PROVISIONS OF THE NEW TAX ACT – FOREIGN PROVISIONS

Unlike the transfer tax area, only modest changes were made to the foreign provisions of the Internal Revenue Code. Continuing our review of the changes, below is a summary of the new provisions, most of which relate to temporary extensions of various favorable rules. For what they are worth (which may be quite a lot to those few taxpayers that are impacted), here they are:

A. The Subpart F exception for active financing income is extended.  The temporary exclusions will apply to tax years of a foreign corporation beginning after Dec. 31, 1998 and before Jan. 1, 2012, and to tax years of U.S. shareholders with or within which such tax years of foreign corporations end.

B. The look-through treatment for payments between related controlled foreign corporations under the foreign personal holding company income rules are extended through 2011.

C. The withholding tax exemption for RIC interest-related dividends and short-term capital gains dividends paid to foreign persons is extended for tax years beginning in 2010 and 2011. Also, the inclusion of RICs in the definition of qualified investment entity is extended for certain FIRPTA purposes through 2011.

D. The IRS authority to reduce withholding rate to 15% on USRPI gains passed through to foreign persons by U.S. partnerships, trusts or estates is extended through 2012.

E. Gain recognition expansion for Code §684 for transfers to nonresident aliens at death and to foreign grantor trusts that were to apply in 2010 will apply only to the extent the election is made to not have the estate tax apply.

F. The allowance of Code §199 deduction for Puerto Rico activities is retroactively extended two years to taxpayer's first six tax years beginning after 2005.

G. The possessions tax credit for American Samoa is extended through 2011 for existing claimants.

PROVISIONS OF THE NEW TAX LAW

I will undertake to summarize the key provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 over several postings. Let’s start with the new transfer tax provisions. Note below that there are some unique opportunities for conducting generation skipping transfers prior to 1/1/2011.

A. Estate and GST taxes reimposed for 2010, with reimposition of prior basis step-up regime.

     1. But with election available to avoid estate tax in 2010 on 2010 deaths, which would use the EGTRRA limited basis step-up provisions.

          a) In that situation, the deadline for filing the Form 8939 relating to basis allocation is delayed until 9 months from date of enactment.

     2. But GST tax rate set to zero. Decedent is still considered to be "transferor" for GST purposes.

          a) This is an incentive to make generation skipping transfers prior to the expiration of 2010, including distributions out of trusts that will be taxable distributions or taxable terminations.

               (1) Outright gifts are subject only to potential gift taxes.

                    (a) Which will deplete the estate for estate tax purposes if the transferor survives an additional three years.

               (2) Or to trusts where beneficiaries are all skip persons.

                    (a) Consider opting out of GST exemption allocation to avoid unnecessarily wasting GST exemption.

               (b) Post-2010 distributions to beneficiaries at the grandchild level (but not to beneficiaries of younger generations) will not be subject to GST tax, per Code §2652(a).

                    (c) If some desired beneficiaries are grandchildren and some are greatgrandchildren, you may want to have separate trusts for the different generation levels.

     3. QDOTs subject to estate tax if noncitizen surviving spouse died in 2010.

B. Increase in exclusion amounts and exemptions to $5 million for 2010-12, with inflation adjustment in 2012.

     1. This is an incentive to make lifetime transfers before 12/31/12 to the extent of available exclusions, since the larger exclusion amounts may revert to much lower amounts in 2013.

          a) But generally want to defer until at least 1/1/11 since gift tax exemption does not increase to $5 million until 2011.

     2. However, gift tax exemption remains at $1 million for 2010 gifts.

C. Maximum estate, gift and GST taxes reduced to 35% through 2012.

     1. This is an incentive to make lifetime transfers before 12/31/12 to the extent of available exclusions, since the rates may revert to much higher levels in 2013 (i.e., 55% maximum rates).

     2. And gift and estate tax rates are reunified.

D. Extended filing deadlines for estates of decedents dying from 1/1/10 to 12/17/10.

     1. 9 months from 12/17/2010 for filing an estate tax return, paying estate tax, making a disclaimer of an interest passing by reason of decedent's death, and filing of GST tax returns and making elections required on a GST tax return).

          a) But watch state law limits on time to make a disclaimer.

E. A surviving spouse can use the unused exclusion amount of his or her LAST deceased spouse for estate tax purposes (but only for spouses dying before 12/31/12).

     1. But it requires an election to be made on the estate tax return of the first spouse to die. This may mean a return is needed even though one would not otherwise be required.

     2. IRS can readjust available unused exclusion amount of first spouse to die, even though statute of limitations for examining that estate tax return has expired.

     3. GST exemption amounts are not portable.

     4. Credit shelter trusts (in lieu of maximizing transfers to surviving spouse or a marital deduction trust) may still be desirable at the death of the first spouse to allow for full use of GST exemption of first spouse, and to protect against estate tax at second death arising from appreciation in the value of assets.

          a) However, credit shelter trusts lose the opportunity for basis step-up at the death of the surviving spouse.

F. Return to 2001 rules and rates will occur on 1/1/13 (unless subsequent changes are made by law).

1. Here we go again!

TAX RELIEF APPROACHING

With the passage of the tax bill today in the Senate, it is looking more and more likely that the Bush tax cuts will be extended for 2 more years, and favorable changes to estate, gift, and generation skipping taxes will be enacted into law. Consideration by the House is next.

The new estate tax rules will introduce a new concept – portability of exemption amounts. To the extent a spouse does not fully use the new $5 million exemption during lifetime time and at death, the surviving spouse can use the unused portion as well as his or her remaining exemption. One quirk of the pending law is that it will require estates of the first spouse to die to file an estate tax return, even if no taxes are due by reason of full coverage under the decedent’s exemption amount, so as to allow portability of the unused exemption to the surviving spouse. This will provide work to accountants that might otherwise see a significant diminution in estate tax return work due to the increased exemptions. Further, the IRS will be able to audit the return of the first spouse at any time to adjust the remaining exemption amount, even after the statute of limitations for the assessment of tax have expired.

In a provision very favorable to taxpayers, the $5 million exemptions will be indexed for inflation starting in 2012. Of course, the measure of inflation is the government’s computation, which many believe significantly understates actual inflation (see www.shadowstats.com). But a half a loaf is much better than no loaf.

At first blush, it might seem that the new portability rules do away with the traditional dual arrangement of a by-pass trust and a marital gift/trust to make use of the first spouse to die’s exemption. However, there are still reasons to use such arrangements – principally to help prevent appreciation in assets pushing the family above the combined $10 million exemption, and to allow full use of the first spouse to die’s $5 million GST exemption. However, the use of a by-pass trust eliminates the ability to get a step-up in basis on the trust’s assets at the death of the first spouse. Thus, disclaimer trust arrangements may be the way to go, allowing the decision of whether and how much to fund into a by-pass trust for the surviving spouse to be made after the death of the first spouse based on the circumstances at that time.

BUSH TAX CUTS EXPIRATION UPDATE

The last minute efforts of Congress and the President to deal with the expiration of the Bush tax cuts on December 31 have been interesting, to say the least. It has also contributed to making year-end tax planning the most complicated and speculative it has been in recent memory, if ever.

The current proposal, backed by President Obama and most Republican Congressmen and Senators, is embodied in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. The Senate and House will be voting on the Act this week. What is keeping things interesting is that the House Democratic caucus met on Thursday and voted to reject the plan. What this means is that for the Act to clear Congress is that it will probably need the votes of many of the lame duck "blue dog" Democrats who were defeated in the recent election. An interesting artifact of the recent election is that while the general shift in Congress was towards the right on economic issues, many Democrats who were conservative on economic issues were swept out of office as part of the big wave, leaving the remaining Democrats further to the left on economic issues than where they were as a whole prior to the election.

For those not following things, the following is a list of the key tax provisions of the Act:

-Existing income tax rates will remain in place for another two years.

-Personal exemption phase-out repeal is delayed for two years.

-The temporary repeal of the itemized deduction limits are extended for two years.

-Capital gains and qualified dividend rates remain the same for two years.

-Individual alternative minimum tax exemptions are increased for two years.

-The unified credit for estate and gift taxes is increased to $5 million per person and $10 million per married couple, and will be indexed for inflation beginning in 2012. The generation skipping tax exemption will also be at $5 million. The exemption is portable between spouses. A 35% maximum rate is imposed for two years for estate, gift and generation skipping taxes. The new tax regime is retroactive to January 1, 2010, but allows an election to choose no estate tax and modified carryover basis for estates arising in 2010.

-FICA tax reduction for employees in 2011 from 6.2 percent to 4.2 percent.

OVERPAYMENT AND UNDERPAYMENT RATES–JANUARY 2011

NO LOSSES TO ESTATE BENEFICIARIES WHEN THEY COULD RECEIVE NOTHING

Code §642(h)(1) permits the capital loss carryover of an estate to be carried over to the beneficiaries succeeding to the estate property upon termination of the estate. What happens if the beneficiaries do not actually succeed to any property?

In a recent Chief Counsel Advice, the estate agreed with the IRS to turn over all of its assets to settle income tax liabilities of the decedent. The beneficiaries who would have received a distribution from the estate were thus barred from receiving anything. Nonetheless, they deducted capital losses of the estate. The Advice indicates that the beneficiaries should not be allowed the deduction.

Treas. Regs. § 1.642(h)-4 does provide an example of a beneficiary receiving a loss even though there were insufficient assets to actually distribute anything to the beneficiary. This is based on the premise that such a beneficiary would have gotten something but-for the loss, and thus suffered it and should receive the capital loss deduction. Nonetheless, the Advice indicated that there was no way the beneficiaries could receive anything pursuant to the settlement agreement, and thus they could not use this example. The Advice does not provide any details on the economics of the settlement – it would seem that if the losses were large enough that if they did not occur and the IRS liability could have been satisfied with something left over for the beneficiaries, then the beneficiaries suffered the loss at least in part and thus should get at least some of the losses. Such an analysis would seem to be required by the definition of beneficiaries in regard to a testate estate under Treas. Regs. § 1.642(h)-3(a) which definition includes persons who bear the burden of any loss for which a carryover relates. Thus, it would seem that an analysis should have been undertaken to determine if any amounts would have been left to the beneficiaries if the IRS was paid its liability in full, assuming that no losses had occurred. However, the Advice does not undertake this analysis and simply hangs its hat on the fact that the agreement existed so the beneficiaries could receive nothing and thus no losses would be allowed to them – end of story.

Treas. Regs. § 1.642(h)-3(b) provides a definition of a “beneficiary” for an intestate estate. That includes heirs and kin of the decedent under an insolvent intestate estate that receive nothing but would have received something if the estate was not insolvent. This concept, if applicable to a testate estate also, should allow a deduction here, at least in part, if the losses were large enough to have cost the beneficiaries part of what they otherwise would have received even after the IRS was paid in full. The Advice noted that the estate at issue above was a testate estate, so the intestate estate rule did not directly apply and would not be applied. More reasonably, the Advice should have used the intestate rule to inform it regarding the need to track the actual economics in the testate situation, but as noted, such an economic analysis was not undertaken.

Perhaps we may see more on this issue if the taxpayers decide to litigate the issue.

CCA 201047021

UNCERTAINTIES PILED UPON UNCERTAINTIES

On Thursday of this week, Senate Finance Committee Chair Baucus introduced an amendment to the Middle Class Tax Cut Act of 2010. It is more likely than not that this amendment will not be currently passed into law, but nobody knows for sure. Indeed, whether the Middle Class tax Cut Act will find its way into law is unknown. While the proposed changes provide substantial estate, gift and generation-skipping tax relief, some of the effective dates provide new risks for any year-end 2010 planning.

Since the proposals are not law, we will not go into great depth in reviewing them at this point. Some of the highlights are:

a. The 2009 estate, gift and GST exemption amount of $3.5 million will be made permanent and indexed for inflation starting in 2011. The maximum rates will be 45%. This change will be retroactive to 1/1/2010, with the reinstatement of normal basis-step up rules – however, taxpayers with transfers in 2010 can elect to apply the 2010 repeal rules instead (with their limited basis adjustments) .

b. The gift tax unified credit will be re-unified with the estate tax exemption, as of 12/2/2010.

c. Provisions will be enacted that resolve many of the 2010 tax uncertainties, including allowing direct skips in trust to take advantage of the move-down rule even if there was no GST tax imposed on the funding in 2010.

d. Unused unified credit of one spouse can be used by the surviving spouse, if an election is made.

e. GRATs will have to have a minimum 10 year period and some value in the remainder interest to obtain favorable GRAT treatment.

A MAJOR aspect of these new rules is that if these amendments are enacted into law, any gifts made after December 2, 2010 will NOT be able to use the 35% gift tax rate and the exemption from GST tax that has been available since January 1, 2010. However, it appears such gifts and transfers will obtain the benefits of the increased unified credit and lower maximum tax rate that are coming in at the same time.

Planning in 2010, especially late this year, has been challenging, to say the least. A large part of this has to do with uncertainties regarding transfers to generation skipping tax trusts and how those trusts will be treated in future tax years. Now, to add uncertainty to uncertainty, any transfers made now through the end of December (or the enactment into law of these provisions if that comes sooner) will face the uncertainty of whether they will be under the 35% maximum gift tax rate and whether they will be exempt from GST tax. Fun, fun, fun!

One word of caution – the above is based on summaries of the proposed changes that I have seen and not a review of the actual legislation. Planners should conduct their own review to determine how exactly the proposals would apply to their situation. 

INNOCENT SPOUSE RELIEF GRANTED EVEN THOUGH WIFE KNEW TAXES MIGHT NOT BE PAID

Each spouse is jointly and severally liable for the tax, interest, and penalties (other than civil fraud penalty) arising from a joint return. However, the Internal Revenue Code provides various routes for relief for an “innocent spouse.”

One of those routes is relief under Code §6015(f). A spouse can obtain equitable relief from joint liability if “taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency.” The procedures for obtaining Code §6015(f) relief are provided for in Rev.Proc. 2003-61.

A recent Tax Court case illustrates the application of the rules in that Revenue Procedure, and further demonstrate the Tax Court favorably granting relief to a spouse under those procedures even though the spouse knew at the time she signed and filed the tax return that there was a good chance the taxes indicated as due on the return would not be paid.

Under Rev.Proc. 2003-61, a prerequisite to equitable relief is that seven threshold conditions described in Section 4.01 must be met. If they are met, the the IRS will ordinarily grant relief to a requesting spouse if three safe harbor conditions in Section 4.02 are met.

In the recent case, a former wife passed the seven threshold conditions of Section 4.01. However, due to her having filed the return with knowledge that the taxes would likely not be paid, she did not meet the three safe harbor conditions of Section 4.02.

Nonetheless, all is not yet lost for a spouse that fails the three safe harbor conditions. In that circumstances, the spouse has one more chance – the IRS can still grant equitable relief after applying a balancing test that weighs various factors in Section 4.03 of the Revenue Procedure. Luckily for the spouse in this case, the Tax Court found enough factors in the wife’s favor that it found the spouse eligible for equitable innocent spouse relief.

I have put together a MindMap that summarizes the various routes to innocent spouse relief, including the various conditions, safe harbors, and factors applied under Rev.Proc. 2003-61, for anyone that wants to dig down into the details of these provisions. Click HERE for an Adobe Acrobat version, and HERE for a flash version. In this case, the wife could not use the relief mechanisms of Code §6015(b) or (c) because the tax due had been reported by the taxpayer on a return.

Gail P. Drayer v. Comm., TC Memo 2010-257