U.S. ESTATE PLANNING FOR EXPATRIATES

Code §2801 imposes U.S. transfer taxes on transfers by former U.S. persons who have expatriated if the transfer is to a U.S. person. This tax is imposed on the U.S. recipient. A recent article by Joseph Toce, Jr. and Joseph Kluemper points out several planning considerations for such expatriates if they have U.S. persons who will be recipients of gifts or testamentary transfers. These include:

a. Making Lifetime Gifts of Property to U.S. Persons that are Subject to U.S. Gift Tax Instead of Testamentary Transfers. Under normal U.S. gift tax rules, gift taxes are tax-exclusive if the donor survives the gift by three years. That is, the taxes themselves are not considered by the gift – there is no tax on the tax. However, §2801 taxes are tax inclusive – thus, they are taxed at higher effective rates. So, similar to the same considerations that apply to U.S. donors, a lifetime gift bears less taxes than a testamentary gift. Since this does not work if the gift is taxed under §2801, the gift must be of property that is otherwise subject to U.S. gift taxes aside from the expatriate status of the donor. This is because §2801 will not apply to a gift of a nonresident that is otherwise subject to U.S. gift taxes. Thus, the donor should use property that is U.S. situs property for gift tax purposes, such as U.S. real property, to make the gift.

b. Make Use of Double Annual Exclusion Gifts. It is likely that if a donor makes an annual exclusion gift of U.S. situs property and of non-U.S. situs, each gift can benefit from a $14,000 annual exclusion. One exclusion is the regular exclusion that applies to U.S. situs assets under the regular gift tax rules, and the second is the annual exclusion that is granted to the donee under §2801.

c. Consider Making Generation Skipping Transfers of Non-U.S. Situs Assets. Transfers of non-U.S. situs assets will still be subject to tax under §2801. However, there is no GST tax under §2801 so when appropriate, a generation skip can be included in the transfer to avoid future transfer taxes.

d. Carefully Allocate U.S. Situs Property and Non-U.S. Situs Property Between U.S. and non-U.S. Recipients. The goal here is to transfer the U.S. situs property to the U.S. people, since it will be taxed under the normal nonresident transfer rules or §2801 – either way. This leaves non-U.S. situs property to go to nonresidents, free of U.S. transfer taxes – if U.S. situs property is instead transferred to them, then U.S. transfer taxes would apply.

Estate Planning for Expatriates Under Chapter 15, by  Joseph Toce, Jr. and Joseph Kluemper, published in the January 2013 issue of Estate Planning Journal

APPLICABLE FEDERAL RATES–JANUARY 2013

LAST MINUTE GIFTING BY CHECK

Time is running out for 2012 gift giving. End of year gifting by check is always an issue for those trying to use their annual exclusion amounts, but in 2012 the issue also relates to those attempting to make larger gifts to use their unified credit amounts before the scheduled reduction of the unified credit in 2013.

The issue with using checks to make gifts is that until the check clears the bank, the donor can revoke the gift by issuing a stop payment or by removing adequate funds from the bank account. A gift that can be revoked is not complete until revocability ends. Thus, a check written in 2012 that does not clear until 2013 is at risk of being a 2013 gift, not a 2012 gift, since the donor could have stopped payment in 2013 before it cleared.

There is case law on gifts by check, and when they will be treated as complete. The safest course is to deliver the check in 2012, have it deposited by the recipient, and have it clear in 2012.

Failing that, Revenue Ruling 96-56 provides a safe harbor. Under that ruling a gift by check delivered in 2012 will be a gift as of the date the check is deposited or presented for payment if:

(1) the check was paid by the drawee bank when first presented to the drawee bank for payment;

(2) the donor was alive when the check was paid by the drawee bank;

(3) the donor intended to make a gift;

(4) delivery of the check by the donor was unconditional; and

(5) the check was deposited, cashed, or presented in 2012 and within a reasonable time of issuance.

Thus, depositing the check in 2013 will be a problem.

These rules are not the same as for charitable contribution deductions – those rules are more liberal.

LATE GIFT FILING COULD NOT USE UNIFIED CREDIT

In a recent Chief Counsel Advice, a taxpayer made a gift in the prior year, but did not file a gift tax return. The taxpayer later died. On the estate tax return for the taxpayer, the earlier unreported gift was reported.

The IRS concluded that a gift tax was due for the year of the unreported gift. This resulted, even though the taxpayer had available unified credit in the year of the unreported gift to avoid gift tax in that year. The quirk in this case is that the taxpayer used her unused unified credit against gifts made in a later tax year, which tax year was then closed for statute of limitation purposes at the time of the IRS adjustments. Since the IRS could not apply unified credit in the earlier year, and then assess gift taxes in the later years (because the statute of limitations was closed), the only recourse for the IRS was to deny the use of the credit in the earlier year. The theoretical basis for such a special determination was the consistency doctrine, per similar facts and issues addressed in PLR 199930002.

Interestingly, interest on the unreported gift was determined to run from the due date of the return for the unreported gift year, and not from the due dates of later years when gift tax would have been imposed if all the gifts had been reported in order. While one perhaps can justify the loss of the use of the unified credit in the earlier unreported year, it does seem inappropriate to charge interest from that year since in no circumstance would taxes have had to been paid in that year.

Chief Counsel Advice 201249015

DON’T EXAGGERATE YOUR INCOME ON CREDIT APPLICATIONS

Taxpayers may be tempted to exaggerate the amount of money they earn when submitting credit or mortgage applications so as to qualify for loans or increased credit limits. This could come back to haunt them, however, in an income tax audit.

That is what happened to Carol Trescott, a massage therapist. She was audited, and she did not cooperate with the IRS. So the IRS used the amounts she listed as income on a credit application as income on a return they prepared for her (since she did not prepare a return herself for the tax year). Carol objected, claiming this was not a reasonable basis for computing her income. The Tax Court disagreed, and accepted the IRS return amounts.

In most audit circumstances, the taxpayer will have prepared a return, so the IRS will not be preparing one for them. However, even when there is a return, if the auditor notes a material difference in income reported on the return and what was used by the taxpayer on a credit application, the auditor’s suspicions will be aroused. That is never a good thing to have happen on an audit.

Trescott v. Comm., T.C. Memo 2012-321

NEW ITIN REQUIREMENTS

The IRS has issued new guidance regarding the issuance of international taxpayer identification numbers for non-U.S. taxpayers.

THE GOOD NEWS

1. Identification documents in most circumstances will not need to be mailed to the IRS with the Form W-7 application. Taxpayers may instead have them reviewed by a Certifying Acceptance Agent, by the IRS at key Taxpayer Assistance Centers, by certain U.S. Tax Attaches, and other alternative reviewers.

THE BAD NEWS

1. ITINs will now expire after 5 years.

2. The recent requirements for original identity documentation, or copies certified by the issuing agency (instead of accepting notarized copies of documents) are kept in place.

3. Certifying Acceptance Agents will have to take formal forensic training to help them identify legitimate identification documents.

Fact Sheet 2012-11, November 2012, IR 2012-98

FEDERAL TAX OVERPAYMENT AND UNDERPAYMENT INTEREST RATES–1ST QUARTER 2013

SLAT BACKUP

By Charles Rubin and Robert Chaves

There is a substantial amount of gifting activity being undertaken in late 2012 to use the unified credit before it is scheduled to be reduced in 2013. Oftentimes, spouses are creating trusts for each other to use their credit, which trusts are commonly known as spousal limited access trusts, or SLATs.

SLATs are not without tax risk, especially if each spouse creates one for each other (e.g., the application of the reciprocal trust doctrine). While with proper planning such risks can be minimized, the possibility that the assets of a SLAT may be includable in the gross estate of a grantor spouse cannot be entirely eliminated. While many believe that such a grantor should be in no worse position than if he or she had not undertaken the planning, this ignores the loss of the ability of such a grantor spouse to use the marital deduction for such transferred assets (if he or she is the first spouse to die).

Therefore, in preparing SLATs, planners should include a provision that allows for the marital deduction in the event of gross estate inclusion in the estate of the grantor spouse. Further, in the circumstances of powers of appointment being exercised by a beneficiary spouse in a SLAT in favor of the grantor spouse at the death of the beneficiary spouse, similar planning may be indicated.

CLAIMS BASED ON TESTAMENTARY INTENT ARE NOT DEDUCTIBLE UNDER SECTION 2053 FOR ESTATE TAX PURPOSES

Code 2053(a)(3) allows an estate to deduct claims that are paid in calculating estate taxes. Oftentimes, estate litigation involves disputed claims. Are the payment of those claims deductible?

They can be, but not if the payment is attributable to the testator’s testamentary intent. This was illustrated in a recent Tax Court case.

In the case, a caretaker of the decedent was a $100,000 pecuniary beneficiary under the decedent’s first set of trust documents. Under a second set of documents, the caretaker became a testamentary trust beneficiary. When the decedent died, litigation ensued between the caretaker and members of the decedent’s family. The parties settled, and the caretaker was paid $575,000.

The estate treated the first $100,000 as a bequest to the caretaker. They then sought to deduct the remaining payment as a deductible claim under Code §2053(a)(3).

Not so fast, said the Tax Court. A requirement for deductibility is that the claim is based on adequate consideration. The Court found that the caretaker had been fully paid for his lifetime services, and thus there was no consideration given to the deceased for the payment to him – also, no claim for unpaid compensation had been filed. Further, per the caretaker being a named beneficiary in both the first and second trust documents, it was clear that the payment was in settlement and a substitute for the gifts provided in the trust documents. As such, the payments were attributable to the decedent’s testamentary intent, and thus not deductible.

The estate also sought deductibility under Code §2053(a)(3) per the payment being made to “preserve estate assets.” The Tax Court determined that such grounds did not apply when the payment is attributable to testamentary intent.

Estate of Sylvia E. Bates, TC Memo 2012-314

EMPLOYERS PAY THE FUTA PRICE OF THEIR STATE'S LACK OF FINANCIAL DISCIPLINE

Employers pay federal unemployment tax (FUTA) at a rate of 6.0% on the first $7,000 of covered wages paid to each employee each year. However, employers can offset this tax with credits of up to 5.4% (the “normal credit”)  for amounts paid to a state unemployment fund by January 31 of the subsequent year. Thus, the net FUTA rate for many employers is only 0.6%.

Under federal law, states with financial difficulties can borrow funds from the federal government to pay unemployment benefits. However, if a state defaults on its repayment of the loan for at least 2 years, the normal credit available is reduced. This effectively increases the employer's FUTA tax rate by 0.3% for each year in which the loan isn't repaid. Are there states out there that have defaulted on repayment? Of course.

Is your state on the default list? Here is the list and how much it is costing their employers:

--0.9% credit reduction - Indiana.

--0.6% credit reduction - Arkansas, California, Connecticut, Florida, Georgia, Kentucky, Missouri, Nevada, New Jersey, New York, North Carolina, Ohio, Rhode Island, and Wisconsin.

--0.3% credit reduction - Arizona, Delaware, and Vermont.

APPLICABLE FEDERAL RATES–DECEMBER 2012

WANDRY ROLLER COASTER CONTINUES

I have written several times about the Wandry decision, and its respect for a formula adjustment clause in the gift tax arena. This decision has had its ups and downs, since it came out earlier this year.

Up – the Tax Court issues its decision upholding the clause.

Down – the IRS appeals the decision.

Up – the IRS withdraws its appeal.

Down – the IRS has now issued its nonacquiescence to the Wandry decision.

After the IRS withdrew its appeal, I don’t think that there were too many people out there who read that as an IRS concession that these clauses were valid and effective (although many hoped so). With its nonacquiescence, the IRS has now made clear that it does not believe Wandry is good law.

For more on Wandry, click here.

What exactly is a “nonacquiescence?” The Internal Revenue Bulletin provides that it means, as to a Tax Court decision, that “although no further review was sought, the Service does not agree with the holding of the court and, generally, will not follow the decision in disposing of cases involving other taxpayers.”

AOD in 2012-46 IRB

A DAY OFF!

Thanks to Kelly Greene at the Wall Street Journal, I am taking the day off from this blog today. She did my work for me today by writing her article on Last-Minute Gift Traps. Not only is it a great summary of the potential risks under the 2012 year end gifting tsunamai, but she includes my name and thoughts throughout the article.

It is always nice to see your name in the paper  - unless it is in the obituaries or the criminal news section!

Here is a link to the article on the WSJ website. If the link has expired, you can download a PDF version here. Regular readers here have probably seen most of what is in the article, but it is a good summary and reminder of some of the potential gifting risks.

Last-Minute Gift Traps, Wall Street Journal, November 9, 2012

POLICY LOANS CAN BITE YOU

Life insurance policies can be great vehicles for income tax deferral. Part of this arises from the fact that earnings growth that occurs inside the policy is not subject to current income tax (and may never be taxed if the policy is maintained in force until the death of the insured). Another part of this comes from the ability of an insured to “borrow” from the cash surrender value of the policy, and thus access policy value and growth, without paying a current income tax.

However, some insureds learn the hard way that unexpected income tax consequences can arise. A recent Tax Court case illustrates a common trigger for taxable income to an insured policy owner.

The tax principle involved relates to the termination of the policy during the lifetime of the insured. This can happen because the owner ceases to pay premiums, cashes in the policy, or the policy otherwise lapses. In this circumstance, if there are loans against the policy, the loan balance is treated as having been paid to the owner at the termination of the policy (principally by the insurance company applying any remaining cash surrender value towards repayment of the loan balance). If this loan amount exceeds the owner’s “investment in the contract” (generally, the total premiums paid by the owner less distributions made to the owner), the taxpayer has to include that excess in its income.

Thus, borrowing against a life insurance policy opens the door to this income, if the policy is cancelled during the owner’s lifetime before the death of the insured. Of course, if the total loan amount, plus additional cash value returned to the taxpayer, does not exceed the premiums previously paid, such income will not arise.

The problem is that there are two sources of policy loan growth that are not immediately obvious. The first is that if there are loans, interest is charged on the loan balance by the insurance company so that the loan balance increases over time just from interest alone. The second is that if some of the policy cash values are used to pay premiums in whole or in part, these are booked as policy loans. These increases can push the policy loan balance beyond the amount that had been paid into the policy in premiums, and an owner may not even be aware of the growing loan balance.

A secondary problem is that insurance companies may cancel a policy of their own accord when the loan balances approach the cash surrender value of the policy. The company then repays itself from the cash surrender value. This loan repayment is treated as a distribution to the owner, thus triggering the potential income recognition described above.

In White, a Tax Court Memorandum decision, this was painfully illustrated to the taxpayer. In the case, the life insurance company canceled the policy when the loan balance exceeded the cash surrender value. The loan balance came about from premium payments being made from the cash value of the policy. The insurance company applied the cash surrender value to the loan balance, and that amount exceeded the owner’s investment in the policy. Thus, the owner incurred income to the extent of that excess. To make matters worse, this income was “phantom” income – that is, the taxpayer picked up income without receiving any actual dollars, and thus had to pay the tax bill out of other funds.

Note that these problems typically go away at the death of the insured, since the loan balance is effectively paid off from the death benefits without an income tax consequence. It is the earlier termination of the policy before the death of the insured that gives rise to these problems.

White, TC Summary Opinion 2012-108

WHEN IS BAD HEALTH AN EXCLUSE FOR A LATE RETURN?

Late filing of a tax return and payment of taxes is subject to penalty absent reasonable cause, if not due to willful neglect. Code §6651(a)(1). In a recent Claims Court case, the key focus by the court in weighing bad health as an excuse for a late gift tax return filing was was whether the taxpayer’s incapacity from illness was “continuous.”

This is not the first case dealing with serious illness as a reasonable cause excuse. The Supreme Court indicated in Boyle, 55 AFTR 2d ¶ 85-1535 (1985) that serious illness of a taxpayer or a member of his immediate family could constitute reasonable cause, but it did not decide how ill that person must be. In Sanford, 71 AFTR 2d ¶ 93-405 (CA 11 1992), the 11th Circuit Court of Appeals recognized the excuse if the taxpayer was unable to exercise reasonable business care. In Williams, 16 TC 893 (1951), an intermittent period of disability was not enough for penalty relief.

In the current case, the taxpayer made substantial gifts in 2007 and owed approximately $1.8 million in gift taxes. She filed her gift tax returns late, and incurred penalties.  The taxpayer suffered numerous health care problems after the gift, including knee replacement surgery, cataract surgery, thyroid problems, heart palpitations, pneumonia, and other respiratory problems. Despite these problems, the Claims Court found that the taxpayer was not continuously incapacitated at the time when she could have informed her tax advisors of the transactions for reporting purposes.

Probably most troublesome for the court was that the taxpayer completed numerous other financial transactions in 2007 through April 15,2008. These including calling tax attorneys, reviewing deeds for the conveyance of real property, visiting notaries, mailing documents to her tax returns, reviewing her 2007 federal and state income tax returns and estimated tax returns, making out checks, and mailing checks to the tax authorities. By able to do these things, the court felt there was no way she was continuously incapacitated.

Stine, 110 AFTR 2d ¶ 2012-5383 (Claims Ct 2012)

SOME 2013 INFLATION-ADJUSTED NUMBERS

Kiddie Tax Exemption	$2,000
Special Use Valuation Reduction Limit	$1,070,000
Regular Gift Tax Annual Exclusion	$14,000
Increased Annual Exclusion for Gifts to Noncitizen Spouses	$143,000
Reporting Foreign Gifts	$100,000 for gifts from nonresident alien individuals or foreign estates, $15,102 for gifts from foreign corporations and foreign partnerships
Foreign Earned Income Exclusion	$97,600
Social Security Wage Cap	$113,700
401k Limit	$17,500
Defined Contribution Plan Limit	$51,000

WINDSOR UPHELD

Earlier this year, I discussed the Windsor case wherein a federal district court struck down Section 3 of the Defense of Marriage Act (DOMA), and allowed a marital deduction in the estate of a deceased same-sex spouse for assets passing to the surviving spouse. You can read that discussion here.

The Second Circuit Court of Appeal has upheld that decision, albeit on a stricter constitutional test than the rational basis test which was applied by the district court. Here, the appellate court applied an intermediate heightened level of scrutiny which is inbetween the rational basis test and strict scrutiny, and found that the DOMA provision did not meet that level of scrutiny.

Windsor, 110 AFTR 2d Para 2012-5378

WANDRY APPEAL WITHDRAWN

I have previously written about the Wandry decision here. Wandry is a favorable Tax Court Memorandum decision that accepted the use of a simplified formula gift clause (that is, one that did not involve disclaimer or charitable elements) as a method of avoiding an inadvertent taxable gift by reason of an IRS upwards revaluation of the value of gifted property.  The Government appealed the decision to the 10th Circuit Court of Appeals earlier this year. An appellate decision upholding Wandry would be welcomed by practitioners – a reversal would not.

Neither is going to happen now. Per the Tax Court website, the Government has voluntarily dismissed its appeal. At this point, I do not know why.

The dismissal is better than a reversal. However, I was looking forward to a more definitive ruling on the issue (one way or the other) due to the limited precedential value of a Tax Court Memorandum decision.

APPLICABLE FEDERAL RATES–NOVEMBER 2012

DO YOU KNOW ABOUT FIRST-TIME ABATE RELIEF?

[Prefer to watch instead of read? Go here.]

If you file an income tax return late, Code §6651(a)(1) imposes a penalty of 5% of the unpaid taxes for each month, up to 25%. If you don't pay income taxes when due, Code §6652(a)(2) imposes a 0.5% penalty for each of nonpayment, up to 25% of the unpaid taxes.

Since 2001, the IRS grants relief to taxpayers subject to these penalties if the taxpayers were otherwise fully compliant for the prior three years. See IRM §20.1.1.3.6.1. This is known as "First-Time Abate" (FTA) relief. Note that it can only be applied for one tax year.

Did you know about this? Don't feel bad if you don't. In a recent report by the Treasury Inspector General for Tax Administration, the IRS has failed to inform about 1.45 million taxpayers that qualified for relief under the program, and collected around $181 million in penalties from those taxpayers. Information on the program is not well-publicized on the IRS' website, nor in forms or penalty notices. Since the IRS does not generally advise taxpayers of the program, and only grants relief if request, if a taxpayer does not know about FTA then they missed out on the opportunity to avoid these penalties. These are not small numbers either - the average estimated penalties per taxpayer are $60,000 for late filing and $21,000 for late payment.

Another problem with the program has been that the above penalties can also be abated if the taxpayer can show reasonable cause. If a penalty is abated due to reasonable cause, the taxpayer can then use FTA in a following year. However, taxpayers may use FTA in a year even though they qualified for reasonable cause abatement. By using FTA instead of reasonable cause abatement, they have locked themselves out of using FTA for the next few years when they didn't have to.

The IRS has indicated it will be taking corrective action to address these problems with the FTA program.

Penalty Abatement Report, September 19, 2012

DOMA STILL THE LAW, ACCORDING TO THE IRS

There have been a number of cases that have declared that Section 3 of the Defense of Marriage Act is unconstitutional. That provision defines marriage for purposes of administering federal law as the “legal union between one man and one woman as husband and wife.” It further defines “spouse” as “a person of the opposite sex who is a husband or wife.”

See my prior posts here and here.

In a recent FAQ, the IRS has indicated that it will continue to treat same-sex married couples as unmarried individuals for tax provisions that relate to marital status, regardless of these court decisions. The FAQ also provides guidance on which member of the couple can claim a child as a dependent (either one, or if they both claim it, the one with whom the child lived with longer) and adoption expense credits.

Answers to Frequently Asked Questions for Same-Sex Couples

VIDEO EXPERIMENT

Time permitting, I am attempting a video experiment for those who would rather watch than read. Go here for the first one which I made this weekend for my last posting. After a few attempts, I’ll see if there are enough views to keep on going with the videos. These videos will mostly be shortened versions – for more details you can always read the written post to which it relates. Comments and suggestions are welcome at crubin@floridatax.com.

INCOME TAX GIFTING HAZARDS

[Prefer to watch instead of read? Go here.]

The great rush is on to complete major gifting in 2012 before the unified credit equivalent amount is reduced from $5.12 million to $1 million in 2013 and thereafter. While planners are focused on transfer tax savings and issues, they must also consider the income tax consequences of the gifts.

Basis Step-Up Issues. Most planners, even those without a strong income tax background, are aware of the trade-off in making a lifetime gift of appreciated property versus transferring such property at death. If a gift is made of the property, the recipient usually receives the same basis that the donor had in the property. If the recipient then sells the received property, it will have to pay income tax on the appreciation that exists in the property, as if the donor had sold it. If the property was held until death and then transferred, the basis of appreciated property would be adjusted at death to the value of the property. This allows the recipient to then sell the property without ever paying income tax on the appreciation that occurred while the decedent owned the property.

Liabilities in Excess of Basis Issues. For those planners that plan on using limited liability company or limited partnership interests to fund 2012 gifts, another income tax issue exists that is not as well-known and is not being widely discussed should be on the review checklist. This involves the transfers of interests in these entities when the entities have mortgage or other indebtedness.

In this circumstance, it is possible that the share of the entity’s indebtedness that is allocable to the transferred interest exceeds the donor’s tax basis in the interest. In that circumstance, a gift of the interest may generate a gain to the donor to the extent that the indebtedness share allocable to the transferred interest exceeds the basis – that is, the donor can be treated as having sold the interest for the amount of the share of the entity indebtedness even though the transaction looks like a gift.

This circumstance is often referred to as a “negative capital account” situation. It typically arises from real estate or other business entities that borrow money and generate tax deductions for the partners or members. These deductions reduce the basis of the owners’ interests, often without an offsetting repayment of the debt or receipt of profits by the entity. Alternatively, the entity may borrow funds and then distribute the cash proceeds to members or partners, again reducing the owners’ basis in their interest while still maintaining the same level of debt in the entity.

Gift tax transfers to grantor trusts may avoid or defer the gain aspects, since the donor/grantor will be treated as still owning the transferred interest for income tax purposes. However, the planning can get tricky to cover the circumstances of death of the participants and beneficiaries. For example, if the grantor trust status terminates by reason of the death of a beneficiary during the grantor’s life, this may trigger a deemed sale at that point in time.

While the above focuses on interests in partnerships and LLC’s, similar issues can also arise if real property or other property is directly transferred if that property is encumbered. Therefore, planners are encouraged to make sure they have their income tax bases covered in addition to transfer tax planning, in making these last minute 2012 gifts. Also, since a transfer at death provides a direct means of eliminating a negative capital account, consideration should be given to finding alternative assets to gift for this reason alone.

IRS EASES RULES ON GIFT-GIVING BY PRIVATE FOUNDATIONS TO FOREIGN ORGANIZATIONS

New Proposed Regulations expand the class of persons who can issue written advice that a foreign organization is eligible to receive grants from a private foundation that constitute qualifying distributions for Code §4942 minimum distribution requirements and that are not taxable expenditures under Code §4945. Previously, such persons included only legal counsel for the donor or donee organization. Now, other attorneys, CPAs and enrolled agents can do so.

FACTS: Distributions to foreign organizations by private foundations can run afoul of two excise tax provisions. First, Code §4942 imposes a minimum level of distributions to qualified recipients each year. Unless a private foundation has enough distributions to other qualified recipients to meet the minimums, it will want distributions to foreign organizations to count towards the minimum. Second, Code §4945 imposes an excise tax on a private foundation’s “taxable expenditures.” Taxable expenditures include expenditures for other than a charitable purpose. Private foundations making grants to foreign organizations want those grants to avoid being characterized as a taxable expenditure.

Generally, grants for charitable purposes to certain foreign organizations may be treated as qualifying distributions under Code §4942 if the private foundation determines that the foreign organization is an organization described in sections 501(c)(3) and 509(a)(1), (a)(2), or (a)(3) (i.e., it is a "public charity") that is not a supporting organization described in section 4942(g)(4)(A)(i) or (g)(4)(A)(ii) or is an organization described in sections 501(c)(3) and 4942(j)(3) (i.e., is a "private operating foundation"). However, grants to organizations controlled, directly or indirectly, by the foundation or one or more of its disqualified persons are not qualifying distributions unless the grant is redistributed for charitable purposes within the period specified in Code §4942(g)(3).

Similarly, grants for charitable purposes to certain foreign organizations may be treated as other than taxable expenditures under section 4945 if the private foundation makes a good faith determination that the foreign organization is a public charity (other than a disqualified supporting organization) or an organization described in sections 501(c)(3) and 4940(d)(2) (an "exempt operating foundation").

If the foreign organization does not have an IRS determination letter that confirms it comes within the above classes, a good faith determination by the private foundation that the foreign organization comes within the above classes will achieve the desired results under Code §§4942 and 4945. Under the current regulations, a “good faith determination” may be based on an affidavit of the foreign organization, or an opinion of counsel of either the grantor or the grantee. The affidavit or opinion must set forth sufficient facts concerning the operations and support of the grantee for the IRS to determine that the grantee would be likely to qualify within the required classes.

The new Proposed Regulations both expand and contract who can issue the above opinion. The opiner must now be a "qualified tax practitioner" who is subject to the requirements in Circular 230, including the requirements in current §§10.37 and 10.51(a)(13) (or successor provisions). A qualified tax practitioner means an attorney, a certified public accountant ("CPA"), or an enrolled agent, as those practitioners are defined in §§10.2 and 10.3 of Circular 230, and thus expands who can issue the opinion. However, the class is contracted to exclude foreign counsel unless the foreign counsel is a qualified tax practitioner.

The written advice must meet the requirements of Treas. Regs. §1.6664-4(c)(1), which are the standards that must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice for purposes of Code §6664. Additionally, as is the case under the present regulations under Code §§4942 and 4945, the written advice must provide sufficient facts about the operations and financial support of the foreign organization for the IRS to determine that the grantee would be likely to qualify as a public charity (other than a disqualified supporting organization) or as a private operating foundation or an exempt operating foundation, as applicable.

While the above changes are in Proposed Regulations, the Proposed Regulations indicate that they may be relied upon on or after September 24, 2012 (unless and until subsequently revised by the IRS including via Temporary or Final Regulations).

COMMENTS. Private foundations are often discouraged from making grants to foreign charitable entities because of the expense involved in making the above determinations. By expanding the class of persons who can provide the requisite opinions to include CPA’s and enrolled agents, the cost of such determinations may decrease. The Treasury Department also believes that by making it easier for private foundations to obtain such opinions, this will encourage more private foundations to obtain written tax advice and thus improve the quality of the determinations being made.

Absent regularly practicing in this area, the time involved for professionals to familiarize themselves with requirements of Code §§4942 and 4945 as to foreign grants (including the above rules) is itself a built-in cost to private foundations making foreign grants. One has to wonder how many enrolled agents have the knowledge or experience to properly address these issues. Nonetheless, the desire of the Treasury Department to reduce costs and expand the class of persons who can make opinions is to be commended.

However, the Treasury Department and the IRS are considering future amendments to take away the ability of the private foundation to rely on an affidavit of the foreign organization, which is an existing alternative to obtaining an opinion of counsel. For those organizations that can obtain such an affidavit, one would think that removing its use would actually raise the cost of compliance. Since the purpose of these modifications is to reduce taxpayer cost, hopefully the Treasury Department and the IRS will not undertake such a change.

REG-134974-12, Preamble to Proposed Treasury Regulations (09/21/2012); Proposed Treas. Regs. §53.4942(a)-3; Proposed Treas. Regs. §53.4945-5

IRS SET TO EASE PRACTITIONER RULES

Almost every email I send out to anyone has this at the end:

CHUCK

Charles (Chuck) Rubin, Esq.
Gutter Chaves Josepher Rubin Forman Fleisher P.A.
Board Certified in Taxation

PRINCIPAL PRACTICE AREAS. Preserving and enhancing individual, family, and business wealth through: Planning to Minimize Taxes (U.S. & International)| Estate Planning, Charitable, Marital and Succession Planning | Business Structuring and Transactions | Trusts & Estates Administration | Creditor Protection | Trust, Estate & Tax Litigation and Disputes

CONTACT INFORMATION. Boca Corporate Center | 2101 Corporate Blvd., Suite 107 | Boca Raton, Fla. 33431-7343 | (561) 998-7847 | (561) 892-0221 (fax) | crubin@floridatax.com | www.floridatax.com | www.rubinontax.blogspot.com

REQUIRED CIRCULAR 230 DISCLOSURE. Pursuant to the provisions of Internal Revenue Service Circular 230 that apply to written advice provided by Federal tax practitioners, please be advised (a) that if any advice herein relating to a Federal tax issue would, but for this disclaimer, constitute a "reliance opinion" within the meaning of Circular 230, such advice is not intended or written to be used, and cannot be used by the affected taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer, and (b) any written statement contained herein relating to any Federal tax issue may not be used by any person to support the promotion or marketing of, or to recommend, any Federal tax transaction(s) or matter(s) addressed herein. We would be happy to discuss the effect of this disclaimer, and alternatives to this disclaimer, with you if desired.

That last block of text above (which I have underlined) arises from the Circular 230 rules governing practitioners, and is intended to make clear that any tax advice rendered does not constitute a ‘covered opinion’ that would require an extensive list of items and analysis to be included in the communication. A similar block of text will be found in most emails of other tax professionals, and indeed in emails of many nontax professionals, too.

In a remarkable reversal of direction, the IRS in proposed regulations will soon make the need for these disclaimers go away. Recognizing that few clients understand them, and that they have become so commonplace that few people even reads them, they are ready to withdraw the disclaimer requirements.

Further, and just as importantly, the IRS will withdraw Treas. Regs. § 10.35 in its entirety. As mentioned above,  these “covered opinion” regulations provide extensive requirements on what a tax practioner must review and put into a tax opinion. The IRS is recognizing that many of the items they require are often not needed, that these requirements increase costs for clients and practioners without providing a worthwhile benefit, and that the problems of tax promoter abuse are abating and were not really reduced by these rules anyway.  Instead, all advice will be governed instead by streamlined, common sense requirements that are similar to those in present Treas. Regs. § 103.7.

Unfortunately, these proposed rules cannot be relied upon until final regulations are issued, so the Internet will continue to be clogged with these unnecessary bits of data on emails. Hopefully, the final regulations will not be too long in coming.  In the meanwhile, don’t delete that disclaimer language from your emails just yet.

IS IT NECESSARY TO RESIDE ON HOMESTEAD PROPERTY ?[FLORIDA]

Can you tell the difference between these two rules of entitlement to homestead status for ad valorem tax purposes?

Fla. Const. Article VII, §6(a): Every person who has the legal or equitable title to real estate and maintains thereon the permanent residence of the owner, or another legally or naturally dependent upon the owner, shall be exempt from taxation thereon . . . upon establishment of right thereto in the manner prescribed by law.

Fla.Stats. §196.031(1): Every person who, on January 1, has the legal title or beneficial title in equity to real property in this state and who resides thereon and in good faith makes the same his or her permanent residence, or the permanent residence of another or others legally or naturally dependent upon such person, is entitled to an exemption . . . as defined in s. 6, Art. VII of the State Constitution.

Okay, I underlined the difference, and the title of this article also clues you in. This difference was the principal issue in a recent Florida Supreme Court case. Under the case, two Honduran parents own a residence on Key Biscayne, Florida. They have temporary visas only, and thus are ineligible to indefinitely remain in the U.S. They live in the residence with their three minor children. The children are U.S. citizens. Miami-Dade County denied homestead status to the residence because the parents were in the U.S. on a temporary basis.

Florida case law does hold that one who does not possess the legal right to permanently reside in Florida cannot establish that their “permanent residence” is being maintained on Florida real property. Therefore, at first it appears that the temporary visas may be an issue here given the requirements for permanent residence.

However, on closer examination, both the Constitutional provision and the statutory provision allow qualification if the residence is the permanent residence of one legally or naturally dependent on the owner – the owner himself or herself need not permanently reside on the residence. Further, the appeals court noted that there is not even an obligation of the owner to reside on the property at all (whether permanently, or otherwise). While there is such a residency requirement for the owner in the statute, there is not one in the Constitution. Thus, the requirement of residency in the statute is unconstitutional. As an aside, this requirement in the statute is probably a hold over from a time when the Constitution did in fact require the owner to reside on the property (which is no longer the case).

The court went on to uphold the homestead status as a factual matter, since the children were eligible to stay in the U.S. permanently, even though the parents could not.  While homestead status itself is not worth that much in savings for ad valorem taxes, presumably the County and taxpayers were more concerned about eligibility of the residence for the Save our Homes cap on annual increases in value for ad valorem tax purposes – an issue that can result in substantial tax savings over time.

While not discussed in the case, once the children are old enough to cease to be the dependents of their parents, then the above provisions will no longer apply and homestead status will then be lost.

Pedro J. Garcia v. David Andonie, Fla. Supreme Court Case No. SC 11-554 (Octo ber 4, 2012)

NEW ITIN DOCUMENTATION PROCEDURES ARE A PAIN

Nonresidents of the U.S. are required to have a taxpayer identification number for most U.S. tax reporting purposes, including FIRPTA reporting on sales of U.S. real property interests. Since such persons do not have social security numbers, they have to apply to the IRS for an International Taxpayer Identification Number (“ITIN”) via a Form W-7 application.

The Form W-7 requires certain documentation to be attached. In the past, a U.S. notary could make a notarized copy of an applicant’s passport, and that would be sufficient. Since earlier this summer, however, applicants must submit original documentation or certified copies of their documentation certified by the issuing agency. The IRS may hold on to this documentation for up to 60 days. Would you want to mail in your passport and hope you get it back? And what if you needed to travel within 60 days?

Instead of submitting an original document, a certified copy from the issuing agency is usable. However, the time, cost, delay, and hassle of getting a certified copy of a passport will vary from country to country. Birth certificates may also be used.

More formal rules are promised for 2013, but there is no indication that there will be any easing of the above requirements. There are some exceptions to this reporting.

Even before these new rules, getting an ITIN has always been something of a pain. Now, it is more difficult than ever. While perhaps it may be easier for someone to defraud the IRS and obtain an ITIN on an invalid form of identification via a certified copy through a notary vs. a direct submission to the IRS, is this level of inconvenience really necessary? Does anyone at Treasury care anymore about inconvenience to taxpayers when writing rules? Anyone who has tried to read the FATCA rules already knows the answer to that.

IR News Release 2012-62

STATUTE OF LIMITATIONS QUIZ

Facts & Law:

A. Income taxes must be assessed within 3 years of the later of the  date the return is filed or the due date of the return.

B. However, the assessment period remains open indefinitely “in the case of a false or fraudulent return with the intent to evade tax.”

C. A shareholder in a Subchapter S corporation is taxable on his or her pro rata share of the net income of the corporation.

D. A Subchapter S corporation files a fraudulent return. The taxpayer-shareholder had nothing to do with the preparation or filing of the return, and was not knowledgeable of the fraud.

Question:

Can the IRS assess the taxpayer for a corrected share of the income of the corporation more than 3 years after the filing and due date of the return?

Answer:

No, according to the IRS.

Interestingly, fraud by one spouse in filing a joint tax return keeps the statute open for the other spouse. That was not persuasive here, because spouses are jointly and severally liable for joint return taxes.

In Vincent Allen, 128 TC 37 (2007), the Tax Court held that an income tax return preparer's fraud kept a taxpayer's income tax return open indefinitely. However, that precedent was not applicable here because the intent in that case was to evade the taxpayer’s tax – that was not the case here.

Chief Counsel Advice 201238026

INCOME FROM SURRENDER OF A LIFE INSURANCE POLICY

The cash value of a surrendered  life insurance policy is includable in gross income to the extent it exceeds the taxpayer's investment in the insurance contract. This excess is taxable as ordinary income.

There are two elements to this computation. First, what is the cash value. Second, what is the “investment in the insurance contract.” A recent case (Brown v. Comm.)  illustrates some elements that go into these two items.

Cash Value. In the case, the insured did not receive the cash value. Instead, it was applied by the insurance company to pay off a policy loan. The court nonetheless included the cash surrender value applied to the loan as being received by the insured.

Investment in the Insurance Contract. This generally is the total insurance premiums paid by the insured. However, the court recognized two reductions to the investment in the contract. First, the insured had surrendered some of his insurance coverage. This surrender was treated as a reduction in the investment in the contract. Second, during the term of the policy the insurance company had used some of the dividends earned on the policy to purchase additional coverage.

Oftentimes, the quick and dirty computation of the income arising from the surrender of a policy is the cash received by the insured, over the premiums previously paid. This case reminds us that adjustments to both these items may apply that can materially impact this computation.

Brown v. Comm., 110 AFTR 2d 2012-XXXX (CA7 09/11/2012)

APPLICABLE FEDERAL RATES–OCTOBER 2012

 

ANNUAL GIFT TAX EXCLUSION TO RISE TO $14,000 IN 2013

Taxpayers can make annual exclusion gifts of $13,000 each year per recipient, without incurring a gift tax and without using up a portion of their unified credit. This amount was originally at $10,000, and is now indexed for inflation. After spending a few years at $13,000 it is projected to move to $14,000.

This move up is not yet official.  Research Institute of America (RIA), a publishing house that serves tax professionals, has crunched the numbers and has made the determination that the increase will take place next year, based on their inflation computations.

LAST CHANCE PLANNING PRESENTATION NOW AVAILABLE ONLINE

For the past few weeks I have been making a weekly presentation in our office regarding planning to make use of the $5.12 million unified credit equivalent amount before its scheduled reduction to $1 million in 2013. I have now made an online version of the presentation for all those that are interested but could not intend. You can view it on YouTube through this link.

If you would like a copy of the written materials that accompanied the presentation, send me a quick email at crubin@floridatax.com with a note to send the last chance planning materials.

MODIFICATION OF TRUST DID NOT GENERATE ADVERSE TAX CONSEQUENCES

A recent Private Letter Ruling addressed some interesting issues relating to a modification of an irrevocable trust under state law that is made with the consent of the settlor and all beneficiaries.

A. Section 2036/2038 Inclusion in Settlor. The question was raised whether the settlor was at risk for inclusion of the trust assets in his or her taxable estate by reason of participation in the modification process. That is, was the exercise of his rights under state law sufficient to show that he has a retained interest in the trust under Section 2036 or 2038?

The IRS ruled that the settlor suffered no estate tax exposure. First, the IRS noted that the settlor did not retain the possession or enjoyment of, or the right to the income from, the trust property. Further, the IRS noted that Section 2038 will not apply if a settlor decedent held a power that could be exercised only with the consent of all parties having an interest in the transferred property, and the power adds nothing to the rights of the parties under local law (Treas. Regs. §20.2038-1(a)(2)). Since the beneficiaries were consenting to the modifications, even if the statutory modification power was an issue for the settlor, the regulation would apply to provide further protection against taxable estate inclusion.

B. Gift Tax Exposure to Settlor. The issue was also raised whether the Settlor’s consent to the modification could result in gift tax liability to the settlor. The IRS ruled that there was no gift tax exposure. First, the IRS noted that the settlor’s original gift to the trust was a completed gift since he did not retain any power to change the disposition for his own benefit or for the benefit of another.  Further, and similar to the 2038 Regulation discussed above, Treas. Regs. §25.2511-2(e) provides that a donor is considered to have a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or its income. Here, the power that the settlor had under state law to modify the trust could only be exercised with all of the beneficiaries (who thus have a substantial adverse interest), and thus for both of the above reasons the IRS saw no gift tax issues for the settlor.

C. GST Exemption Preserved. The trust at issue was exempt from generation-skipping tax by reason of allocation of the settlor’s GST exemption to it. The issue was raised whether the modification of the trust could jeopardize the exempt status of the trust.

The IRS noted that there is no guidance regarding whether the partial termination or modification of a trust will affect the status of a trust that is exempt from GST tax because sufficient GST exemption was allocated to it. So the IRS instead applied its regulations whether a “grandfathered” generation skipping trust is modified in a manner that the exempt status would be lost – i.e. Treas. Regs. §26.2601-1(b)(4). The IRS found that under the regulations the modifications did not rise to a level that would result in loss of exempt status - the partial termination and modification would not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation than the person or persons who held the beneficial interest prior to the modification and the partial termination and modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.

While the exempt trust rules do not directly apply to this question, the IRS noted that “[a]t a minimum, a partial termination or modification that would not affect the GST status of a grandfathered trust should similarly not affect the exempt status of [a trust that is exempt by reason of allocation of GST exemption].” Accordingly, the IRS ruled that  the partial termination and modification of the trust did not cause it to lose its exempt GST status.

COMMENT: Modification of irrevocable trusts with the involvement of the settlor are common. Confirmation that such modifications do not adversely impact the settlor when the settlor retained no rights or interest over the trust, and further do not upset the GST exempt status of the trust, is reassuring.

However, there may be circumstances when the modification may involve a shift of a beneficial interest to a lower generation – such a circumstance would not fit within the facts of this ruling on the GST issue. Presumably that should not impact the exemption allocation, but it does remain an open issue.

PLR 201233008

TURBOTAX DEFENSE FAIL

Russell Long, describing tax reform, once said, "Don't tax you, don't tax me.  Tax that fellow behind the tree."

A variation that taxpayers who make mistakes on their tax returns often claim is, “Don’t penalize you, don’t penalize me, it was TurboTax’s fault, so set me free.”

The so-called “TurboTax defense” is raised by taxpayers to avoid penalties – they claim reasonable cause for their tax return errors because they used TurboTax or similar return preparation software to prepare the erroneous tax return. That is what Brenda Bartlett claimed when she was penalized for not reporting all her income on her tax return. Brenda maintained that the failure to report was an honest mistake resulting from her lack of familiarity with the TurboTax program and that she relied on the audit portion of the program to catch any mistakes she made.

The Tax Court rejected her defense, since the problem was that Brenda entered the information incorrectly into the program – not that the program made a mistake. The Court noted:

TurboTax is only as good as the information entered into its software program…Simply put: grabage in, garbage out.

Brenda Frances Bartlett v. Commissioner, T.C. Memo. 2012-254 (Sept. 4, 2012)

‘BLAME THE PROFESSIONAL’ DEFENSE DOES WORK SOMETIMES

Dr. James formed an irrevocable trust in Nevis, West Indies for asset protection purposes. He properly reported the trust to the IRS on a Form 3520-A, but neglected to file a Form 3520. He is at risk for a penalty of the greater of $10,000 or 35% of the gross reportable amount – not an insignificant penalty (more than $578,000 in penalties for Dr. James). Code section 6677(a).

As is the case for many penalties, there is an exception if the failure to file was due to reasonable cause and not due to willful neglect.  Dr. James claimed that he reasonably relied on his accountant to advise him on what returns should be filed, and that he had no personal knowledge of the Form 3520 filing requirements.

A taxpayer may reasonably rely on an expert’s advice as to tax filing obligations – this can constitute reasonable cause under the above penalty exception. In many cases, however, the facts do not support the exception. For example, the taxpayer may not have provided adequate information to the professional, or did not engage the professional to advise him on all required tax filings.

In the case of Dr. James, he had enough favorable facts to allow for a further review whether reasonable cause existed for his failure to file. These facts included:

     a. Dr. James gave his accountant all the applicable trust documents;

      b. Dr. James relied on the accountant to advise him on all required trust filings;

     c. The accountant did advise him on some tax matters relating to the trust;

     d. The accountant prepared Dr. James’ personal returns. On those returns he checked the box ‘no’ to the question whether Dr. James received a distribution from, or was the grantor of or transferor to, a foreign trust. This could be construed as advice to Dr. James that a Form 3520 was not needed.

     e. Dr. James believed he filed all required returns, based on his discussions with his accountant.

Dr. James is not out of the woods yet – the case was simply a denial of the IRS’ motion for summary judgment that the exception to the penalty did not apply. Based on the court’s opinion, it would seem that the IRS has a difficult road ahead in convincing the court to apply the penalty.

The case is also representative of the zealousness with which the IRS is pursuing offshore accounts and trust nonreporting. It would seem that this was not a case of an intentional or egregious nonfiling, especially given the reliance on the taxpayer’s accountant and that other disclosure reporting was undertaken by the taxpayer of the trust to the IRS – instead, it looks more like a zero tolerance policy by the government. The case does not reveal whether Dr. James avoided reporting income from the trust – if he did that might provide additional justification for the IRS to throw the book at him.  

James,  110 AFTR 2d ¶2012-5196 (2012, DC FL)

WANDRY NOW ON APPEAL

In my March 31 posting, I discussed the Wandry decision of the Tax Court. The decision was a very favorable determination that approved of a formula clause to limit the amount of a gift (and thus limit exposure to gift tax) upon an IRS redetermination of value of the gifted property. While formula gifts have withheld scrutiny in other decisions, those cases involved more complex planning involving charitable lids or disclaimers – Wandry greatly simplifies the methodology involved to have an effective clause.

Notice of appeal was filed in the Tax Court on August 28, with the appeal going to the 10th Circuit Court of Appeal. Look for more here as soon as a decision is out.

MANDATORY E-SERVICE BEGINS IN FLORIDA ON SEPTEMBER 1, 2012 [FLORIDA]

By Sean Lebowitz

Mandatory service of court pleadings by e-mail begins on September 1, 2012. The Florida Supreme Court, in opinion SC10-2101, issued a holding requiring e-mail service of pleadings for all attorneys practicing in the civil, probate, small claims and family law divisions of the trial courts as well as in all district court of appeals. Mandatory service by e-mail is Florida’s initial step to a state-wide internet portal, similar to PACER in federal courts, which is currently scheduled to commence on April 1, 2013.

Florida Rule of Judicial Administration 2.516 (Service of Pleadings and Papers) is the principal newly adopted rule. The Rule replaces Florida Rule of Civil Procedure 1.080, which currently governs service of pleadings. The key provisions of Florida Rule of Judicial Administration 2.516 are as follows: 1) Attorneys are required to state their e-mail address on every pleading filed with the Court; 2) All documents required or permitted to be served on another party must be served via e-mail and need not be served via US Mail; 3) Service of a document via e-mail is made by attaching the document in PDF format to the e-mail; 4) The e-mail subject line must begin with the words “SERVICE OF COURT DOCUMENT” followed by the relevant case number; 5) The body of the e-mail must contain the name of the court, case number, name of the initial party on each side, the title of the document being served via e-mail and the sender’s contact information; and 6) The original documents must still be filed with the Court.

In addition, although service by e-mail is instantaneous, the rule still provides an additional five (5) days for transmittal pursuant to Florida Rule of Civil Procedure 1.090(e), unless another means of service is utilized with differing time limits (for instance, facsimile).

The e-mail and attachment may not exceed five (5) megabytes in size, and if the enclosures are larger, the e-mail may be sent in multiple e-mails. The document being served may be electronically signed by the “/s/” format, but the document filed with the Court must be appropriately signed. Permitting a document to be signed by the “/s/” format should alleviate the strict size requirements since the pleading does not need to be scanned (and can be saved as a PDF using Word or Word Perfect).

The mandatory service by e-mail rules have exceptions and contain other nuisances. The author encourages all attorneys to read the new rule and opinion (which can be found here: www.floridasupremecourt.org/decisions/2012/sc10-2101.pdf).

FEDERAL TAX OVERPAYMENT & UNDERPAYMENT INTEREST RATES–OCTOBER 2012 QUARTER

DISTINGUISHING CORPORATE DISTRIBUTIONS FROM LOANS

The question often comes up whether a distribution to a shareholder is a taxable distribution (e.g., a dividend), or a nontaxable loan. A recent 5th Circuit Court of Appeals decision listed the general considerations courts will consider, and applied those considerations to the facts of the case.

Generally, the test of whether a distribution is a loan is whether there was an intent that the advanced monies be repaid. The following seven objective factors are what courts will focus on:

(1) Whether the promise to repay was evidenced by a note or other instrument. In the case, the note was not signed until six months after the distribution, so even though there was a promissory note its late preparation was an unfavorable fact for finding a loan.

(2) Whether interest was charged. In the case, interest was charged, which was a good thing, but the rate was below the market, which was not a favorable factor for a loan.

(3) Whether a fixed schedule for repayment was established. A schedule was provided, but not until 3 months after the first payment was due.

(4) Whether collateral was given to secure payment. In the case, the note was secured.

(5) Whether repayments were made. In the case, no payments had been made – obviously, not a good fact for finding a valid loan. While there were insurance mechanisms to allow for eventual payment if necessary from a plan death benefit, there were too many contingencies attached to such payment to treat it as an actual payment.

(6) Whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan. The borrower was a neurosurgeon who made a good living, so there was a reasonable prospect of repayment.

(7) Whether the parties conducted themselves as if the transaction was a loan. Not here – they did not make payments in accordance with the note, and no collection was attempted.

So how do you think the court ruled? Both the Tax Court and the appellate court found that there was no bona fide loan.

Clearly, taxpayers seeking loan treatment in similar circumstances should attempt to meet as many of the above factors as possible.

Todd, II v. Comm., 110 AFTR 2d ¶ 2012-5205 (CA 5 8/16/2012)

APPLICABLE FEDERAL RATES–SEPTEMBER 2012

COMMENT: With interest rates on the uptick again, will this be the lowest rates will be for awhile?

ASSIGNMENT OF LAWSUIT RECOVERY–DOES ASSIGNMENT OF INCOME DOCTRINE APPLY

What happens if a litigant obtains a judgment in a lawsuit, and then assigns that judgment to a third party before it is paid? The assignment of income doctrine generally provides that an assignor of a right to income will generally be taxable on the income when it is received by the transferee, even if the transferor no longer has any rights to the income. Does this mean the litigant under the above facts will be taxable when the transferee of his or her judgment gets paid by the defendant (assuming that the damages received are otherwise taxable)?

A recent private letter ruling reviewed existing case law on the subject. It summarized the law to be that a transferor who makes an effective transfer of a claim in litigation to a third person before the time of the expiration of appeals in the case is not required to include the proceeds of the judgment in income under the assignment of income doctrine because such claims are contingent and doubtful in nature. If the transfer is made after the appeals are done, then the assignment is no longer contingent and the assignment of income doctrine will apply.

Interestingly, in the ruling request, the assignment of the judgment was contingent on the issuance by the IRS that the assignment of income doctrine did not apply, so long as the ruling was issued  before a final settlement of the lawsuit or the expiration of the appeals period. Thus, the ruling had to be issued while recovery was still contingent, and thus the IRS ruled that assignment of income did not apply. If the ruling could be issued after the expiration of the appeals period, then the assignment could be effective after it ceased to be contingent, and thus presumably in that circumstance the assignment of interest doctrine could apply. The result also did not change even though a portion of the judgment would be applied to the payment of attorneys fees.

PLR 201232024

DOMA MARRIAGE DEFINITION STRUCK DOWN BY ANOTHER LOWER COURT

In June, I wrote about how a married same-sex couple was able to persuade a U.S. District Court in New York to strike down the definition of marriage as being only the legal union between a man and a woman. This definition is in Section 3 of the Defense of Marriage Act (DOMA). In the case of Windsor v. U.S., 109 AFTR 2d ¶ 2012-870 (DC N.Y. 6/6/2012), the court struck down the definition and allowed the estate tax marital deduction to apply to a same-sex married couple. You can read my initial analysis here.

A District Court in Connecticut has now also ruled against the federal definition. This case involved several same-sex married couples, and the issues involved included income tax savings by being able to file as a married couple, eligibility of a surviving spouse for Social Security Lump Sum Death benefits, eligibility under the Family Medical Leave Act, and Medicare Part B supplemental insurance availability.

Like Windsor, the DOMA provision was struck down based on failing the rational basis test under the Equal Protection Clause of the U.S. Constitution. Unlike Windsor, the Connecticut Court undertook a lengthy analysis as to whether homosexuality is a “suspect class” under that Clause – however, it ultimately ruled that such a finding was unnecessary to strike down the marriage definition given its failure to pass the lower scrutiny rational basis test.

The Windsor case is under appeal to the Second Circuit, so more authoritative precedent (one way or the other) will likely come out of that case. Interestingly, the Connecticut case noted that there are at least 1,138 federal laws and regulations that are impacted by the federal definition of marriage.

 Pedersen, et al, v. Office of Personnel Management, et al, (DC CT 07/31/12) Civil Action No. 3:10-cv-1750.

LAST CHANCE PLANNING–SEMINAR ANNOUNCEMENT

There are only four months left to implement gift giving before year end to take advantage of the $5.12 million unified credit, before it reverts to $1 million in 2013. Given the increasing interest in planning for such gifts, and a few requests, I am putting on a one-hour in-house presentation on basic and advanced planning techniques. Included topics will include the pros and cons of gift planning, basic gifting techniques, SLATs and other gift trusts, formula fundings, and discounting, with a special focus on planning to allow continued economic interests to a donor after gifting.

The free presentation will be of interest to accountants, attorneys, financial planners, clients, bank, brokerage & trust officers,  and other interested persons. CPE credit is available, and CLE credit is applied for.

The presentations will be held on successive Fridays, on September 7 and 14, at 8 a.m. in our offices.

Since we have run out of room at past presentations, I am making this seminar available for a few days first to the readers of this blog, before a more general announcement goes out – so if you are interested, I suggest you sign up as soon as reasonably convenient. Please call or email Susana at 561-998-7847 or sibanez@floridatax.com with your preferred date.

For a copy of our Full Announcement, go here.

IT IS OKAY TO MAKE A CHARITABLE CONTRIBUTION TO AN LLC WHOLLY OWNED BY A §501(C)(3) ORGANIZATION, IF YOU WERE WORRIED ABOUT THAT

In 1997, the IRS issued final regulations providing that a domestic LLC wholly owned by single owner could be disregarded as a entity separate from its owner and its operations treated as a branch of its owner.  Consistent with those rules, in Announcement 99-102, the IRS provided that an owner that is exempt from taxation under Code §501(a) must include, as its own, information pertaining to the finances and operations of a disregarded entity in its annual information return (Forms 990, 990-EZ, 990-T, and 990-PF).

Well, it has only taken 15 years, but the IRS is now acknowledging in Notice 2012-52 that it will treat as a charitable contribution to a U.S. charity a contribution to a disregarded entity wholly owned by the U.S. charity.

Notice 2012-52

NONBUSINESS VS. BUSINESS BAD DEBT

Individuals who are stockholders or employees of a corporation often lend it funds. When the loan turns sour and does not get repaid, a "business" bad debt deduction, if allowed, allows for an ordinary loss. However, if the loan is a "nonbusiness" bad debt, the lender only receives short-term capital loss treatment. Further, for nonbusiness bad debts, a deduction is allowed only if the debt is wholly worthless - business bad debts are allowed for partial worthlessness.

If the lender is an employee of the corporation and that employment is the lender's primary employment, the taxpayer can often make a reasonable showing that he or she made the loan to protect his trade or business as an employee (and not just as an investment). In that situation, business bad debt treatment should be available. That is, if the lender believed the corporation needed the loan to keep the lender's job going, that should be enough.

Problems arise when the lender's motivation relates more to the investment side of things, and not protection of his or her employment. This tends to come up more when the lender is both an employee and a stockholder. As such a lender in a recent Tax Court case learned, this opens the door to a strong argument that the loan was made more to protect the lender's investment in the company than his or her employment. There, the taxpayer lost his bid for business bad debt treatment. In finding that the loan was a nonbusiness bad debt instead, it noted:

[T]he dominant motivation for making the loans was not petitioner's trade or business as an employee of the companies. ... Petitioner designed the software used by the companies and invested a significant amount of time and money to ensure the success of the companies. Protection of petitioner's investment interests in the companies, rather than protection of his salary, was the dominant motivation for the loans.

What was especially problematic for the taxpayer was that in the year after the loan was made, the lender did not receive any pay from the two companies involved. While not explicitly discussed, the Court's mentioning of this fact presumably helped it reach the conclusion that the loan was not made principally for employment purposes. Whether it would have ruled for the taxpayer if the lender continued to receive compensation is unknown.

Harry R. Haury, TC Memo 2012-215

HOW NOT TO DESIGNATE A REVOCABLE TRUST AS AN INSURANCE POLICY BENEFICIARY

In a recent Florida case that likely has relevance to other states, a decedent established a revocable trust for the benefit of his heirs. The trust had typical language that directed that the after the death of the settlor, the trust should be used to pay death obligations of the decedent and his estate. After such payment, the remaining trust proceeds would be used to fund residuary trusts for the decedent’s children.

The decedent named the revocable trust as beneficiary of two life insurance policies on his life. Due to financial reversals during his lifetime, at the time of his death the insurance proceeds were needed by his estate to pay the decedent’s death obligations, and thus would not pass to the trusts for the children.

The decedent’s personal representative and the trustee of his revocable trust (who was the same individual) asserted that Fla.Stats. §222.13(1) exempted the insurance proceeds from the claims of the decedent’s creditors.  Fla.Stats. §222.13(1) reads:

Whenever any person residing in the state shall die leaving insurance on his or her life, the said insurance shall inure exclusively to the benefit of the person for whose use and benefit such insurance is designated in the policy, and the proceeds thereof shall be exempt from the claims of creditors of the insured unless the insurance policy or a valid assignment thereof provides otherwise.

The decedent’s creditors claimed that Fla.Stats. §222.13(1) didn’t apply to protect the insurance benefits because the proceeds were payable to the revocable trust, and the revocable trust expressly provided for the payment of the decedent’s death obligations. The trial court agreed with the creditors, and on appeal, the appellate court concurred.

The court noted that a payment of insurance proceeds to a trust does not void the statutory exemption under Fla.Stats. §222.13(1). However, Fla.Stats. §733808(1) makes it clear that life insurance payable to a trust “shall be held and disposed of by the trustee in accordance with the terms of the trust as they appear in writing on the date of the death of the insured.” Since the terms of the trust directed payment of the decedent’s death obligations, then those terms would be given effect. Pursuant to the court’s reference in footnote 4 to  Fla.Stats. §733.808(4) which addresses payments to a revocable trust and the statutory direction for the payment of death obligations from a revocable trust, the court did not appear to believe that provision changed the analysis.

The case is relevant since oftentimes insurance, annuities, and other plan assets designate a trust to be established under a will or trust at the death of a decedent as the beneficiary. This allows the proceeds to pass into trust for the beneficiary and not outright to him or her, without the establishment of a separate trust for that purpose. Clearly, as this case confirms, a designation directly to the revocable trust which bears death obligation payment provisions will open such payments up to estate creditors.

While not addressed by the court, the better course of action would have been beneficiary designations directly to the testamentary subtrusts established under the revocable trust agreement, and not the revocable trust itself. Such subtrusts will usually themselves not be subject to the reach of the reimbursement obligation to the decedent’s estate as to assets flowing into them from assets situated outside of the revocable trust. Nonetheless, an express provision to that effect in the trust agreement  (i.e., that testamentary funding of a subtrust from insurance proceeds or other beneficiary designations is not intended to subject the funding assets to the  death obligation payment provisions of the revocable trust) would be helpful to avoid the interpretative issue whether it is intended that such fundings are subject to the death obligation payment provisions. Presumably, the statutory death obligation payment provisions (which exist outside of the payment provisions which are in the trust) will likely not be operable against such proceeds either, per the provisions of Fla.Stats. §733.808(4) which reads that a beneficiary designation to a trust “shall not be subject to any obligation to pay the expenses of the administration and obligations of the decedent’s estate or for contribution required from a trust under s. 733.607(2) to any greater extent than if the proceeds were payable directly to the beneficiaries named in the trust.”

While the above analysis does turn in part on Florida statutory law, it was the combination of the payment of the insurance proceeds directly to the revocable trust (and not a testamentary subtrust) and the express payment language in that trust, that created the problem. Therefore, the concept of choosing the right trust as beneficiary likewise should also have application in other states where the proceeds of life insurance payable directly to a beneficiary are not subject to the claims of a decedent’s creditor.

As an aside, the trial court and appellate court also turned down an attempt to reform the the trust to not have the death obligation payment provisions apply to the insurance, citing a lack of proof of intent that this is what the settlor intended.

Morey v. Everbank, 2012 WL 3000608 (1st DCA July 24, 2012)

IRS VICTORY IN FBAR WILFULNESS PENALTY CASE

[This entry was prepared by Mitchell Goldberg of our office]

In an unpublished opinion, the Fourth Circuit Court of Appeals in U.S. v. Williams, reversed the district court’s holding that the taxpayer’s failure to file Form TD F 90-22.1 (“FBAR”) was not willful and in so holding, gave the IRS a boost in its efforts to combat offshore noncompliance.  A case out of the District Court of the Eastern District of Virginia, Williams had been one of the few sources of precedent for how willful FBAR penalties will be enforced.  The District Court held in favor of the taxpayer, finding, in part, that mere failure to check “yes” as to whether the filer held an interest in a foreign account on Schedule B of Form 1040 was insufficient, alone, to prove willfulness, and the facts and circumstances had to be examined to determine willfulness.  The Fourth Circuit reversed the lower court’s holding as being clearly erroneous.  Significantly, without examining the facts and circumstances, the Fourth Circuit found that the taxpayer’s signature on his return was “prima facie evidence that he knew the contents of the return.”  Moreover, the Second Circuit found that the instructions to line 7a of Form 1040, which cross referenced the FBAR requirement, put the taxpayer on “inquiry notice” of the FBAR filing requirement.  Such notice, combined with the taxpayer’s admission that he never read his tax return nor consulted the FBAR form, resulted in a “conscious effort to avoiding learning about reporting requirements... meant to conceal or mislead sources of income or other financial information... that constitutes willful blindness to the FBAR requirements.”  (emphasis added).  The Fourth Circuit therefore held that the taxpayer willfully failed to file FBARs and found him liable for willful penalties under 31 USC § 5314.

U.S. v. Williams (4th Circuit, unpublished)

APPLICABLE FEDERAL RATES–AUGUST 2012