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Saturday, December 31, 2011


The IRS issued a levy to US Airways in regard to the tax liability of an employee. US Airways garnished the wages of the employee and paid them over to the IRS.

The employee was not pleased, and sued US Airways, claiming it should not have complied with the levy. Two reasons were provided. The first was that US Airways failed to ensure the levy was valid. The second was that the employee had indicated on his W-4 that his wages were exempt, and thus should not have been subject to garnishment.

The District Court threw out the lawsuit. Code §6332(e) provides protection to persons satisfying an IRS levy. It reads:

Any person in possession of (or obligated with respect to) property or rights to property subject to levy upon which a levy has been made who, upon demand by the Secretary, surrenders such property or rights to property (or discharges such obligation) to the Secretary (or who pays a liability under subsection (d)(1) ) shall be discharged from any obligation or liability to the delinquent taxpayer and any other person with respect to such property or rights to property arising from such surrender or payment.

Valid or not, the employer had no responsibility for challenging the levy, and indeed had no standing to do so even if it wanted to. The fact that the employee’s wages were characterized on the W-4 as “exempt” did not change the employer’s obligation to comply with the IRS’ levy.

All this makes perfect sense from a policy standpoint. If property holders can contest levies they receive relating to property they hold of a taxpayer, collection by the IRS would be impaired by persons without a direct interest in the subject property. That being said, a grant of immunity to the party receiving the levy for complying with a levy that they have no ability to contest is both necessary and proper.

Gust v. US Airways, 108 AFTR 2d ¶2011-5603 (DC NC 12/16/2011)

Sunday, December 25, 2011


Taxpayers that desire to contest an IRS assertion of tax liability in Federal district court or the Court of Federal Claims must first FULLY pay the asserted tax liability, and then sue for a refund. If the liability is high enough, a taxpayer may be unable to afford to do this.

However, under the “divisible tax” analysis, some tax penalties may be divisible from others – when that analysis applies, the taxpayer can only pay some and not all of them, and still get to court by suing for a refund. In a recent Chief Counsel Advice, the issue was raised whether Code §6048 penalties failures to report contributions to, ownership of, and distributions from foreign trusts are “divisible taxes” that would allow for less than all asserted penalties to be paid and still allow a refund suit.

At first, such penalties would appear to be divisible, since different penalties arise under Code §6048 for different types of failures to report, and because multiple tax years may be involved. Nonetheless, the IRS concluded that Code §6048 penalties are NOT divisible. Thus, taxpayers seeking to get to district court or the Claims Court will need to first prepay all asserted penalties in full.

The theory of the CCA was that if payment of only one portion of the penalty was sufficient for jurisdiction, the court nonetheless would have full jurisdiction of all the asserted penalties. Further, different reasonable cause defenses against different portions of the penalty could be argued by the taxpayer. The CCA concluded that this was inconsistent with the theory of a “divisible tax,” and thus partial payment would not give rise the sought after jurisdiction.

There are two important provisos to this determination. First, this is only the IRS’ position, and thus a taxpayer could contest that determination in court. Second, the CCA notes that if the taxpayer is willing to drop its opposition to the unpaid tax portion, it could proceed to obtain court jurisdiction over a portion of the penalties asserted by paying just those penalties first.

Chief Counsel Advice 201150029

Thursday, December 22, 2011


For those readers who are situated in South Florida, I am giving you first crack at seats to a complementary small group presentation I will be giving at our firm office on several Fridays in January on the above topic. As you may be aware, substantial new reporting requirements relating to foreign financial assets apply to income tax returns due for the 2011 tax year.

Click the link to download the full invite which will go out to a broader audience in the next few days. The invite has the dates and times and RSVP information. Since space is limited, please call or email (the instructions are on the invite) as soon as practicable to reserve a space if you are interested.

For any larger organizations within decent driving range (Palm Beach to Ft. Lauderdale) that have 5 or more interested persons, I would be happy to schedule a visit to your office to make the presentation (if my schedule permits) – feel free to contact me at in that regard.


Wednesday, December 21, 2011


The earned income credit (EIC) can provide tax refunds to qualified low income taxpayers. Due to faulty submissions (intentional or unintentional), efforts have escalated over the years to pressure preparers to limit filings to eligible cases only – that is, to get preparers to police this area. For example, in 1997 a penalty of $100 was added for preparers who fail to comply with due diligence requirements in determining eligibility for the EIC.

More recent changes to the law and regulations have ramped up the compliance burden. For example, earlier this year, the preparer penalty was increased to $500 (Code §6695(g)). Now, the IRS has issued proposed and final Regulations that affect this area.

Previously to avoid the penalty, a preparer had to prepare an Eligibility Checklist (Form 8867) and a Computation Worksheet, and retain them for three years. Under proposed Regulations that were issued on December 19, the Form 8867 would now be required to be submitted with the filed tax return. The three year retention period may also be extended in some circumstances under the proposed Regulations, and other changes have been made under both the proposed and final regulations.

Preparers that prepare EIC claims should review the new Regulations to minimize their exposure to the increased preparer penalty.

T.D. 9570, 12/19/2011, Reg. § 1.6695-2

Sunday, December 18, 2011


In an effort to stake out its own piece of the regulatory State, the IRS now requires return preparers to register with them and obtain a Preparer Tax Identification Number (PTIN), for returns filed after 12/31/10. For preparers with PTINs, the first renewal date is now coming up.

PTIN holders will need to go online to to renew before December 31, 2011. PTIN holders will have to pay $63 for the privilege of being regulated.

For more information on the PTIN requirements and how to renew, consult IRS News Release 2011-119.

IR 2011-119.

Thursday, December 15, 2011


[This article was prepared by Sean Lebowitz of our office]

The Agee v. Brown* decision has been a highly talked about recent 4th DCA opinion among Florida estate planners and probate litigators. In Agee, an attorney prepared a Will (“2007 Will”) for the Decedent naming himself and his wife as beneficiaries of real property. Two years later, the Decedent went to a different attorney and prepared a subsequent Will (“2009 Will”) that removed the attorney and his wife as beneficiaries.

When the Decedent passed away, the Personal Representative sought to have the 2009 Will admitted into probate. The drafting attorney of the 2007 Will filed a Petition to Revoke Probate which alleged the 2007 Will is the last valid Will of the Decedent.

In response, the Personal Representative filed a Motion to Dismiss which alleged that the drafting attorney lacked standing to contest the 2009 Will. The Motion to Dismiss asserted that the drafting attorney’s bequest in the 2007 Will is void since it is in violation of the Rules Regulating the Florida Bar. In particular, Rule 4-1.8(c) does not permit an attorney to prepare an instrument for a client which gives the attorney or a person related to the attorney a substantial gift unless the recipient of the gift is related to the client. In the instant case, the drafting attorney and his wife were not related to the Decedent. The Probate Court granted the Personal Representative’s Motion to Dismiss and determined that the drafting attorney lacked standing to contest the 2009 Will because his bequest in the 2007 Will was void due to public policy.

The Fourth District Court of Appeal reversed the Probate Court and found that notwithstanding his ethical violation, the drafting attorney did have standing to contest the 2009 Will. The Appellate Court determined that the Probate Code does not provide any exception to prohibit a drafting attorney who is also a substantial beneficiary from contesting a will. Instead, the Probate Code simply permits an “interested person” to file an action contesting a Will. “Interested person” is defined very broadly in the Probate Code, allowing any person reasonably affected by the proceeding to file an action. The Appellate Court conservatively analyzed the Probate Code and found that the Probate Court imputed ethical rules not found in the Probate Code.

*Disclaimer: Our firm represents the Appellee/Respondent, Mr. Brown, in his capacity as Personal Representative and Trustee in the probate and trust litigation.

Tuesday, December 13, 2011


An owner of real property that donates a conservation easement to a qualified organization may be able to deduct the value of the easement for income tax purposes. Such a deductible contribution requires the contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes. A qualified real property interest is a restriction granted in perpetuity on the use, modification, and development of property such as parks, wetlands, farmland, forest land, scenic areas, historic land or historic structures.

The IRS has revised it Conservation Easement Audit Techniques Guide as of September 30, 2011. This lengthy guide should be reviewed by those structuring such contributions to assure compliance with all statutory and regulatory requirements.

Exhibit 12-1 is especially beneficial since it provides an all-inclusion list of potential issues. It includes general problems that may arise with charitable contributions, deficiencies in the appraisal process, deficiencies as to the perpetuity requirements, deficiencies as to the recipient organization, and deficiencies as to the requisite conservation purpose. The list is a gift for planners and return preparers – it should be used as a checklist for planning and compliance.

For those with an interest, I have reproduced the Exhibit 12-1 issue list below:





Conservation Easement Audit Techniques Guide

Monday, December 12, 2011


Under the Controlled Foreign Corporation (CFC) rules, U.S. shareholders of foreign corporations will have to include in their income their pro rata share of the CFC’s income on a pass-through basis under certain circumstances. Such inclusion can be required in the year the income is earned, or in a later year if and to the extent the CFC invests its untaxed earnings in U.S. property. Such income is included in the shareholder’s income at ordinary income rates, like a dividend.

Hmm, like a dividend. Does that mean the U.S. shareholder can pay tax on this income at the preferential 15% rates presently allowed for qualified dividend income under Code §1(h)(11) if the CFC is otherwise a qualified foreign corporation?

I think most international tax planners would tell you the answer is no. While the Code taxes these inclusions as ordinary dividend like a dividend, it does not actually characterize them as dividends. There are plenty of other situations in the Code when it will specifically characterize a deemed distribution or other amount as a deemed dividend, but that language is not present in the CFC rules.

This analysis didn’t stop at least one taxpayer from reporting this income relating to the reinvestment of CFC earnings in U.S. real property as a dividend to be taxed under the reduced rates, to the tune of about $3 million in income. The IRS challenged the treatment, and the taxpayer took the issue to the Tax Court. The Tax Court took the side of the IRS, and disallowed the application of the 15% maximum tax rate.

The Tax Court noted the items above, such as the lack of an explicit dividend label to the CFC income inclusion, and that Congress has given that label in other areas when it intends such treatment. The taxpayer did note that the 2004 instructions to Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, indicated that individual CFC shareholders should report section 951 inclusions as “ordinary dividend income.” Nonetheless, the Court noted that there were other instructions to the contrary that accompanied that Form, and further that “taxpayers cannot rely on Internal Revenue Service instructions to justify a reporting position otherwise inconsistent with controlling statutory provisions.”

Osvaldo Rodriguez, et ux. v. Commissioner, 137 T.C. No. 14,

Saturday, December 10, 2011


The Treasury Department greatly simplified tax planning and compliance with the check-the-box regulations. One aspect of those regulations is that certain single-owner entities (either by default or via the check-the-box election) are entirely disregarded for all federal tax purposes.

Or that is how it started. As time has progressed, so have the number of exceptions to disregarded status that have been promulgated. Making the job of tax professionals more difficult, there is no centralized list of the exceptions to disregarded entity treatment. Instead, they are scattered in various regulations, creating traps for unwary taxpayers and planners. Planners would be well-served by maintaining their own cheat sheet of exceptions to these rules to make sure that a particular transaction is not covered by an exception.

A new exception now has been added to the list. Under final regulations issued under Section 881, the IRS can treat a disregarded entity in a financing structure as a person separate from its owner (that is, as a non-disregarded entity), in determining whether a financing arrangement exists that should be recharacterized under the multiple-party financing rules of Code §7701(l) and Treas. Regs. §1.881-3. These rules allow the IRS to disregard the participation of one or more intermediate entities in a financing arrangement and recharacterize the financing arrangement as a transaction directly between other parties. It will often be applied where intermediate entities are employed by taxpayers to obtain treaty or other tax benefits that would not be available if a financing transaction was directly conducted between the ultimate lender and borrower.

T.D. 9562, 12/08/2011; Reg. § 1.881-3

Tuesday, December 06, 2011


Planners often grant Code §675(4) power of substitution rights to a grantor of a trust to create a grantor trust (i.e., a trust whose income is taxable to the grantor). That provision creates a grantor trust if the grantor has the power in a nonfiduciary capacity, without the approval or consent of any person in a fiduciary capacity, to reacquire trust corpus by substituting other property of an equivalent value.

Such planning was given a boost in Rev.Rul. 2008-22 which provided that such a power, when properly structured, will not result in estate tax inclusion of the trust assets in the gross estate of the grantor. Thus, the advantages of grantor trust status can be obtained without the cost of estate tax inclusion.

However, if the trust involved is an irrevocable trust holding a life insurance policy, the use of a power of substitution has raised the issue whether gross estate exclusion will apply as to the life insurance policy or proceeds. More particularly, the issue has been whether such a power of substitution constitutes an “incident of ownership” by the grantor in the insurance policy that results in gross estate inclusion at death under Code §2042.

The IRS has now ruled that such a power of substitution will NOT create an incident of ownership in the grantor. Thus, such grantor trust planning will not be problematic for trusts owning life insurance.

Note that Crummey withdrawal rights in a beneficiary, which are often used in life insurance trusts, will not defeat grantor trust status as to the grantor.

In relying on the ruling, planners should attempt to come as close as possible to the facts of the ruling as practicable, including:

  1. The grantor is not the trustee.
  2. The trust terms prohibit the grantor from serving as trustee.
  3. The grantor has no power to revoke, alter, amend, or terminate the trust.
  4. The substitution power is exercisable in a nonfiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity.
  5. The grantor must certify equivalent values when exercising the substitution power.
  6. The trustee has a fiduciary obligation to confirm equivalent values on a substitution.
  7. The trustee has a duty under local law to act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries, if there is more than one beneficiary.
  8. The trustee has discretionary power to acquire, invest, reinvest, exchange, sell, convey, control, divide, partition, and manage the trust property in accordance with the standards provided by law.

Code §677(a)(3) provides that income of a trust that may be applied to premiums on a policy insuring the grantor’s life creates a grantor trust. That being the case, an argument can be made that another grantor trust power, such as a substitution power, is not needed to create a grantor trust. However, the benefit of this ruling is that there is some uncertainty regarding whether Code §677(a)(3) creates a fully grantor trust, or only a partial grantor trust equal to the amount of the insurance premiums.

Many life insurance trusts do not earn income, so grantor trust status may not be needed. However, at other times, grantor trust is desired. For example, the trust may be funded with other income earnings assets, to help pay premiums or to be used for other purposes. Also, grantor trust status may be desirable so as to allow the trust to be funded with noncash assets via a sale to a defective installment trust.

Rev. Rul. 2011-28, 2011-49 IRB 830, 12/01/2011

Sunday, December 04, 2011


IRS compliance initiatives in 2010 and 2011 have focused attention on the U.S. requirements for disclosure of non-U.S. accounts, and the penalties that apply for nondisclosure. For the past 2 years, the IRS has provided special initiative mechanisms for late reporting that involve reduced penalties, or no penalties under some circumstances.

It looks as if there may be country-specific relief coming, with the first relief to come to U.S. persons with accounts in Canada, at least according to this article.

Saturday, December 03, 2011


Bloomberg just published an article that does a state-by-state analysis of state tax burdens.

The 5 states with the highest state tax burdens are Connecticut, New Jersey, New York, Massachusetts, and Maryland (interestingly, all in the Northeast).

The 5 with the lowest burdens are Mississippi, South Carolina, Tennessee, Alabama, and Alaska. Many of these states nonetheless have both an income and sales tax.

Florida (my state) is considered a tax haven because it lacks an income tax and an inheritance tax. It apparently did not make the lowest 5 due to the significant real property taxes collected. The article noted the following about Florida:

Retirees have good financial reasons to flock to Florida. It has no state tax on Social Security, no tax on capital gains, and no inheritance tax. Revenue must come from somewhere, though, so property taxes per capita rank in the nation's top 10. Florida Governor Rick Scott pushed for major cuts to the corporate income tax rate and to state fees during the last fiscal year. The legislature passed more than $300 million of the cuts, including lower fees for a driver's license and car registration.

You can read the full report here.


For a view on what may happen to federal estate and gift taxes should President Obama be reelected and the Democrats win enough seats in Congress, tax a look at the recently introduced “Sensible Estate Tax Act of 2011.” A wish list of tax increases, the Act proposes:

  • raising the maximum estate and gift tax rate, and the GST rate to 55%;
  • lowering the applicable exclusion amount to $1 million. This would include indexing for inflation after 2012, but with adjustments going back to 2000;
  • restricting valuation discounts on investment assets;
  • restoring the state death tax credit;
  • eliminating GST exemption benefits after 90 years;
  • requiring a minimum 10 year term for GRAT’s.

Of course, the first of these items will occur automatically in 2013 under current law even without the passage of a new law.

Wednesday, November 30, 2011


There are a number of favorable business and individual tax provisions that will expire or be substantially reduced after 2011. Perhaps Congress may extend some or all of them, or perhaps not.

There is still one month left to make use of these items, so relevant taxpayers may want to get moving on these items, if they are of interest or relevance.

I have created an abbreviated list, in both map and list format, that highlights the most important of these items. Click here or go to to access it in your browser.

Sunday, November 27, 2011


Lots of things, obviously! In context of tax and business, a number of specific items (not exhaustive), including:

a. Creditor protection via the special protections afforded by property held jointly as tenants by the entireties (in those states recognizing such tenancies and protections, such as Florida);

b. Use of gift splitting to double annual exclusion gift amounts to a specific beneficiary;

c. Use of two unified credit amounts to make larger gifts; and

d. Decontrolling entities for valuation reduction purposes.

But there is nothing special about those items for 2011 and 2012. What is special for these two years is the $5 million unified credit amount for gift and estate tax purposes. This is the highest amount by far ever permitted, and it is scheduled to revert to $1 million on January 1, 2013.

Many high net worth families will want to take advantage of all or a part of this high amount to make gifts free of estate tax before 2013. If such amounts are used to establish long-term trusts for family members and are properly structured for generation-skipping tax exemptions, dynasty trusts that can pass assets through several generations without incurring estate, gift or generation-skipping tax can established.

Many parents are not eager to establish trusts for children or grandchildren. It may be because they want to hold on to the subject assets in case needed for their own future living expenses if their circumstances change, or perhaps they don’t want to “spoil” their lineal descendants with a large trust for them while they are young.

The benefit of being married is that each spouse can create a gift trust, naming the other as the current beneficiary, instead of (or in addition to) a younger generation beneficiary. This trust need not require current distributions, so it can grow over time and eventually pass to the children or younger generations when the parents die. Importantly, the parents will have access to the funds if needed during lifetime, as beneficiary of each other’s trust.

The trusts can be grantor trusts, so that the spouses will be directly taxed on the income of each trust and allowing the trusts to grow in an income-tax free environment. The trusts can also use a formula funding clause and variable dispositive provisions based on QTIP treatment, to allow partial QTIP treatment and division, if funded with difficult-to-value assets. This avoids the risk of the IRS successfully challenging the values to create a taxable gift over the remaining unified credit if that credit amount is exceeded. It may also allow for more aggressive valuation planning on in-kind funding of the trust.

Care must be taken, however, to avoid the application of the reciprocal trust doctrine. This is not difficult to accomplish, as long as one is conscious of the need for such planning.

This type of planning is not without its drawbacks, but all-in-all it provides significant benefits. It should be considered by those families with spouses in the older generation that are planning to use all or a portion of the enhanced unified credit in 2011 and 2012.

Tuesday, November 22, 2011


Travelers entering or leaving the U.S. with more than $10,000 in “monetary instruments” have to file a Currency and Monetary Instrument Report (CMIR) with U.S. custom officials.

Due to concerns that prepaid cards are being used for money laundering and other criminal uses, new proposed rules will extend the definition of “monetary instruments” to include prepaid cards and gift cards, gift cards, and potentially even cell phones to the list of “monetary instruments” whose value must be declared upon entering or leaving the country. When the total exceeds $10,000, the individual would have to file a special report with customs officials.

Interestingly, the rules may be extended to cell phones that can be used to accomplish digital fund transfers.

Credit cards and debit cards, which are considered more visible to law enforcement, are exempt from the rule.

Sunday, November 20, 2011


Taxpayers are permitted to use a value for estate tax return purposes that is six months after the date of death, instead of the date of death value (or at times, at dates after death but before six months). Code §2032. In 2008, the IRS published proposed regulations. Due to numerous issues raised with the proposed regulations, the IRS went back to the drawing board and has now issued new proposed regulations.

For those of you that would rather not read through them, a shortened summary can be downloaded here (click the link and then download from the page that opens).

Sunday, November 13, 2011


The IRS has issued final regulations that add generation-skipping tax avoidance as reportable under the tax shelter reporting and disclosure rules. Do we care?

The short answer is “not yet.”

Promoting, advising taxpayers about, or participating in a transaction that is the same as or substantially similar to a transactions determined by IRS to be a tax avoidance transaction and a “listed transaction” triggers numerous disclosure and penalty rules. Taxpayers may need to disclose their participation and material advisors may need to disclose these transactions. Material advisors also must maintain lists of advisees and other information with respect to these listed transactions. “Transactions of interest” are included in reportable transactions. These are transactions that IRS believes have potential for tax avoidance or evasion, but for which it lacks enough information to determine whether they should be identified specifically as tax avoidance transactions.

The final regulations finalize proposed regulations that include GST taxes as coming under this rules. It is the position of the Dept. of the Treasury that the changes were “corrective,” not “expansive.”

The reason we don’t care yet is that there are no transactions on the IRS “listed transaction” list or the “transactions of interest” list that involve generation-skipping taxes. Therefore, the rules will only be relevant if the lists are expanded to include transactions involving GST taxes in the future.

Objections to the expansion were raised by persons representing corporate fiduciaries – that they would be subject to reporting as a material advisor simply by being a trustee or a personal representative when a reportable transaction was undertaken by a trust or estate. In response to those comments, Treasury noted that  a “fiduciary will not be treated as a material advisor merely by acting as an executor or trustee with respect to an estate or trust that is incidental to a transaction. A fiduciary will be treated as a material advisor only if the fiduciary provides material aid, assistance or advice as described in § 301.6111-3(b)(2), the fiduciary directly or indirectly derives gross income in excess of the threshold amount as described in § 301.6111-3(b)(3), and the transaction is entered into by the taxpayer.”

T.D. 9556, 11/10/2011; Reg. § 26.6011-4, Reg. § 301.6111-3, Reg. § 301.6112-2

Thursday, November 10, 2011


A recent Florida appellate court decision bears review by practitioners drafting post-nuptial agreements.

The case involved a husband who provided for assets to pass to his wife in his Last Will. After the Will was signed, the spouses entered into a post-nuptial agreement. The husband then died while the parties were still married. The probate court determined that the gift to the wife was waived by the wife under the agreement, and thus she could not inherit the gifted property. It appears that the husband had children from a prior marriage, and it was the husband’s prior wife who challenged the gift to the surviving spouse in favor of her minor children with the decedent.

Let’s assume that the terms of the agreement, in conjunction with Fla.Stats. §732.702(1), constituted a waiver of rights by the surviving spouse of her rights under the Will - this is what the probate court and the appellate court found. This is an interpretative issue.

The more interesting part of this case was the effect of the following common clause that was in the post-nuptial agreement:

Notwithstanding the terms of this Agreement, either party shall have the right to voluntarily transfer or convey to the other party any property or interest therein, whether Separate Property or other property, which may be lawfully conveyed or transferred during his or her lifetime, or by will or otherwise upon death. Neither party intends by this Agreement to limit or restrict in any way the right and power of the other to receive any such voluntary transfer or conveyance. Such gifts shall not constitute an amendment to or other change in this Agreement, regardless of the extent or frequency of such gifts. Any gifts given by one party to the other hereafter shall constitute the receiving party’s separate property.

The first two sentences of this clause clearly authorized the husband to make a valid and effective gift to the wife in his Last Will. However, the courts found that the term “hereafter” in the last sentence meant that only a Will signed AFTER the post-nuptial agreement would be given effect.

This is a strained reading of that clause. The purpose of such clauses is to establish the property rights of the spouses in various property, but to allow for the parties to make their own voluntary transfers to the other spouse if they want. Whether those transfers are set out in a Will that predated the agreement seems irrelevant, and a trap for unwary spouses (and their counsel). That the Will doesn’t take effect until the post-agreement death of the spouse further suggests that the date of the Will should not matter.

Further, all the last sentence appears to be doing here is characterizing gifts as “separate property” under the Agreement. This makes sense – if an inter vivos gift was made, it would be appropriate to treat that as the separate property of the recipient spouse that cannot be reached by the other spouse per the terms of the agreement relating to separate property. It does not appear to be designed to address any testamentary transfer issues – how would the label “separate property” in the hands of a surviving spouse have any relevance to anything?

How would this principle be applied to other testamentary transfers, such as a revocable trust or beneficiary designation made before the marital agreement? Would a post-agreement codicil addressing other dispositions or Will terms eliminate the pre-agreement character of the gift? Is this a narrow case that is dependent on the “hereafter” wording in the above clause, or is it of broader import that may have precedential value in all prenuptial and postnuptial situations?

Of course, in the future, agreements can be drafted with terms that specifically address pre-existing dispositions between the spouses. Alternatively, pre-existing dispositions can be redone post-agreement. However, such technical solutions are apt to be overlooked in many circumstances.

Steffens v. Evans, 4th DCA (Case No. 4D10-2467), October 5, 2011

Wednesday, November 09, 2011


As part of the 2010 budget showdown, the unified credit equivalent for federal gift taxes was bumped up to $5 million for 2011 and 2012. In 2013, the amount will be reduced down to $1 million with the expiration of the Bush tax cuts, unless Congress and the President act to modify that amount. What this means is that high net worth taxpayers only have until the end of 2012 to take advantage of the $5 million exemption.

Or do they? About a month ago, rumors started that the Congressional budget “Super Committee” that is tasked with producing budget cuts to Congress by November 23 was considering a reduction in the exemption to $1 million. What was once a trickle is now becoming a torrent of newsletters and warnings regarding the possible reduction with an effective date of November 23.

So far, I have not seen anything from official sources on this. Personally, I find it hard to swallow that the Republicans on the Super Committee would accept this, but of course, anything is possible in Washington D.C. Even if a change is contemplated, there is no certainty that the effective date would be on November 23 – it could be before or after that.

Friday, November 04, 2011


Medicine and tax law are two distinct fields. However, when tax law allows a deduction for expenditures relating to disease, tax lawyers and courts have to apply medical concepts.

Code §213 allows a deduction for medical expenses if paid for the diagnosis, cure, mitigation, treatment or prevention of disease. Cosmetic surgery doesn’t come under his unless related to a congenital abnormality, personal injury, or a disfiguring disease.

Do expenses for hormone therapy and sex reassignment surgery relate to a disease, so that they are deductible?

In O'Donnabhain, 134 TC 34 (2010), the Tax Court allowed the deduction for some of these items. It was able to do this by locating a disease – here, “sever gender identity disorder.” What likely tipped the scale was that such an order is listed in the Diagnostic and Statistical Manual of Mental Disorders. That is published by the American Psychiatric Association. In other words, it had enough scientific recognition to be a “disease.”

The Tax Court allowed deductions for expenses of hormone therapy and sex reassignment surgery. However, expenses relating to breast augmentation surgery were found to be cosmetic only and therefore nondeductible. For some reason, below the belt surgery was deemed noncosmetic and above the belt surgery was cosmetic. We won’t dwell on the legitimacy of that distinction, nor the applicable mental images – the opinion does have something of an involved discussion of this issue.

The IRS initially opposed the Tax Court’s determination. However, it has now acquiesced and says it will follow the decision.

AOD 2011-03, 11/2/11

Tuesday, November 01, 2011


A recent post noted that disregarded entities are not treated as disregarded for employment tax purposes, but are instead treated as corporations. This special treatment came into effect in 2009, and the treatment as a corporation was specifically provided for recently.

Some wage payments are exempt from FICA and FUTA taxes.  For example, services performed by a child under the age of 18 in the employ of his father or mother is not considered employment for FICA purposes. Code §3121(b)(3)(A). Services performed by an individual under the age of 21 who is employed by his father or mother, or performed by an individual employed by his spouse or son or daughter (subject to certain conditions) for domestic service in a private home of the employer is not considered employment for FICA purposes. Code §3121(b)(3)(B). Services performed by an individual in the employ of his son, daughter, or spouse, and service performed by a child under the age of 21 in the employ of his father or mother, are not considered employment for FUTA purposes. Code §3306(c)(5).

If the employer is a disregarded entity owned by an employer described in one of the preceding exemptions, the treatment of the employer as a corporation and not a disregarded entity for employment tax purposes acts to convert exempt wages to taxable wages for FICA and FUTA taxes. In recognition of this problem, the IRS has issued temporary Treasury Regulations that will allow the exemptions to continue to apply in this circumstance. Essentially, they provide a partial exception to the nondisregarded entity treatment applied to otherwise disregarded entities for employment tax purposes – yes, quite a mouthful.

The new regulations also confirm that information reporting and backup withholding is applied to the owners of disregarded entities, and more specifically, that the disregarded entities themselves are relieved of such obligations.

Treas. Regs. §§31.3121(b)(3)-1T(e) , 31.3127-1T(d) , 31.3306(c)(5)-1T(e) , and 301.7701-2T(e)(5)

Saturday, October 29, 2011


Under the check the box rules, entities owned by one person can often be disregarded for federal tax purposes. Such entities are referred to as "disregarded entities."

As time has progressed since the passage of the check the box rules, the IRS has created more and more exceptions to the disregarded treatment. For example, disregarded entity status is ignored or modified in regard to employment and withholding taxes of a disregarded entity.

The IRS has now issued final treasury regulations that provide that an entity whose disregarded status is ignored for employment tax purposes will be treated as a corporation. Treas. Regs. §301.7701-2(c)(2)((iv)(B).

It would be helpful to put in one place the several exceptions that now exist to disregarded entity status. The following is a summary of the principal exceptions, but is not intended to be exhaustive. If any readers think I have missed anything major, please feel free to comment to this posting and let us know what the item is.

     A. Status is modified if the single owner of the entity is a bank. Treas. Regs. §301.7701-2(c)(2)(iii).

     B. Status is modified for certain tax liabilities. Treas. Regs. §301.7701-2(c)(2)(iii). These include:  (1) federal tax liabilities of the entity with respect to any taxable period for which the entity was not disregarded; (2) federal tax liabilities of any other entity for which the entity is liable; and (3) refunds or credits of federal tax.

   C. Disregarded status ignored or modified for taxes imposed under Subtitle C—Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24, and 25 of the Internal Revenue Code) and taxes imposed under Subtitle A, including Chapter 2—Tax on Self-Employment Income. Treas. Regs. §301.7701-2(c)(2)(iv)(A).

     D. Status is modified for certain excise taxes, as described in Treas.Regs. §301.7701-2(c)(2)(v). Although liability for excise taxes isn't dependent on an entity's classification, an entity's classification is relevant for certain tax administration purposes, such as determining the proper location for filing a notice of federal tax lien and the place for hand-carrying a return under Code §6091 .

     E. Conduit financing proposed regulations will treat a disregarded entity as separate from its single member. Code §7701(l).

     F. Special rules will apply in hybrid situations. Hybrid situations are circumstances where an entity is not disregarded in one jurisdiction but is disregarded in another.

          (1) Hybrid payments made between a CFC and its hybrid branch, or between two hybrid branches of a CFC, would be recharacterized as subpart F income in the same amounts, if the conditions of the regulations are met. Those conditions are as follows: (1) the hybrid branch payment reduces the foreign tax liability of the payer; (2) the payment would have been FPHC income if paid between two CFCs; and (3) a disparity exists between the effective rate of tax on the payment in the hands of the payee and the hypothetical rate of tax that would have applied if the payment had been taxed to the payer. If no tax rate disparity exists, no recharacterization would occur. Proposed Regulations under TD 8827, 1999-30 IRB 120.

          (2) In certain cases, payments made by domestic reverse hybrid entities to related foreign interest holders are recharacterized as a dividend. Such payments are recharacterized as dividends to the extent of the interest holder's proportionate share of payments by the domestic entity to the domestic reverse hybrid entity that are treated as dividends by either jurisdiction. The recharacterization as a dividend means that the payments cannot be deducted by the domestic reverse hybrid entity. This prevents the use of a domestic reverse hybrid entity to make deductible payments to the foreign interest holder that are taxed at lower withholding tax rates. Treas.Reg. §1.894-1(d)(2)(ii)(B).

          (3) Special rules relating to allocation of foreign tax credits. Prop.Regs. §1.901-2(f)(3).

Sunday, October 23, 2011


There has been quite a bit of buzz about a recent bankruptcy case involving an Alaska asset protection trust. However, the case merely confirms a weakness in the use of domestic asset protection trusts that was obvious even before this case.

Domestic asset protection trusts (DAPTs) promise the holy grail of creditor protection – a trust where the settlor/grantor can transfer assets to, be a discretionary beneficiary of, but still have the assets of the trust be protected from the settlor’s/grantor’s creditors. Alaska, Delaware, and Nevada are three popular jurisdictions for these trusts.

There are open questions about the effectiveness of the trusts for creditor protection purpose, including enforceability across state lines under the U.S. Constitution. A major issue is the 10 year voidability provision of 11 U.S.C. §548(e) that entered the U.S. Bankruptcy Code in 2005. That provision provides that a trustee in bankruptcy can reach the assets a debtor transferred to a trust:

that was made on or within 10 years before the date of the filing of the petition, if –

(A) such transfer was made to a self- settled trust or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar device; and
(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

A transfer to a DAPT will typically meet the requirements of (A)-(C) above. The big question is whether a transfer to a DAPT demonstrates the requisite “actual intent to hinder, delay or defraud” under (D). Since DAPTs were created to address creditor issues, and are marketed as providing that benefit, a reasonable person would suspect that the use of one demonstrates the actual intent to hinder, delay or defraud, even if the settlor was not rendered insolvent by reason of the transfer. Note, however, that Alaska law expressly provides that a settlor’s expressed intent to protect trust assets from a beneficiary’s potential creditors is not evidence of an intent to defraud.

In Battley v. Mortensen, a bankruptcy court in Alaska found that a transfer to a DAPT could run afoul of 11 U.S.C. §548(e), even though the debtor was solvent at the time of creation of the trust. The court noted:

when property is transferred to a self-settled trust with the intention of protecting it from creditors, and the trust’s express purpose is to protect that asset from creditors, both the trust and the transfer manifest the same intent. In this case, I found that the trust’s express purpose could provide evidence of fraudulent intent.

The court did not give any effect to the provision of Alaska law that indicated the trust language could not be used as evidence of an intent to defraud. There were other factors that the court found that evidenced intent to defraud, so it is uncertain how the court would have ruled absent those other factors.

Nonetheless, the case confirms the exposure that the use of a DAPT leaves the door open to the reach of a trustee in bankruptcy within 10 years of the funding of the trust. Since a debtor can be placed in bankruptcy by his creditors on an involuntary basis, one cannot simply avoid this exposure by not filing for bankruptcy protection.

DAPTs are still useful for those that do not expect to have significant creditor issues within the next 10 years, but are in a high risk field and thus still desire its protections over an extended period beyond 10 years. Further, DAPTs can provide tax benefits via moving assets out of the taxable estate of a grantor while still allowing a discretionary beneficiary interest to the grantor. Nonetheless, in these circumstances, the constitutional issues regarding DAPTs still remain.

Battley v. Mortensen, Memorandum Decision & Memorandum on Defendant’s Motion for Reconsideration (Case No. A09-00565-DMD, United States Bankruptcy Court, D. Alaska)

Saturday, October 22, 2011


The IRS has released detailed guidance to taxpayers on how to file and administer protective refund claims for amounts that are not currently deductible under Code Section 2053 when the Form 706 is filed (such as contested or uncertain claims and expenses that have not yet been paid). As part of its guidance, the IRS announced that it will create a Schedule PC to be attached to the Form 706 to assist taxpayers in filing these protective claims at the time of filing of the Form 706.


Final regulations under Code Section 2053 were published on October 20, 2009 to provide guidance in determining the deductible amount of a claim against a decedent's estate, particularly in regard to contested or uncertain claims and expenses. The final regulations provide, with certain exceptions, that the amount deductible for a Code Section 2053 claim or expense is limited to the amount actually paid in settlement or satisfaction of that claim or expense. For amounts not paid or otherwise deductible by the time the Form 706 is filed, the Regulations allow a protective refund claim to be filed. This allows for a refund to be sought later if amounts are paid or become deductible after the expiration of the estate tax statute of limitations. Rev.Proc. 2011-48 provides details on how to file and administer protective refund claim.

TIMING. The protective refund claim must be filed before the expiration of the Code Section 6511(a) statute of limitations. This is 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid.

CONTENT OF PROTECTIVE CLAIM. The protective claim must be a written declaration that is executed under penalties of perjury, listing each ground upon which a refund is claimed and facts sufficient to apprise the Commissioner of the exact basis of the claim. Required information includes:

a. An explanation of the reasons and contingencies delaying the actual payment to be made in satisfaction of the claim or expense.

b. Information on whether other protective claims for refund are being filed or were previously filed and the approximate date on which each was filed.

c. If the claim is being contested, specified information about the contested matter and the potential liability of the estate.

EVIDENCE OF AUTHORITY. The protective claim must be accompanied by documentary evidence, including certified copies of the letters testamentary, letters of administration, or other similar evidence, to establish the legal authority of a fiduciary or other person to file and pursue a protective claim for refund on behalf of the estate of a decedent. However, if the protective claim is filed by same person that submitted the Form 706, the only thing needed is a statement affirming that the fiduciary or other person filing the protective claim for refund also filed the Form 706 and that such fiduciary or other person is still acting in a representative capacity.

WHICH FORM TO USE. For decedents dying after October 19, 2009, and before January 1, 2012, the claim is filed using Form 843. For decedents dying on or after January 1, 2012, the claim can be filed on a Form 843, or on a Schedule PC filed with Form 706. This Schedule does not yet exist, but should simplify the process for making a protective claim if made at the time of the Form 706 filing.

SEPARATE CLAIM REQUIREMENT. A separate claim filing is required for each claim or expense for which a deduction may be sought. Multiple Schedules PC should be used, if making the claims with the Form 706 filing.

Related and ancillary expenses relating to resolving, defending, or satisfying the identified claim or expense as well as certain expenses relating to pursuing the claim for refund for the identified claim or expense are not considered separate claims for this purpose, but are included in the separate claim to which they relate.

REJECTION PROCEDURES. If a protective claim filing is rejected by the IRS, a corrected (and signed) protective claim for refund can be refiled before the expiration of the period of limitation or within 45 days after the date of the Service's notice of the defect, whichever occurs later. Thus, a defective election filed shortly before the expiration of the statute of limitations should have an opportunity to cure even though the statute runs out before receiving the Service’s rejection.

FOLLOW-UP REQUIREMENTS. The IRS will generally accept or reject filed protective claims, and notify the taxpayer. The taxpayer should contact the IRS if no IRS acknowledgment of the protective claim filing is received within 180 days of filing a Schedule PC or 60 days of filing a Form 843. If such taxpayer contact is not made within 30 days of the applicable deadline, an estate will lose the ability to correct a defective claim if the statute of limitations has expired (even if the estate has proof of mailing the protective claim to the IRS).

NOTIFICATION OF RESOLUTION OF CONTINGENCIES. To obtain a refund, the taxpayer must notify the IRS when the claim is ready for consideration (that is, once deductibility is permitted by reason of payment or otherwise meets the regulatory requirements for deduction). The notification generally should describe the relevant facts that support, and provide evidence to substantiate, a deduction under Section 2053 and should claim a refund of the overpayment of tax based on the deduction under Section 2053 and the resulting recomputation of the estate tax liability.

This notification must be submitted within a "reasonable period" after the item becomes deductible. There is a 90 day safe harbor that will meet the “reasonable period” requirement. If filed later, a reasonable cause explanation must be submitted. Special rules apply for multiple or recurring payments.

The Revenue Procedure provides specific information on what must be included in the notification, and whether the notification must be made on a Supplemental Form 706 or a Form 843.

MISC. The existence of a protective claim will not affect Form 706 audits. The new rules are applicable with respect to protective claims for refund filed on behalf of estates of decedents dying on or after October 20, 2009.


The drafters of the Revenue Procedure should be commended for providing detailed and precise rules to address most of the basic protective claim filing issues.

The ability to make a protective claim on a Schedule PC on the Form 706 is especially welcomed. This will make it easier for taxpayers to comply with the requirements. Also, it will help taxpayers avoid inadvertently missing the statute of limitations deadline for submitting the protective claim. Presently, many estates will defer filing a protective refund claim, instead adopting a wait-and-see attitude to see if claim and expense issues resolve themselves before the statute of limitations expires and hopefully avoiding the bother of a Form 843 filing. By easing the process for filing the protective claim, more taxpayers should take advantage of the procedure at the time the estate tax return is filed and thus avoid missing the deadline later. Indeed, the existence of the Schedule PC will likely educate some preparers that might not be knowledgeable of the protective claim procedure of its availability.

Note that some claims are deductible, even if not paid when the Form 706 is filed. These include executor and attorney fees (Treas. Regs. §20.2053-1(d)(4)), claims against the estate relating to property or claims included in the gross estate (Treas. Regs. §20.2053-4(b)), and claims not totaling more than $500,000 (Treas. Regs. §20.2053-4(c)). Taxpayers may still want to file a protective claim for additional amounts not reported on the Form 706 or that do not meet the foregoing statutory requirements. There is a trap, here, since the Revenue Procedure requires that such protective claims, in addition to meeting the regular protective claim requirements, the taxpayer must also disclose the amount of the deduction already claimed on the Form 706 for the subject claim or expense and must reference the regulatory provision under which the deduction was claimed. See §4.05(4) of the Revenue Procedure.

For more information regarding when uncertain or contested claims and expenses can be deducted under the Code Section 2053 regulations, I refer readers to my article on the subject in the March 2010 Journal of Taxation.

Rev. Proc. 2011-48

[This article will also be published on Leimberg Information Services, Inc.]

Wednesday, October 19, 2011


According to the Tax Policy Center, presidential candidate Herman Cain’s 9-9-9 tax plan is essentially three sales taxes.

Obviously, the 9% national sales tax component is just that – a retail sales tax.

The business tax component is effectively a subtraction method value-added tax, or a business transfer tax. It is a 9% tax on all sales minus purchases from other businesses. It is the same as a retail sales tax, but it is collected in pieces on the value added at each stage of production. In the aggregate, all retail sales are then taxed under this component.

The 9% individual flat tax is also a subtraction method value-added tax, except that businesses may deduct wages and workers are taxed on their wages. A charitable contribution deduction may be allowed.

The plan has the merits of a certain level of simplicity, the removal of various tax regimes (such as estate and gift taxes) and the spreading of the tax burden. It has the detriments of a lack of progressivity (if you consider that a detriment based on your political beliefs, although persons below the poverty line are exempted from the taxes), being a disincentive to consumer purchasing, and the introduction of a tax regime (the VAT) that many blame for the anemic economies of Europe.

Whatever its pros and cons, this is the first I have seen it characterized as being effectively a combined 25.38% national sales tax (which would be in additional to state and local sales taxes).


Sunday, October 16, 2011


A recent case before the 5th Circuit Court of Appeals provides an instructive illustration of a sham partnership.

A condensed version of the facts are as follows (with some liberties taken to keep this simple):

1. LLC formed, with Chinese government-owned financial institution (Cinda) and  a 1% third party. Cinda contributes $1.1 billion portfolio of nonperforming loans. A U.S. investor (Beal) contributes $180 million of GNMA securities to the LLC and buys 90% of Cinda’s interest from Cinda for $19.4 million. Lots of strings are tied to the LLC’s ability and economic benefits from the GNMA securities, all running to the benefit of Beal.

2. The loans are carried on the LLC books at a tax-loss, since Cinda invested much more into them than current value. Normally, when these losses are realized by the LLC, they would be allocated back to Cinda under Section 704(c). However, by buying most of Cinda’s interest, Beal now gets the benefit of most of the losses when they arise. Since he obtained a large basis in the LLC via his investment of the GNMA securities, he has a large basis against which to use the losses.

3. The LLC operates, and losses are generated and allocated to Beal. Cinda, who is responsible for servicing the loans, does a terrible job, and in fact threatens to bring the matter to the IRS if the LLC and Beal don’t stop bothering it about its failure to properly service the loans. The LLC and Beal back down, and indeed do another deal with Cinda.

The IRS sought to challenge the losses taken by Beal. The court affirmed the lower court that the acquisition of the loans had economic substance. Unfortunately for the taxpayer, the court also affirmed a finding that the LLC was a sham partnership. Beal was instead treated as having bought the loans directly and receiving a tax basis equal to what he paid – and thus lost the ability to deduct Cinda’s losses (as successor partner to Cinda) on the loan portfolio.

Under the Supreme Court’s decision in Culbertson, whether a partnership will be respected for tax purposes depends on whether “the parties in good faith and acting with a business purpose” genuinely “intended to join together for the purpose of carrying on the business and sharing in the profits and losses.” This determination is made in light of all the relevant facts and circumstances. The appellate court focused on three particular aspects of this test.

LACK OF AN INTENT TO JOIN TOGETHER. At first, it does appear that the partners intended to operate a joint venture to make a profit on collecting the nonperforming loans. However, when the partners failed to force Cinda to fulfill its functions as loan servicer (after Cinda threatened to disclose the transaction to the IRS), the court determined that the tax benefit was the real purpose of the transaction, not the potential profits from loan collections. It also did not help that Cinda obtained regulatory approval for the transaction by indicating that its retained 10% LLC interest was only “symbolic” and characterizing its transaction as a “package sale of bad debts.”

LACK OF INTENT TO SHARE PROFITS AND LOSSES. Again it first, such an intent appears – Beal did after all contribute $180 million of GNMA securities to the LLC which were at risk of loss. However, by retaining the rights to income, and controlling the use and disposition of funds and the securities themselves, the court found that Beal personally received all of the potential benefits from those securities and retained all of the risks. Even though Cinda could benefit from appreciation in those securities, Beal’s ability to control any sales of the securities substantially diminished any chance of Cinda benefitting in this manner. Thus, there was a lack of intent to share profits and losses.

LACK OF A BUSINESS PURPOSE. This question focused on whether there was a non-tax need to form the LLC to profit from the nonperforming loans investment – or whether it was all about tax benefits. The taxpayer raised six reasons why an LLC was needed, but the court did not buy into any of them.

Thus, the court found that Beal directly purchased the loans from Cinda. The LLC was ignored, and the loss benefits predicated on the partnership form, disappeared.

The court did not impose any penalties on the taxpayer based on tax opinions obtained from a law firm and an accounting firm that the taxpayer relied on.

SOUTHGATE MASTER FUND, L.L.C. v. U.S., 108 AFTR 2d 2011-XXXX, (CA5), 09/30/2011

Monday, October 10, 2011


Section 163(h) of the Code allows a deduction for qualified residence interest. This is interest paid or accrued on acquisition indebtedness with respect to any qualified residence of the taxpayer (or home equity indebtedness), subject to maximum debt limits.

A "qualified residence" is the principal residence of the taxpayer, and one other residence used by the taxpayer as a residence.

In a recent Tax Court case, a taxpayer purchased land, upon which he was going to build a residence. He took out a mortgage loan to buy the property. He then started the design and approval process to build the residence. Two years after, everything was set for construction to begin. However, because of the decline in the real estate market, the taxpayer could not obtain financing for additional funds needed for construction. The house was never built and the taxpayer eventually sold the land (for a large loss).

The taxpayer deducted the interest he paid on the mortgage loan for two years as qualified residence interest. The IRS disallowed the deductions, claiming that there was never a "qualified residence."

The Tax Court sided with the taxpayer and allowed the deduction, even though the residence was never built. The key provision allowing deductibility was Treas.Regs. Section 1.163-10T(p)(5) which allows a taxpayer to treat a residence that is UNDER CONSTRUCTION as a residence for up to 24 months after construction has begun. The Court did not care that the residence was never completed. In effect, it would be illogical for the deduction to be ultimately determined on whether a residence is built, since the deduction that is allowed for the 2 year construction period would have to be taken on a return oftentimes before it is known whether construction will be completed. This would violate the principle that each tax year stands on its own.

The court was also generous with the term "construction." It held that construction began even before the taxpayer acquired the land, since the taxpayer required the seller to demolish an old house on the lot and clear the land before closing. Further, taxpayer's permitting process was also considered to be construction.

Rose v. Commissioner, T.C. Summary Opinion, 2011-117

Saturday, October 08, 2011


When amounts are paid in settlement of litigation, different tax consequences can apply based on what the payments are for. For example, punitive damages will typically generate ordinary income for the recipient, while payments for damage to goodwill can generate capital gain. Such differing tax consequences bring about taxpayer efforts to characterize payments in the manner most favorable to them.

Two principles are important in determining whether the IRS will respect an agreed-upon characterization of settlement proceeds.

The first is the origin of the claim doctrine, under which the tax treatment of the proceeds of a settlement or judgment will depend on the nature of the claims made and the actual basis of the recovery. The tax consequences of a settlement depend on the nature of the claim that was the basis for the settlement, rather than the validity of the claim.

The second is that the IRS will be more likely to respect a settlement allocation of the parties if they have adverse interests as to that characterization. If one party is indifferent to the allocation, or both parties obtain tax advantages from the same characterization, the risk of IRS challenge is heightened. 

A recent Tax Court case demonstrates the real world application of these principles. The case involved the settlement of a lawsuit for false advertising, unfair competition, and trademark dilution, with damages relating to loss of goodwill and reputation, lost profits, and punitive damages.

ORIGIN OF THE CLAIM. The Tax Court determined that the character of the settlement proceeds paid was to be allocated among the various claims made, in accordance with the origin of the claim doctrine. The parties characterized only a relatively small portion of the settlement to lost profits (an item which would produce ordinary income and not capital gain to the recipient) and no portion to punitive damages (another ordinary income item).  Under the origin of the claim doctrine, the settlement proceeds should have been allocated among all the claims made.

ALLOCATION AMONG CLAIMS – NO ADVERSE INTERESTS. The court determined that the parties’ allocation was suspect since the payor was generally indifferent to the characterization (and the payee would benefit from allocations away from ordinary income items). Thus, the parties did not have an adverse interest to each other and their allocation was subject to much higher scrutiny. As to the punitive damages question, the taxpayer pointed out that the payor was against paying punitive damages and was not indifferent, since it would put the payor in a bad light and implied wrongdoing. Thus, the implied argument was the allocation away from punitive damages was not collusive and done solely to avoid ordinary income for the recipient, but was a bargained for element by the payor and was perhaps sought but compromised away by the recipient. This was an interesting argument, but the Tax Court did not buy into it since the payor was agreeable to the amount to be paid for punitive damages but just didn’t like the label applied.

An important aspect of this case is that just because the settlement arises from a bona fide dispute involving unrelated and truly adverse parties, the parties cannot count on IRS acceptance of a damages allocation unless the parties have adverse interests over the allocation itself. The type of adversity that most impresses courts in these circumstances is where a given type of payment produces a tax negative for one party while producing a better tax result for the other – that was not the situation here.

ALLOCATION AMONG CLAIMS – THE SEARCH FOR OBJECTIVE EVIDENCE. The origin of the claim doctrine does not provide any direct guidance on how to allocate settlement proceeds among various claims when there is more than one. In this situation, one can expect taxpayers, the IRS, and courts, to search for objective guidelines to use in the allocation. Such objective guidelines may not always exist – however, in the instant case they did. The lawsuit at issue was actually the second lawsuit arising from similar facts and claims. Since the original lawsuit was tried and a judgment was made by a jury that allocated the damages, the Tax Court used the percentage allocations from that case and applied them to the settlement.

ALLOCATION AMONG CLAIMS – OTHER HELPFUL ASPECTS. Taxpayers seeking to uphold an allocation that does not involve truly adverse issues should look long and hard for some methodology or expert opinion to help backstop their allocation. Such contemporaneous methodology and analysis will put the taxpayer in a better defensive position than the parties simply agreeing on an allocation with no methodology or analysis to justify it.

Healthpoint, Ltd, et al, TC Memo 2011-241

Sunday, October 02, 2011


Employers have a strong withholding and employment tax incentives to classify their workers as independent contractors instead of employees. Such a course avoids income tax withholdings and FICA, FUTA, and Medicare taxes and withholdings, shifting responsibility of such items to the worker.

As such, employers may have aggressively or inappropriately classified employees as independent contractors. An IRS settlement program known as the “Voluntary Classification Settlement Program,” or VCSP, provides a semi-painless way for employers to correct their classifications and come into the fold of compliant taxpayers. A recent set of FAQs provides details on the new program. Below is a summary of the key provisions.


Businesses, tax-exempt organizations, and government entities.


To be able to apply, the employer must:

     (1) have consistently treated the subject workers as nonemployees,

     (2) have filed all required Forms 1099 for the workers for the previous three years, and

     (3) not be under audit by IRS, or currently under audit concerning the classification of the workers by the Department of Labor or a state government agency.


The employer will have to pay a relatively small sum to enter the program, but will then receive absolution for its mischaracterizations for past years. More particularly, the employer  will:

     (1) owe 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, applying the special reduced rates of Code Section 3509, and without interest or penalties being imposed on that liability,

     (2) be safe from an employment tax audit for the worker classification of the subject workers for prior years, and

      (3) have to agree to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees.

Of course, the employer will begin classifying the subject workers as employees and paying appropriate employment and withholding taxes.

Given the relatively small amount that is due, the program provides an excellent opportunity for taxpayers to put themselves into compliance. In an example provided in the FAQ, an employer who paid $1,500,000 to workers in the subject tax year owed only $16,020 for the required 10% payment.

Application for the program is made on Form 8952, Application for Voluntary Classification Settlement Program. More information on the VCSP is available in Announcement 2011-64.

Voluntary Classification Settlement Program (VCSP) Frequently Asked Questions

Wednesday, September 28, 2011


U.S. residents, and other nonresidents of Mexico, are restricted from owning certain real estate in Mexico. The Mexican Constitution prohibits foreigners from purchasing or owning real estate within 60 miles of an international border or within 30 miles of the Mexican Coast.

To facilitate foreign ownership, Mexico law allows for foreign persons to own property through a fideicomiso. A fideicomiso is a Mexico trust arrangement under which a Mexico bank acquires title to the real property, and foreigners own the beneficial interest.

A recently released letter from the Office Chief Counsel warns that such arrangements may constitute foreign trusts for U.S. tax purposes, and thus may trigger Form 3520 and 3520-A filing requirements for U.S. beneficiaries. Interestingly, the letter does not conclude one way or the other whether a fideicomiso will be treated as a trust, only that it may be. The taxpayer recipient of the letter was instructed to review Regs. Section 301.7701-4 for the definition of a trust for U.S. tax purposes, and Code Section 7701(a)(31)(B) and the Regulations thereunder for whether a trust is foreign.

There is a reasonable possibility that many fideicomisos will meet the regulatory definition of a trust (at least in the opinion of the IRS), even though common law trusts are not a regular feature of Mexico law. The Regulations define a trust as:

…an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.

Further, if a fideicomiso is considered a trust, it should then be considered a foreign trust, at least if a Mexico bank serving as trustee.

However, one may be able to argue that a fideicomiso is more akin to a “business trust” which is subject to taxation as a business entity under Regulations Section 301.7701-4(b).

Some facets of U.S. reporting of interests in foreign trusts only apply if distributions are made to U.S. beneficiaries. However, rent-free use of trust properly can be treated as a distribution to a beneficiary, so this is a reporting trap for many if the fideicomiso is characterized as a foreign trust since most beneficiaries will not be paying rent to use the Mexico property.

The actual income taxation of the U.S. beneficiaries will depend on whether the trust is a grantor trust or a nongrantor trust (or, of course, whether the fideicomiso is taxed as a trust or a business entity). Also, different reporting requirements are triggered based on grantor vs. nongrantor trust status or busines entity status.

Thus, the IRS’ letter is helpful in reminding taxpayers of potential reporting and income tax issues relating to a fideicomiso interests. However, each case will require its own analysis as to whether a foreign trust or other entity exists, if a trust whether it is a grantor or nongrantor trust, and what particular reporting is required. If worth the cost, a private letter ruling as to “trust” status could also be sought from the IRS.

INFO 2011-0052 dated 11/17/2010 (released 6/24/11)

Sunday, September 18, 2011


Irrevocable life insurance trusts are a mainstay of transfer tax planning with the object of avoiding estate tax on life insurance policy payouts. Such trusts often provide a Crummey withdrawal feature to one or more trust beneficiaries, so that premium payments by the grantor are eligible for exclusion from taxable gifts as present interest annual exclusion gifts.

Clients are instructed that the grantor should transfer premium payments to the trust, and that the trust should remit the proceeds to the insurance company. Further, the trustee should provide notice to the beneficiaries of their withdrawal rights at or about the time of the contributions of premium amounts to the trust. These protocols are intended to minimize the risks of IRS challenge to present interest status of the contributions.

Oftentimes, clients disregard these instructions, and the grantor makes direct payments of premiums to the insurance company. This is what occurred in the recent Tax Court case of Estate of Turner v. Commissioner. As one might expect, the IRS challenged the present interest exclusion status of the premium payments. However, in a boon to other taxpayers who have similarly funded their premium payments, the Tax Court still allowed the present interest exclusion treatment.

The IRS first argued that the trust beneficiaries had no meaningful rights to withdraw the premium payments since they were not first paid to the trust. The Tax Court noted that the key factor in a present interest gift such as this is whether the beneficiary had the "legal right to demand" the withdrawal. Under the terms of the trust, the beneficiaries have the absolute right and power to demand withdrawals from the trust after each direct or indirect transferred to the trust. That the funding occurred indirectly was thus irrelevant to the right to demand.

The IRS also argued that there was no meaningful withdrawal rights because some, or even all, of the beneficiaries may not have known they had the right to demand withdrawals per the absence of notice to them. Again, the Tax Court indicated such lack of notice did not affect the "legal right to demand" withdrawals and thus lack of notice was not determined to be an impediment to present interest status. The court appropriately noted that lack of notice was not an impediment in the Crummey case, either.

Does this mean that taxpayers can now make direct premium payments that bypass the trusts, and avoid delivering withdrawal notices to beneficiaries? For taxpayers that end up in the Tax Court, and that are willing to front the litigation costs to get there, the answer is probably yes. However, since the IRS has not conceded this issue, and since other courts may not agree with this interpretation, proper contribution and withdrawal notice protocols should still be observed (but with the comfort that favorable Tax Court treatment will backstop the protocols if they are not fully observed). Also, practitioners should confirm that their life insurance trust forms allow for withdrawals for both direct and indirect contributions.

Estate of Turner v. Comm'r, T.C. Memo. 2011-209 (Aug. 30, 2011)

Thursday, September 15, 2011


Grantors and contributors to charities often need to know if the charities qualify as "public" charities under Internal Revenue Code Section 170(b)(1)(A)(vi), so as to properly determine various tax consequences. Code Sections for which such status is relevant include Sections 170, 507, 545(b)(2), 642(c), 4942, 4945, 4966, 2055, 2106(a)(2), and 2522.

Grantors and contributors can request a copy of the charity’s exemption letter to determine if the IRS has recognized its status under Section 170(b)(1)(A)(vi). Alternatively, the status can be reviewed in IRS Publication 78, “Cumulative List of Organizations described in Section 170(c) of the Internal Revenue Code of 1986.” This publication is available in paper, or online through 

But what if the charity has had its Section 170(b)(1)(A)(vi) revoked, but the grantor or contributor is not informed of this? For example, the charity may provide the contributor with a copy of the original exemption letter, even though it has been revoked. Alternatively, the grantor or contributor may check the status online and see the charity has the proper status, but perhaps the IRS had not yet updated its database to show a revocation.

Under recently issued Regulations, the IRS will allow a contributor or grantor to rely upon an IRS determination letter or ruling (notwithstanding its revocation) until the IRS publishes notice of a change of status. Reg. Section 1.170A-9(f)(5)(ii). This is both a good and a bad thing. It is good, in that it provides a clear methodology to determine status, without risk that the status may have been changed. It is bad, since it imposes a clear burden on the taxpayer to review Publication 78, as updated, to confirm that there has been no revocation.

Previously, newly formed charities had only a five year advance ruling period for their “public charity” status – at the expiration of the period the charity had to go back to the IRS and seek a permanent ruling. While this process has been changed, there are organizations out there with ruling letters that have a fixed advance ruling period expiration date, but that are no longer obligated to seek a permanent ruling. The Regulation provides that a taxpayer may rely on advance rulings that expired on or after June 9, 2008.

A taxpayer cannot use these reliance rules if it was responsible for, or aware of, an act or failure to act that resulted in the organization's loss of classification under Section 170(b)(1)(A)(vi) or acquired knowledge that the IRS had given notice to such organization that it would be deleted from such classification. At first glance, this would appear to be a problem for large contributors, since if a contributor makes a large enough contribution to an organization, this may mathematically remove it from “public charity” status. However, the Regulations anticipate this and provide that an outsider to the charity (that is, is not a founder, creator, or foundation manager) will not be considered responsible for, or aware of, a loss of public status if it received and relied upon a written statement by the charity that the grantor contribution will not result in the loss of public status. Reg. Section 1.170A-9(f)(5)(iii). Such written statement must meet specific criteria, including the provision of five years of financial data to allow for a computation of public charity status.

Note that the online Publication 78 describes various types of exempt organizations. Various codes are used to assist readers to determine the status of the organization. The code needed to confirm public charity status is actually the absence of a code, or “none.” Below is a table of the various codes.


Saturday, September 10, 2011


Individuals who were not domiciled in Florida are not eligible to serve as a Personal Representative of a Florida decedent, except under limited circumstances (e.g., if they are related within certain stated family relationships to the decedent).  Fla. Stats. Section 733.304. Florida law also provides that persons who are served a copy of the Notice of Administration must file an objection to the appointment of a Personal Representative within three months of service. Fla.Stats. Section 733.212(3).

A recent Florida Supreme Court case took on the question whether the three-month objection period applies to a challenge of an individual to serve as Personal Representative when that person is not within the class of persons authorized to serve as a Personal Representative (in this case, because he was not domiciled within Florida and was not within the requisite family relationship). The Supreme Court took on the case due to a split between appellate courts on this question.

The Court determined that the three-month objection period does apply.

This is an important case because many times estate beneficiaries do not engage counsel to assist them until a dispute or problem arises, and that often occurs beyond the three-month objection. At that time, their counsel may note that the Personal Representative is not qualified to serve. Per this decision, in most cases it will now be too late to seek the removal of the Personal Representative as a disqualified person under the statute.

The door to objections is not completely closed, however. The opinion is clear that if there was fraud or misrepresentation relating to the petition for administration, a later action for removal should not be time-barred.

 Hill v. Davis, Fla. Supreme Court case No. SC 10-823, September 2, 2011

Monday, September 05, 2011


When a corporation makes a check the box election, it is treated as having liquidated and then being reestablished as a partnership. In context of an insolvent corporation, this raises questions about worthless stock treatment, bad debts, and other tax consequences. A recent Chief Counsel Memorandum provides the IRS' opinion on these issues.

WORTHLESS SECURITY DEDUCTION. In the deemed liquidation of a solvent corporation, the shareholders realize gain or loss based on the deemed distribution that occurs. However, an insolvent corporation has no net assets to distribute. Therefore, the shareholders do not receive anything and thus there is no sale or exchange to fix gain or loss. See Rev. Rul. 2003 – 125. In this circumstance, however, the shareholders will be entitled to a worthless security deduction in the amount of their basis in their stock pursuant to Code Section 165(g). Code Section 165(g) provides that if any security which is a capital asset (such as a share of stock in a corporation) becomes worthless, a loss from a seller or exchange of that security is deemed to occur.

Note that this result holds even if the shareholder is a corporation owning 80% or more of the stock of the insolvent subsidiary. That is, Code Section 332 (which applies to liquidations of corporate subsidiaries into a parent corporation) will not apply to disallow the loss. This result occurs because Code Section 332 will not generally apply to the liquidation of an insolvent subsidiary when the parent corporation receives no assets as shareholder.

TAXABLE SUBSTITUTION OF LIABILITIES. The substitution of a debt instrument that differs materially in kind or in extent from an existing debt instrument may constitute a sale or exchange of that debt instrument under Code Section 1001. Changes in obligor of the debt instrument can constitute such a taxable substitution.

Since an insolvent corporation will likely have liabilities to its shareholders or third parties, the issue arises whether such a substitution of debt occurs when the debt is deemed transferred and reestablished in the partnership, since at a minimum, there is a new obligor for federal tax purposes. Notwithstanding this new obligor, the Memorandum concludes that there is no such taxable substitution occurring under Code Section 1001.

BAD DEBT DEDUCTION. We noted above that the shareholders of the insolvent corporation are eligible to receive a worthless stock deduction upon the deemed liquidation of the corporation. This might lead you to believe that a creditor of the corporation should likewise receive a bad debt deduction under Code Section 166 since the corporation disappears. Code Section 166 allows as a deduction any debt which becomes worthless within a taxable year. However, you would be wrong in that conclusion (at least according to the Memorandum).

The Memorandum determines that Code Section 166 does not apply because the full amount of the liability is treated as surviving the liquidation and being assumed by the partnership. Thus, the debt was not rendered worthless by reason of the election.

BASIS IN PARTNERSHIP INTEREST AND PARTNERSHIP BASIS IN ASSETS. The Memorandum then addresses various basis issues arising from the deemed liquidation and deemed formation of the partnership. Interested persons should consult the Memorandum – we will not run through them here to avoid the risk of readers never wanting to read this blog again.

Office of Chief Counsel Memorandum AM2011-003, August 26, 2011