RELIANCE ON COUNSEL DEFENSE WAIVES WORK PRODUCT AND ATTORNEY-CLIENT PRIVILEGE PROTECTION

In litigation, the work-product doctrine and the attorney-client privilege protect materials and communications from discovery by an adversary in litigation. The work-product doctrine excludes from discovery materials prepared in anticipation of litigation because discovery of such materials would hamper the orderly prosecution and defense of legal claims in adversary proceedings. The attorney-client privilege extends to communication between a taxpayer and a “federally authorized tax practitioner” with respect to tax advice, to the extent the communication would be privileged if it were between a taxpayer and an attorney.

Many tax penalties will not apply if the taxpayer had reasonable cause for its tax position. At times, reliance on the advice of counsel in adopting a tax position constitutes reasonable cause.

Reliance on counsel, the work-product doctrine, and the attorney-client privilege, do not play well together, as Salem Financial, Inc. learned in a recent Court of Claims case. Salem is a successor to Branch Investments LLC, a subsidiary of BB&T. In tax litigation, Salem raised reliance on counsel to defend itself against asserted penalties. The Government used that defense to claim access to documents and communications that would otherwise have been protected under the work-product doctrine and attorney-client privilege. The Claims Court sided with the Government, and authorized the release of the contested items since they related to the reliance on counsel defense.

The reliance on counsel defense has saved many a taxpayer from penalties. It is unknown if the taxpayer in this case knew that by using that defense it would be forfeiting the above evidence protections – perhaps the benefits of the defense outweighed the negatives relating to the disclosure of the subject items and thus was intentional.

WHERE’S THE VALUE HERE? A reminder to litigating taxpayers that a reliance on counsel “reasonable cause” defense may result in a waiver of protections otherwise available under the work-product doctrine and the attorney-client privilege.

SALEM FINANCIAL, INC v. U.S., 109 AFTR 2d 2012-XXXX, (Ct Fed Cl  01/18/2012)

REPORTING OF TAX INFORMATION WITH YOUR PASSPORT APPLICATION

Passports are not under the purview of the IRS, and generally do not involve tax administration issues. However, since 1986, U.S. passport applicants have to report certain information when they make their application. Code §6039E.

Proposed Regulations on what must be reported were issued in 1992, but never finalized. Treasury has now issued new proposed Regulations. Under these, the items to be reported are:

(1) the applicant's full name and, if applicable, previous name;

(2) address of regular or principal place of residence within the country of residence and, if different, mailing address;

(3) taxpayer identifying number (TIN); and

(4) date of birth.

Not a burdensome filing, but an additional filing for taxpayers to deal with, nonetheless. The changes from the 1992 proposed Regulations are minor.

Code §6039E also requires reporting for individuals applying for lawful permanent resident status (green card). The items to be reported are more broad. Haowever, while the 1992 proposed Regulations included these items, the new proposed Regulation does not address such applicants.

Most people think the income tax is all about tax. What often goes unrealized is that the income tax provides legal justification for the gathering of reams of data on taxpayers, including marital status, business and investment activities, and asset holding that might otherwise be beyond the interest of government.

Proposed Treas. Regs. §301.6039E-1

APPLICABLE FEDERAL RATES–FEBRUARY 2012

FOREVER IS A LONG TIME

Usually, a taxpayer cannot obtain a charitable income tax deduction for a contribution of property if the taxpayer transfers less than his or her entire interest in the property. However, Code §170(h) does allow for a charitable deduction for a conservation easement granted in property owned by a taxpayer. To qualify, the easement must be granted “in perpetuity” (among other requirements).

In a recent Tax Court case, the taxpayers conveyed a conservation easement in their Colorado property to a charitable organization. The deeds restricted the charity’s use of the gift to “preserve and protect in perpetuity the Conservation Values of the Property for the benefit of this generation and generations to come.” The deeds also provided for the extinguishment of the easement under certain circumstances:

“Extinguishment—If circumstances arise in the future such that render the purpose of this Conservation Easement impossible to accomplish, this Conservation Easement can be terminated or extinguished, whether in whole or in part, by judicial proceedings, or by mutual written agreement of both parties, provided no other parties will be impacted and no laws or regulations are violated by such termination.” (emphasis added)

The IRS sought to deny the deduction since the conservation could be terminated by mutual agreement of the parties, and thus violated the perpetuity requirement (even though the purposes of the easement first had to be rendered impossible to accomplish). The Tax Court agreed with the IRS. Forever means forever, so the retention of a mutual right to terminate violated the perpetuity requirement.

Treas. Regs. §1.170A-14(g)(3) provides that a charitable deduction will not be disallowed merely because the interest which passes to, or is vested in, the donee organization may be defeated by the performance of some act or the happening of some event, if on the date of the gift it appears that the possibility that such act or event will occur is so remote as to be negligible. The taxpayers argued that the likelihood of a mutual termination of the easement was so remote that this regulation should save the charitable deduction. The Court held that this “remoteness” exception was something separate and apart from the perpetuity/extinguishment requirements, and thus could not be applied to override the perpetuity/extinguishment requirements.

So what happens if circumstances change so that the easement no longer makes sense? Does tax law nonetheless require the easement to still go on forever? Treas. Regs. §1.170A-14(g)(6)(i) provide an out:

“If a subsequent unexpected change in the conditions surrounding the property that is the subject of a donation under this paragraph can make impossible or impractical the continued use of the property for conservation purposes, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the donee's proceeds *** from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution…” (emphasis added)

Thus, a judicial termination under these conditions is allowed, without that violating the perpetuity requirements. Forever is a long time, but under the appropriate circumstances, it need not go on, well, forever.

Kayln M. Carpenter, et al., TC Memo 2012-1

REPORTING OF SPECIFIED FOREIGN FINANCIAL ASSETS – TRUSTS & ESTATES

[The following was also published on Leimberg Information Services on January 9, 2012]

EXECUTIVE SUMMARY. Taxpayers with non-U.S. financial assets are subject to new and extensive reporting, commencing with the 2011 tax year filings. The IRS has recently issued guidance, which includes specific rules relating to grantor trusts and interests in foreign trusts and estates. All return preparers should have some familiarity with these new rules.

FACTS. Code §6038D, enacted as part of the Hiring Incentives to Restore Employment (HIRE) Act, will result in the first foreign asset disclosure filings in 2012. Form 8938 will be used to report. In recent weeks, Treasury has released a final version of the Form 8938, Instructions under the form, and temporary and proposed regulations relating to this reporting. Before addressing the specific provisions relating to estates and trusts, a short overview of the filing requirements is helpful.

WHO MUST FILE? (a) A “specified person,” (b) with an “interest,” (c) in “specified foreign financial assets (SFFAs),” (d) that meet stated filing thresholds, and (e) that otherwise has to file an income tax return, is required to prepare the Form 8938. Generally, a “specified person” at this time is an individual that is a U.S. citizen or resident alien. An “interest” means ownership of a subject asset in such a manner that income, gain, loss, expense from that item would be reported on an annual return of the taxpayer (regardless of whether there is income, gain, loss or expense for the current year). The filing threshold for a U.S. resident is SFFAs in excess of $50,000 on the last day of the tax year or $75,000 at any time during the year. Higher thresholds exist for married persons, and persons residing abroad.

WHAT IS AN SFFA? There are two types of assets that are a “specified foreign financial asset.” The first is a financial account of the taxpayer maintained by a foreign financial institution. The second is an asset not held in such an account, if held for investment, and that is: (a) stock or securities issued by a non-U.S. person, (b) a financial instrument or contract with a non-U.S. issuer or counterparty, or (c) an interest in a non-U.S. entity.

VALUATION. Values of SFFAs must be determined, both to determine if the filing threshold has been met, and to report the value on the Form 8938. Reasonable estimates of value are (thankfully) allowed.

PENALTIES. Failure to fully disclose will result in monetary penalties of $10,000 (up to a maximum of $50,000), absent reasonable cause. Failure to report will also result in statute of limitations extensions on income, both relating to the unreported SFFAs and potentially to all income of the taxpayer.

DUPLICATIVE REPORTING. For FSSAs reported on other tax forms, reporting may not be necessary under the Form 8938. However, those filings must be referenced on the Form 8938.

TRUST AND ESTATE ISSUES. There are some specific rules and aspects that relate to trusts and estates.

1. At this point in time, domestic trusts are not reporting taxpayers – only individuals need to report. At some point in the future, domestic entities that are availed of to avoid reporting will also need to report.

2. In counting SFFAs to see if the filing threshold is exceeded, or in actually reporting SFFAs, a beneficiary is not treated as owning the assets of a trust or estate. However, owners of an interest in a grantor trust will report the SFFAs of the trust attributed to them, subject to some exceptions.

3. An interest of a beneficiary in a foreign trust or a foreign estate is itself an SFFA. However, the beneficiary needs to know or have reason to know about the foreign trust or estate based on readily accessible information before it will be considered an SFFA. A receipt of a distribution from the estate or trust constitutes knowledge for this purpose.

4. In determining the “maximum value” of a beneficial interest in a foreign trust, the maximum value is the sum of (a) the fair market value on the last day of the year of all cash and property distributed to the beneficiary, and (b) the actuarial value on the last day of the year of the beneficiary’s rights to receive mandatory distributions. If the beneficiary cannot obtain information to calculate (b), they can use only the value under (a).

5. In determining the value of a beneficial interest in an estate, the taxpayer can limit the computation to that described in 4.(a) above, if it cannot obtain the information needed to value the beneficial interest.

COMMENT. Tax preparers are now obligated to inquire about the foreign assets of their clients so that proper reporting can be made. This will require preparers to be familiar with the foregoing rules, including what constitutes an SFFA and the application of the rules to interests in trusts and estates. Note that the Form 8938 instructions and accompanying regulations provide additional detail and exceptions beyond the general overview provided above.

Importantly, reporting of foreign accounts on an FBAR does NOT relieve taxpayers of reporting SFFAs on the Form 8938.

As noted above, a mere beneficial interest in a foreign trust or a foreign estate is an SFFA that is subject to reporting if the filing thresholds are met. There is no guidance that limits this to current beneficiaries or vested remainder beneficiaries. Thus, contingent beneficiaries at this point should report to avoid a risk of penalty, although an argument can be made that such persons do not have the requisite “interest.”

The valuation aspects are interesting. As to interests in a foreign trust, a beneficiary is not generally required to obtain valuation of the trust assets, since he or she needs only to report the value of distributed property. However, if the beneficiary has a mandatory distribution right, an actuarial computation is required. To compute this, the value of the underlying trust assets in that situation will be needed. For foreign estates, some effort will need to be undertaken to obtain the value of the beneficiary’s interest. Helpfully for beneficiaries of foreign trusts and foreign estates, if readily accessible value information is not available, valuation can be limited to the value of distributed property that is received.

The question arises whether values reported on the Form 8938 can be used by the IRS to challenge asset values for other purposes, such as estate or gift tax transfer values for transfers occurring in the tax year or in the future. There is nothing that prohibits the IRS from using the reported values, although the probative value of such reporting is arguably limited since the form only requires “reasonable estimates” of value. Nonetheless, to avoid issues if there are somewhat contemporaneous transfers subject to estate or transfer taxes, some coordination of reporting is advisable to avoid creating inconsistent reporting problems to the extent workable within the confines of the Form 8938 reporting rules.

CITES: Code §6038D; Form 8938 and Instructions; TD 9567, Reporting of Specified Foreign Financial Assets (12/14/11); Treas.Regs. §1.6038D-1T, -2T, -3T, -4T, -5T, -7T, & -8T.

VALUE OF AN LL.M. DEGREE

I almost never link to other blogs, but I am making an exception today. I am often asked about the value of an LL.M. degree. This blog post suggests that the only worthwhile LL.M. degree in law is for tax, and then only if it is obtained from NYU, Georgetown, or the University of Florida. I would also add degrees from the University of Miami School of Law - perhaps there are others, but I don't know enough about them to comment.

The Value of the LL.M. Degree? Still Low, by Elie Mystal

SOME IMPORTANT 2012 DATES AND AMOUNTS

Most readers are aware of the $5 million exemption amounts for 2011 and 2012 for federal estate, gift and GST taxes. Keep in mind, however, that the exemption for 2012 is indexed for inflation, and thus is actually $5,120,000. Rev.Proc. 2011-52, §3.29.

Federal tax returns usually due on April 15 will be due on April 17 in 2012 (April 15 is a Sunday and April 16 is Emancipation Day, a Washington D.C. holiday).

IRS OPENS 3RD OFFSHORE VOLUNTARY DISCLOSURE PROGRAM

Taxpayers with unreported offshore accounts or entities now have a third bite at the apple. The IRS has reopened its offshore voluntary disclosure program to allow delinquent reporting with reduced penalty and criminal exposure.

The program is similar to the 2011 program, but there is presently no deadline to apply (unlike prior programs which had a fixed expiration date). However, taxpayers with an interest should not unduly delay, since the IRS has reserved the right to close the program or increase penalties at any time. The new program also has a penalty of 27.5% of the highest aggregate balance in the foreign bank account or entities or the value of the unreported assets during the eight full tax years prior to disclosure. This is up from the 25% that applied in the 2011 program.

Participants must file all original and amended tax returns and include payment for back taxes and interest, as well as paying accuracy-related and/or delinquency penalties. At times it may be beneficial to conduct reporting outside of the program. Consultation with a qualified tax professional is recommended.

IR-2012-5, Jan. 9, 2012

THAT’S A GOOD WAY TO AVOID INCOME ON DAMAGES

The starting point for most damages recovered by litigants is that the damages are gross income. The hunt then is on for some exception to gross income treatment. A recent private letter ruling illustrates one favorable path, if it fits the facts.

Here, the taxpayer recovered damages from a defendant that had interfered with the taxpayer’s agreement to buy assets of a unit investment trust. The effect was the taxpayer had to pay more for the acquired property than if there had been no interference.

Instead of treating the damages as an item of gross income, the ruling allows the taxpayer to treat it as a nontaxable return of capital in the acquired assets. Thus, the effect is no income tax on the proceeds received, to the extent they do not exceed the adjusted basis of the taxpayer in the subject assets. Should the damages exceed the total basis, then income to that extent would occur. Also, the adjusted basis of the taxpayer in the assets would be reduced for the damages received. This will increase the likelihood of future gains from the property if and when sold.

The key here was an injury to property. If a recovery compensates a taxpayer for injury or loss to the taxpayer's property, it is considered a restoration of capital to the extent of the taxpayer's capital interest therein. Rev.Proc. 67-33, 1967-2 CB 659. Therefore, a review of the facts in recovery situations to determine if there is a property interest that was damaged and compensated is a worthwhile endeavor.

PLR 201152010, December 30, 2011

BEWARE THE INTERMEDIARY SALE CORPORATION

There are acquisition companies out there that promote a benefit to ‘C’ corporation shareholders that are looking to sell their business. If the corporation sells its assets, there will often be substantial corporate gains and income tax. The acquisition companies instead offers to buy the shares of the company from the shareholders. The acquisition companies represent that they have available tax losses that can be used to offset the corporate gains, and thus indicate they can avoid or minimize the corporate taxes on the sale of assets. The assets of the corporation are sold and the proceeds of the sale are used to pay off the purchase price for the share purchase of the shareholders. The benefit to the shareholders in doing a stock sale is that the acquisition company will pay them more for their stock than they would receive if the corporation sold its assets, paid its income taxes on the sale, and then liquidated and distributed the remaining sale proceeds to the shareholders. Of course, the acquisition corporation retains some of the sale proceeds as its pay for its role. The additional payment to the shareholders and the compensation retained by the acquisition corporation is funded by the purported corporate tax savings from the tax losses of the acquisition corporation.

This is what occurred in a recent Tax Court case. Unfortunately, the Tax Court made three findings that potentially leave the shareholders in a bad place.

First, the Tax Court held that the asset sale by the corporation, followed by the sale of shares by the shareholders to the acquisition corporation, was recast as an asset sale followed by a liquidation and not a stock sale. This recharacterization alone may have been enough to blow up the tax planning, since presumably the acquisition corporation’s losses could not be used to offset the selling corporation’s gains on the asset sale – thus the anticipated tax savings that lubricated the transaction would not exist. The Tax Court did not need to take this tack. Instead, the Tax Court determined that the tax losses that the acquisition corporation claimed to have were not valid. The result was the same – the selling corporation had no losses to offset its gains, and thus unexpected corporate level taxes were incurred.

The third finding was that since the transaction was characterized as a corporate liquidation, the shareholders as recipient of corporate assets under the deemed liquidation were personally responsible for the unpaid corporate tax  liabilities as transferees under Code Section 6901. Since the acquisition corporation was paid through the retention of some of the sale proceeds that effectively should have gone for payment of corporate taxes, it is likely that the shareholders will end up with less after they pay the corporate taxes than if they had just sold the assets and liquidated. Of course, perhaps the shareholders can recover their shortfall, including potential interest and penalties, from the acquisition corporation. But then again, perhaps not.

It is notable here that the corporation sold its assets and ceased its business prior to the sale of the shares to the acquisition company. Perhaps if the sale of shares preceded the sale of assets, the court may not have found a constructive liquidation. However, it is likely that some risk of a constructive liquidation will nonetheless remain since one doubts whether the acquisition corporation would purchase the shares of the company absent a binding contract by the company to sell its assets to a third party shortly after the stock purchase. Such a binding arrangement would still leave plenty of room for a court to still impose its recharacterization.

Feldman, TC Memo 2011-297