Thursday, September 30, 2010

TREATMENT OF PROPERTY THAT IS BOTH RENTED AND SOLD

A taxpayer in the business of selling property holds it in inventory. A taxpayer that rents property does not. In many circumstances, rental treatment is superior to inventory treatment – such property can be depreciated (and thus generate depreciation deductions), and it can be swapped in tax-free exchanges under Code Section 1031 for other like-kind property.

What if the taxpayer BOTH sells and rents property? In a recent Chief Counsel Advice, the taxpayer acquired property. Pending sale of the property, it rented it out. In selling property, it would typically swap the property for other property so as to minimize gain recognition on the swaps. The question was whether the taxpayer could depreciate the property and use Code Section 1031, or must the taxpayer hold the property as inventory instead.

There is no fixed rule in these circumstances. Instead, the taxpayer should examine its PRIMARY PURPOSE for holding the asset to determine whether it is inventoriable. In the situation that was analyzed, the IRS concluded the property belonged in inventory. Some of the factors noted by the IRS that tipped the scales towards inventory were (1) 91% of the taxpayer’s income came from sales with only 9% from rental operations, and (2) much of the new equipment was sold before it could be rented out. Of course, in this situation it was probably in the IRS’ interest to conclude the property was inventory, so as to deny the depreciation deductions and the gain deferral under Code Section 1031. Nonetheless, per the above facts it was probably a reasonable conclusion as to the taxpayer’s PRIMARY purpose.

Chief Counsel Advice 201025049

Saturday, September 25, 2010

SUMMARY OF KEY PROVISIONS OF SMALL BUSINESS JOBS ACT OF 2010

Congress has now passed the Small Business Jobs Act of 2010. The Act provides some welcome tax relief to business that hopefully will spur growth and job creation. However, Congress was stingy, with most of the tax benefits expiring after 2011. I remember, even though it was many years ago, when if a tax benefit was a good idea, it was enacted permanently because it was a good idea, and would not expire after a few years. These days, tax legislation tends to make increases in penalties and compliance obligations permanent, while tax benefits and reductions are only temporary. If Congress was really serious about these issues, it would make the changes on a permanent basis (or at least as permanent as a law that could be changed at any time in the future can be).

Below is a summary of the key new provisions.

I. Expensing

     A. Increase of §179 annual expensing to $500,000 from $250,000 for 2010 and 2011

          1. Increase threshold for beginning of phase-out to $2,000,000

          2. Will allow expensing of some types of depreciable real property

          3. Reducing back to $25,000 in 2012

     B. Extension of 50% bonus first year depreciation for qualified real property

     C. First year depreciation cap for autos and trucks increased by $8,000 for 2010

     D. Deduction for start-up expenses increased to $10,000 from $5,000 for 2010 and 2011

II. Credits

     A. Eligible small business credits can be carried back 5 years instead of one year, and extension of carryforward periods

III. Gain Exclusions

     A. Gains from the disposition of qualified small business stock can now be 100% excluded (up from 75%) and will not be an AMT tax preference item for stock acquired before 2011

     B. S Corporation built-in gains period reduced to 5 years for 2011

IV. Misc.

     A. 2010 health insurance expenses are deductible in computing self-employment tax

     B. Substantiation requirements for cell phones and similar equipment are elimianted by removing them from being "listed property"

     C. Recipients of rental real estate income are deemed to be in a trade or business for information reporting requirements (and thus must report all expenditures of $600 or more)

     D. Increased penalties for failure to file information returns

V. Retirement Plans

     A. Roth options added to Section 457 plans

     B. Retirement plan distributions may be rolled over to Roth IRA accounts (other than periodic distributions, minimum required distributions, and hardship distributions)

VI. International

     A. Guaranty fees paid by a U.S. person are U.S. source income, as well as fees paid by a foreign person if effectively connected with a U.S. trade or business (overides Container Corp., 134 TC No. 5 (2010))

Thursday, September 23, 2010

SEPTEMBER 20 IS NOT A FREE PASS TO REFORMING DESIGNATED BENEFICIARY TRUSTS

In a recent Private Letter Ruling, the IRS addressed a trust established by a decedent that was a beneficiary of the decedent's IRA. It was clear from the trust instrument that the decedent desired that the IRA payouts be based on the age of the designated beneficiary so as to defer distributions and income taxes, pursuant to applicable tax rules. However, the subject trust allowed for the appointment of a charitable beneficiary, which power prevented there from being a designated beneficiary that would allow for the "stretch" of the post-death IRA payouts. To address this situation, a state court action was filed and an order obtained that removed the problem power to appoint a charitable beneficiary. The question before the IRS was whether this state court reformation would be given retroactive effect so as to allow for a designated beneficiary.

Generally speaking, state court reformation of dispositive instruments will be respected by the IRS only if there is a specific tax statute authorizing such reformation. There is no such specific statutory authorization in regard to determining if there is a designated beneficiary of an IRA trust. However, the beneficiaries of an IRA are measured/determined on September 30 of the year following the death of the decedent. This would imply that if a reformation is undertaken prior to such September 30 date, such reformation should be given tax effect. Indeed, this reasoning was followed in Private Letter Rulings in the past that allowed qualification of a designated beneficiary through state court reformation actions.

In this most recent ruling, the IRS has changed its analysis, and it denied effective retroactive effect to the change to the trust. Thus, the state court reformation was not effective to allow the subject trust to have a designated beneficiary for IRA purposes.

It would appear that the IRS had legal wiggle room to provide a favorable result for the trust, as evidenced by its prior rulings. It will be interesting to see if the taxpayer under the subject ruling, or some similarly situated taxpayer, litigates this issue in the hopes that the court will adopt the IRS' earlier analysis of the issue.

PLR 201021038

Sunday, September 19, 2010

GRAEGIN LOANS – DO THE MATH!

There is an often an estate tax advantage to an estate borrowing funds, especially from related parties. If the estate is in a high estate tax bracket, it can deduct the interest, and thus save estate taxes. For example, if the estate is solidly in or above the 45% tax bracket, then the estate tax savings are at least 45% of the interest cost. The recipient will have to pay income taxes on the interest income, but maximum income tax rates in this example would be higher than the estate tax savings (except perhaps in some states with high state income tax rates), so a net tax savings would result. If the lender is a tax-exempt entity such as a family foundation, then the income taxes are almost entirely eliminated, enhancing the overall tax savings (even though the savings accrue for charitable purposes).

This is what the Estate of Henry Stick did – it borrowed funds from a family foundation (well, in this case, the remainder beneficiary actually did the borrowing). However, the estate failed to appreciate the simple mathematics at work that address the estate tax deduction, and thus lost its estate tax deduction for the interest paid when the Tax Court reviewed the matter.

Treas. Regs. §20.2053-3(a) requires that estate tax deductions must be actually and necessarily incurred, to be deducted. In the context of interest expense for borrowings by the estate, the Tax Court looks to see if the borrowing was needed by examining whether there are enough liquid assets to pay the estate tax liability and other administrative expenses. In the Stick Estate, the estate had approximately $1,953,617 in liquid assets. Putting together its administrative expenses and federal and state estate taxes, these obligations totaled $1,723,799. Thus, at least in the absence of other compelling circumstances, there was no need for the estate to borrow funds. In a short and sweet opinion, the Tax Court noted the excess of liquid assets over obligations and denied the interest deduction for the loan taken.

Estate of Henry H. Stick, TC Memo 2010-192

APPLICABLE FEDERAL RATES – OCTOBER 2010

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Saturday, September 18, 2010

BRAGGING RIGHTS

The inaugural edition of the U.S. News & World Report law firm rankings came out this week. I am happy to note that our firm received Tier 1 rankings in the Miami metropolitan area in the areas of Tax Law and Estates and Trusts.

We also received a Tier 2 national ranking in Tax Law. We note in that regard that almost all of the Tier 1 and Tier 2 rankings were given to law firms ranging in size from 100+ to thousands of attorneys, and that at 9 lawyers we were the smallest firm to make it into those tiers – thus validating our business model to deliver large firm quality services in a small, boutique firm environment.

Thank you to all attorneys and clients who participated in the surveys that allowed us to receive such favorable rankings.

2011 TAX HIKES LOOM

If the expiration of the 2001 tax breaks are allowed to proceed as planned, 2011 will see the highest tax hike in U.S. history. Discussion is heating up regarding extending some or all of the existing breaks, so perhaps not all of the changes will arrive in 2011. Below is a table of many of the looming changes:

ITEM

CHANGE

10% income tax rate disappears
amount of income covered by 15% income tax rate shrinks
top 25%,  28%, 33% & 35% income tax rates convert to 28%, 31%, 36%, and 39.6% rates
45% estate tax top rate (although there is no estate tax in 2010) increases to 55%, with 5% surtax to phase out graduated rates for the highest estates
estate tax unified credit exemption equivalent (was $3.5 million in 2009) reduced to $1 million
15% capital gains rate increased to 20% (18% for assets held at least 5 years)
15% qualified dividend income tax rate eliminated – increased to ordinary income rates
income exclusion for employer provided education assistance eliminated
above-the-line student interest income tax deduction reduced
household and dependent care income tax credits reduced
ability of heirs and estates to use Section 121 home sale exclusion of decedent eliminated
backup withholding rates on various types of income raised
reduction in itemized deductions for higher income taxpayers applies once again
phase-out of personal exemptions for higher income taxpayers applies once again
15% accumulated earnings and personal holding company tax rates increased to 39.6%
generation skipping tax reinstated, with a $1 million exclusion amount and a 55% rate
transfers at death to nonresident aliens appreciation in property subject to income tax
35% maximum gift tax rate increased to 55%

Sunday, September 12, 2010

PRENEED GUARDIAN DECLARATION HOLDS UP [FLORIDA]

Florida, along with many other states, allows a competent individual to prepare a written preneed guardian declaration that names a person to serve as guardian for the declarant in the event of incapacity. This is an important tool, allowing persons to name who shall be responsible for their person and property in the event of incapacity, and thus avoiding relatives, caretakers, or others who the declarant does not want to serve from being named guardian. We all know people that would not be good guardians, either because they lack the requisite skills, are too self-centered, or that may act with bad motives (for example, seeking to conserve assets which they may inherit in the future instead of using such assets to support the ward).

In the event of incapacity, what weight must the guardianship court give to the preneed declaration? Fla. Stats. §744.3045 indicates that the declaration is a rebuttable presumption that the preneed guardian is entitled to serve. However, the court may disregard the declaration if the preneed guardian is found to be unqualified to serve by the court. Thus, if the named guardian is unfit, or unsuitable, or if a conflict of interest exists between the guardian and the ward, the court need not point the named person.

In a case arising in Miami-Dade County Circuit Court, the guardianship court declined to follow a declarant’s naming of three persons to serve as preneed guardian, and named one person only to serve as guardian. The court did this based on representations that the declaration required unanimous actions by the three appointed guardians, and that this was not workable because the guardians disagreed as to certain care-giving issues.

In an opinion that gives due recognition and respect to the declaration, the Third DCA reversed the guardianship court and required the appointment of all 3 named guardians. The appellate court noted that the intent of the ward is the polestar that should guide probate judges in the appointment of guardians, and that this was not respected in this case.

There were a number of procedural problems with the guardianship court’s order. First, the court never examined the declaration itself, and the representation to the court that it required unanimous action by the guardians was erroneous. Further, there was no finding  by the court that any of the named guardians was unqualified, unwilling, or unable to serve as guardian.

Therefore, we don’t know if the court would have upheld the lower court if in fact unanimous action was required. To avoid this issue entirely, practitioners should give thought to avoiding a requirement for unanimous action when multiple guardians are named (even the appointment of 2 guardians has the risk of deadlock). Alternatively, they could give final decision-making power to one of the named guardians in the event of deadlock on any given issue.

It is always reassuring when the courts give due regard to statutory presumptions, although it did take an appellate court reversal to reach that result in this case (but again, in the guardianship court’s defense, that was due in large part to a misrepresentation by one of the attorneys before the court.

Acuna & Magill v. Dresner, 2010 wl 3025111 (3rd DCA 2010)

Wednesday, September 08, 2010

CAN A DISCLAIMER BE RESCINDED?

Craig and his sister were the two remaindermen that succeeded to his parents’ property at the termination of  10 year QPRTs that the parents set up. Craig wanted to transfer his remainder interest in the property to his sister when the QPRTs terminated. His attorney told him he could disclaim his QPRT interests, and that his interests would pass to his sister without gift tax. Thus, he entered into disclaimers to accomplish this.

Oops! After doing the disclaimers, he learned that the nine month period for doing a qualified disclaimer for gift tax purposes ran from the time of establishment of the QPRTs (well, actually from the time when Craig became an adult after the QPRTs were established), and not from the 10 year termination date of the QPRTs. Therefore, his disclaimers were done too late. As nonqualified disclaimers, they transferred his interests to his sister under state law, but resulted in a taxable gift by him to his sister since they were not qualified disclaimers under Code Section 2518. The IRS sought to impose gift taxes.

That would seem to be the end of the story. However, resourceful Craig learned that under applicable Massachusetts law, a written instrument may be reformed or rescinded in equity on the grounds of mistake when there is “full, clear, and decisive proof” of the mistake. Craig thus brought an action to rescind the disclaimers.

While the action commenced in state court, it was eventually removed to federal court. Applying Massachusetts law, the court allowed the rescission.

Could it be that simple? Could a state law rescission of a transaction eliminate the federal transfer tax consequences that arose on the original transfer prior to its rescission? The IRS claimed that while the rescission may be binding for state law purposes, it could not  undue the original gift tax consequences of the disclaimer transfer.

Clearly, the government has a valid concern that rescissions that eliminate taxable gifts can be problematic, since there often will not be an adverse party at the court proceeding that would inhibit collusive agreed rescissions between the parties that are entered into to avoid gift taxes. Indeed, there are a number of court decisions that will disregard a rescission for these purposes, at least when the government is not a party to the rescission proceedings.

Nonetheless, Craig was able to persuade the federal District Court that under his facts, the taxable gift was eliminated. The key facts that appear to have persuaded the Court were (a) the rescission action was heard by a federal court, not a state court, and (b) the IRS was a party to the action, thus eliminating the risk of collusion by the private parties.

The case instructs us that if a taxable transfer was the result of a transfer only undertaken by a mistaken belief that the transfer was free of gift tax, and if state law allows for rescission due to mistake, it may be possible to unwind the taxable transfer. However, to accomplish this, it will likely be necessary to find a procedural route that brings the IRS in as a party.

Breakiron v. Gudonis, 106 AFTR 2d 2010-XXXX (DC MA), 08/10/2010

Sunday, September 05, 2010

AN ELECTRONIC MINISTRY IS NOT A CHURCH

Code Section 501(c)(3) organizations are generally exempt from federal income taxes, and contributors may qualify for charitable deductions for their contributions. Such organizations by default are typically treated as "private foundations," but if qualified, they can achieve non-private foundation status. Non-private foundation status is preferable, because it avoids the potential application of various excise taxes to the organization, and may allow for greater income tax charitable contribution deductions for donors.

Beyond this private/non-private dichotomy, "churches" have further advantages. First, a church escapes from private foundation status without having to demonstrate public financial support, unlike most other private charities. Further, churches are exempt from annual information filings and exempt application procedures, and there are restrictions on audits of churches.

Many religious organizations can qualify as Code Section 501(c)(3) organizations due to their religious activities. However, not all religious organizations are "churches" for purposes of the above rules - only a smaller subset of such organizations will qualify as churches.

The Internal Revenue Manual provides 14 criteria that will be examined to determine if an organization is a church for these purposes. These criteria are (1) a distinct legal existence, (2) a recognized creed and form of worship, (3) a definite and distinct ecclesiastical government, (4) a formal code of doctrine and discipline, (5) a distinct religious history, (6) a membership not associated with any other church or denomination, (7) an organization of ordained ministers ministering to their congregations, (8) ordained ministers selected after completing prescribed courses of study, (9) a literature of its own, (10) established places of worship, (11) regular congregations, (12) regular religious services, (13) Sunday schools for religious instruction of the young, and (14) schools for the preparation of ministers.  The courts do not strictly apply this 14 criteria test, although they will often heavily consider these factors. Instead, the courts often apply an "associational test." Focusing on the association of congregants and believers, this test examines whether there is a body of believers or communicants that assembles regularly for communal worship.

In a recent case before the Court of Appeals for the Federal Circuit, a religious organization challenged the IRS' rejection of its status as a church, which rejection had been upheld by the Court of Federal Claims. Among other arguments, the organization argued that its "electronic ministry" qualified it as a church. The organization asserted that its members regularly assembled to worship as a virtual congregation by listening to sermons broadcast over the radio and the Internet at set times.

The Appeals Court noted the overlap between the 14 criteria test and the "associational test," and that to qualify as a church the religious organization must create the opportunity for members to develop a fellowship by worshiping together. Applying this test, the court noted that listeners simultaneously receiving the organization's message over the radio or the Internet did not mean that those members associated with each other and worshiped communally. Further, a "call-in" show that enabled individuals to call and interact with the organization's clergy over the telephone, with such calls being simultaneously broadcast, did not provide individual congregants with the opportunity to interact an associate with each other and worship.

Thus, the Appeals Court refused to qualify the organization as a church.

This should not mean that religious organizations that provide electronic broadcast of their services cannot meet the definition of a "church" for these purposes. However, it does suggest that such organizations must conduct a material part of their activities through in person, communal worshiping activities to qualify under the 14 criteria test or the "associational test."

Foundation of Human Understanding v. U.S., 106 AFTR 2d ¶2010-5204 (CA Fed Cir 08/16/2010)  

Friday, September 03, 2010

CHECK-THE-BOX RELIEF FOR FOREIGN ENTITIES

Foreign entities that provide limited liability to their owners, shareholders, or members will generally be classified by the U.S. as corporations/associations for U.S. income tax purposes. However, if such entities make a check-the-box election with the IRS, they can be classified as a disregarded entity (if there is one owner) or a partnership (if there is more than one owner) - although some types of entities are not eligible at all for such elections.

Since the election is due within 60 days of formation of the entity, as a practical matter it may be difficult to know at the time of filing how many owners there will be. Therefore, some entities may be filing check-the-box elections as partnerships when they end up having only one owner, and some entities may be filing as disregarded entities when they actually have more than one owner.

The IRS is now allowing such entities to correct their elections, without being stuck with an erroneous/invalid election. There are some conditions attached, but they are not too onerous:

1. Original or amended returns must be filed by the owners and the entity consistent with the revised/corrected treatment;

2. All required amended returns must be filed by the expiration of period of statute of limitations on assessments for the applicable tax years; and

3. A corrected Form 8832 is filed with the IRS and attached to the appropriate returns.

While I don’t know how often this problem actually arises, any relief for taxpayer errors is always welcome.

Rev.Proc. 2010-32