy is to protect other members, it is not surprising that a creditor was not limited to a charging order as its sole remedy in the single member LLC situation.

However, the way that the Court went about this is questionable. Instead of simply addressing the situation of a single member LLC, the Court ruled with a broad stroke, seemingly interpreting that the Florida Statutes do not support a reading that charging orders are an exclusive remedy for LLC interests. The problem is that the case may stand for the proposition that charging orders are not an exclusive remedy, even in the case of multiple member LLC’s.

In the end, this may not be that big a deal, at least in Florida. There is a strong likelihood that a legislative fix will be enacted to clarify that charging orders are an exclusive remedy, at least for multiple member LLC’s (as many commentators thought was already presently the case).

As noted, in a future posting, I’ll address the question whether having charging orders being an exclusive remedy is really that big a deal – as you may be speculating, I don’t think it is.

Shaun Olmstead, et. al., vs. The Federal Trade Commission,  Supreme Court of Florida. Case No. SC08-1009 (June 24, 2010).

TAX AMNESTY WINDOW OPEN UNTIL SEPTEMBER 30 [FLORIDA]

Did you buy some artwork out of state that you brought back to Florida and did not pay Florida use taxes on? Did you forget that your ‘c’ corporation has to pay Florida corporate income taxes? Did you sell items upon which  you should have collected Florida sales tax?

If a taxpayer answers yes to any of these, or has any other failures to pay Florida taxes, a tax amnesty program opened on July 1 and will run through September 30, 2010. Those coming forward will have no penalties imposed and need not worry about criminal prosecution. They may also get a break on up to half of the interest owed on delinquent taxes if there is no ongoing audit or investigation by Florida.

The last time Florida had an amnesty program such as this was in 2003.

The program will not apply, however, to Florida unemployment taxes and Miami-Dade County Lake Belt Fees. Further, those who are under criminal investigation, whose liability is already covered by a settlement or payment agreement, or are involved in certain other programs are ineligible.

To participate in the program, a Tax Amnesty Agreement has to be submitted by the September 30 deadline. This can be done online. Proper returns must also be filed for the applicable taxes.  It may be possible to make an installment arrangement for payment of the late taxes.

Interestingly, taxpayers currently under audit can participate in the program.

More information on the program is available at http://dor.myflorida.com/dor/amnesty/.

MUTABILITY DOCTRINE

When tax issues turn on international conflict of laws analysis, attempting to determine tax consequences can become a hair-pulling exercise. A recent Tax Court case provides a good illustration.

On its face, the tax issue was fairly simple. A married resident and domiciliary of Belgium died while owning a significant amount of shares in a U.S. corporation. Under U.S. tax law, those shares are subject to U.S. estate tax. The issue for the court was whether the decedent owned 100% of the shares for estate tax purposes, or whether he owned only 50% with the other 50% of the shares being deemed owned by his surviving spouse under community property principles.

The husband and wife were married in Uganda, which at the time of their marriage was governed by United Kingdom law. The UK is a “separate property” regime - not a community property regime. The couple later moved to Belgium, where they resided for many years and had their domicile. Belgium is a community property regime. They never changed their nationality, however, out of the UK. It was while they were domiciled in Belgium that the decedent acquired the U.S. shares.

To determine whether the surviving spouse had a community property interest, the Tax Court had to work through and ultimately apply the following conflict of law and marital property issues:

a. Which country’s conflict of laws provisions should be applied? In this situation, the general rule that the law of the country of domicile applies to determine ownership of intangible property was applied - so Belgium law applied. Interestingly, Belgium conflict of laws rules then kicked the question of ownership back to England since both the husband and wife were U.K. nationals.

b. Which country’s spousal ownership rules should be applied? Applying the doctrine of immutability, the Tax Court determined that the law of the couple at the time of their marriage applied. This was the U.K.’s separate property regime. Thus, since the stock was titled solely in the name of the decedent, all of the stock was included in the decedent’s U.S. gross estate and subjected to U.S. estate tax.

The case is interesting for two particular reasons.

The first relates to the discussion under a. above. Applying the “use the law of the country of domicile for intangibles” rule to determine ownership of intangible personal property, many would think that Belgium law should decide the ownership of the marital property. As noted above, however, since the individuals were UK nationals, Belgium conflicts of law rules apparently applies UK law even though the individuals were Belgium domiciliaries.

The second relates to the doctrines of mutability vs. immutability. It isn’t often that one sees these doctrines discussed in tax cases, so the case provides a good review (and learning opportunity for those not familiar with the concepts). The doctrines apply to determine what happens when a married couple get married under one marital property regime, but later acquire property while domiciled under another regime. The doctrine of mutability provides that the law of the country of domicile at the time of acquisition of the property governs questions of separate vs. community property. This doctrine is more often applied in the U.S. The doctrine of immutability provides that the law of the country of marriage applies (absent affirmative steps by the spouses to change the applicable law) to any later property acquisition. This concept is more often applied in European jurisdictions. In the case, it was a finding by the Tax Court that a U.K. court would apply the doctrine of immutability that ultimately resulted in 100% gross estate inclusion.

Estate of Charania, et al. v. Shulman, 105 AFTR 2d ¶2010-988 (1st Cir. 2010)