DING TRUSTS–A PRIMER

As a practitioner in Florida, a state without a state individual income tax, planning for state income taxes is not an every day event. Nonetheless, it does come up on occasion, and of course, it is a regular issue for residents of states with such taxes.

Below is an overview and primer on a planning technique that has received some favorable private letter rulings. It generally involves the transfer of assets (oftentimes a highly appreciated asset) to a trust in an asset protection trust jurisdiction. The principal purpose of the arrangement is to avoid state income on income and gains from the asset.

Thanks to Stephen Liss of Barclays for much of the information for this primer, taken from his presentation on the subject in Boca Raton last week.

I. Benefits

     A. Avoid state income taxes on sale of appreciated assets and other investment earnings

     B. Asset protection

     C. Grantor retains access to gifted property via usual asset protection trust mechanisms

II. Elements

     A. Trust in an asset protection trust jurisdiction (e.g., Delaware, Nevada) that has no state income tax

          1. Delaware useful with its directed trust statute

     B. Non-grantor trust

          1. To avoid state income tax to the grantor under grantor trust rules

          2. Typically done by requiring an adverse party to have to consent to distributions to spouse or grantor (i.e., a trust beneficiary)

               a) Can have several beneficiaries and allow distribution only on consent of one of them

     C. Funding via incomplete gift

          1. To avoid transfer tax on funding of the trust

III. Detriments

     A. Need for a local trustee in the trust jurisdiction

     B. Costs

          1. Drafting

          2. Accounting/tax returns

          3. PLR cost, if sought

          4. Trustee fees

     C. Makes no sense if grantor will not already be in the highest federal tax bracket, per trust tax rate compression which will push the trust quickly into the highest income tax bracket. Saving state income taxes while increasing federal income taxes will diminish or eliminate the benefits of the planning

     D. Distributions of trust income to the grantor (or other beneficiaries) may still be subject to state income tax

IV. Watch

     A. Confirm qualification under state law to avoid income tax

          1. Some states, such as Illinois, Virginia, and Wisconsin may tax the trust or the settlor if the settlor was a resident there when the trust was established

          2. Some states will subject the trust to tax if there is a resident co-fiduciary

V. Candidates

     A. Grantor is in a high income tax state

     B. Grantor is in a high or the top federal income tax bracket

     C. Pending sale of a highly appreciated asset

PRODUCTION INCLUDES GROWING

A U.S. shareholder of a controlled foreign corporation (CFC) has gross income on its share of the CFC's subpart F income. This income includes “foreign base company sales income” or FBCSI. FBCSI generally involves income from the related party purchases or sales of property.

However, Treas. Regs. §1.954-3(a)(4)(i) excludes from FBCSI income derived in connection with the sale of personal property manufactured, produced or constructed by the CFC. A recent private letter ruling addressed the question whether planting and growing activities constitute manufacturing or production for this purpose.

The IRS did allow for the growing activities to constitute production under the facts of the ruling. So it is useful that the IRS did not declare that growing activities cannot be production.

Beyond that, it is hard to say what the IRS meant. Did they say that growing activities in conjunction with other related production activities can give rise to excluded production income for the combined activities, but that pure growing activities alone will not? Or did they say that growing activities alone can constitute production if and when it meets the specific tests provided in the regulations, such as the substantial transformation test, the substantial in nature test, or substantial contribution test?

PLR 201340010

MORE RISK FOR QUIET DISCLOSURES

I have previously written on the “quiet disclosure” alternative for complying with U.S. offshore reporting requirements. See my prior posts here and here. Under this alternative, late filing taxpayers will not participate in the Offshore Voluntary Disclosure Initiative (OVDI) program. Instead, they will simply file the delinquent returns and reporting forms late – (i.e., a “quiet disclosure”), and hope that the IRS does not pick up on them for audit or penalty purposes.

A key benefit of the OVDI program is the substantial mitigation of criminal tax prosecution. Those that proceed with a quiet disclosure do not obtain this benefit. Nonetheless, in pursuit of a policy of seeking to have taxpayers become compliant by whatever means, perhaps the Treasury Department would not want to pursue criminal prosecutions against quiet filers since that would likely deter future compliance by other taxpayers. Presumably, Treasury would prefer “quiet disclosure” to no disclosure.

Recent discussions by professionals suggest that quiet filers may be more at risk than they suppose. For example, some practitioners have indicated that it is clear that the IRS has figured out a way to detect non-program disclosures, and that such filers may be subject to civil penalties higher than those imposed on OVDI participants (even OVDI participants that opt out of OVDI penalty procedures).

See Jaime Arora, IRS Auditors Taking Closer Look at 'Quiet' Disclosures of Offshore Accounts, 2013 TNT 202-4 (10/18/13) for an article on this subject. Thanks to Mitchell Goldberg of our firm for bringing this article to my attention.

LATE PAYMENT OF INTEREST VOIDS CODE §6166 DEFERRAL OF ESTATE TAX ARRANGEMENT

Code §6166 can be a lifesaver for estates with large business assets. The provision will allow qualifying estates to defer payment of estate taxes on their business interests, and then pay off the tax liability over a 10 year period. Interest must be paid annually on the unpaid tax. Essentially, the IRS becomes a bank and allows the estate to defer full payment of the estate tax for up to 15 years. The purpose of the section is to avoid a fire sale of the business interest to pay estate taxes, and thus to allow a more orderly sale to occur or to allow time to pay the tax out of the cash flow of the business or other sources.

In a recent Tax Court case, an estate made several years of interest payments, but then stopped. The estate applied for, and received, additional extensions to make interest payments based on inability to pay and ongoing estate litigation issues. Eventually, however, the IRS lost patience and asserted its rights under Code §6166(g)(3)(A) to terminate the deferred payment arrangement when payments are late. The estate sought to challenge such termination as an abuse of discretion by the IRS.

The Tax Court ruled in favor of the IRS and upheld the termination of the Code §6166 election.

Some takeaways from the case:

     a. The estate was embroiled in litigation between beneficiaries and its fiduciaries. To a certain extent, the IRS was sympathetic and granted extensions of times for interest payments. At some point, the IRS lost patience and terminated the election. Oftentimes in estate litigation it is difficult or impossible for the disputants to act coherently or uniformly as to applicable tax issues. Such problems may be used to obtain discretionary extensions of time to pay interest and taxes from the IRS, but the IRS may or may not by sympathetic to such requests.

     b. The fact that the total amount of estate tax due is under audit and the subject of dispute with the IRS will not bar the IRS from being able to terminate the Code §6166 election for nonpayment. In this case, one of the business properties was the subject of dispute as to value – the original Form 706 reported its value at approximately $9 million (the value upon which the original Code §6166 deferral was sought and obtained), a supplementary Form 706 reported it at $0, and the IRS is now seeking to value at over $90 million (yikes!). The Tax Court explicitly ruled that such pending valuation matters were not a bar to the IRS terminating the election for nonpayment.

Estate of Franklin Z. Adell, TC Memo 2013-228 (September 30, 2013)

THE GOVERNMENT SHUT DOWN

Libertarians exclaim – “see, the government is shut down and people barely notice!” Big government types exclaim – “see, the government is shut down and things are terrible!”

Well, there is one group that should be happy  - federal tax delinquents. The IRS has updated its website to advise:

During the lapse in appropriations, the IRS is not sending out levies or liens - either those generated systemically or those manually generated by employees.

The website further advises:

In non-criminal cases, the only enforcement actions the IRS is taking during the appropriations lapse involve isolated instances where we need to take immediate action to protect the government's interest.

Viva la shutdown!

Just so no one gets the wrong idea that there is only good news:

Taxpayers should continue to file and pay taxes during a lapse in appropriations as they would under normal government operations. Individuals who requested an extension of time to file should file their returns by Oct. 15, 2013. Taxpayers can file their tax return electronically or on paper, though the processing of paper returns will be delayed until full government operations resume. Payments accompanying paper tax returns will still be accepted as the IRS receives them. Tax refunds will not be issued until normal government operations resume.

IRS Operations During The Lapse In Appropriations

TAX COURT RESPECTS “NET, NET GIFT” TREATMENT

Okay, I know what you are thinking – what is a “net, net gift?”

Most estate planners know that a “net gift” is a gift transfer when the donee assumes responsibility for applicable gift taxes. Normally, a donor is responsible for gift taxes on a gift, and they are paid from separate assets or funds of the donor. If it is a net gift, the donee pays the taxes – usually, but not always, from the assets that are gifted. Since the donor is receiving consideration for the gift (the payment of tax paid by the donee), the amount of the gift subject to gift tax is reduced.

A “net, net gift” adds in a second payment obligation. Here, the donee also agrees to pay any increase in estate taxes imposed on the donor’s estate under Code §2035(b) relating to the gift. That provision adds back to the gross estate any gift taxes paid on a gift if the donor dies within 3 years of the gift. Remember that there is an advantage to making gifts and paying gift taxes, instead of holding the assets until death and paying estate taxes. If a gift tax is paid by the donor, the tax is gone and no gift or estate tax is paid. If the gift is not made, the estate tax on the same transferred assets are still included in the gross estate and are thus subject themselves to estate tax. Code §2035(b) was enacted to prevent death bed gifts from obtaining this gift tax benefit – if death occur within 3 years the gift tax is subject to estate tax so no transfer tax benefit arises from the gift.

The Tax Court had previously ruled in McCord v. Commissioner, 120 T.C. 358 (2003) that a net, net gift payment obligation could not reduce the value of a gift for gift tax purposes. The Court was reversed by the 5th Circuit Court of Appeals in Succession of McCord v. Commissioner, 461 F.3d 614 [98 AFTR 2d 2006-6147] (5th Cir. 2006), which allowed the reduction. Since the current case is not a 5th Circuit case, the Tax Court is not bound by the Court of Appeals in Succession of McCord under the Golsen rule. Nonetheless, the Tax Court discarded its prior analysis in McCord and allowed a gift tax value reduction for the Code §2035(b) estate tax assumption element.

Here are some interesting take-always from the opinion:

     a. Computing the actuarial value of the assumption of the contingent obligation to pay estate taxes if the donor does not survive three years is not simple. For those with an interest, the petitioner’s attorney and her appraiser wrote an article on the subject which was referenced in the opinion: Michael S. Arlein & William H. Frazier, “The Net, Net Gift”, 147 Tr. & Est. (Arlein & Frazier) 25 (2008).

     b. A relatively large gift is needed to obtain a material reduction from the net, net gift. A large gift was involved in the case – total gifts of more than $71.5 million. The value of the estate tax assumption obligation (and thus the gift tax value redction) was determined to be approximately $5.8 million.

     c. If the payment of consideration is “too speculative,” then no reduction in the value of the gift should apply. The Court of Appeals in McCord applied the willing buyer/willing seller test to this determination by asking whether a willing buyer would insist that the seller factor the contingency into the price – if yes, then it should be recognized as consideration reducing the amount of the gift.

    d. If actuarial science cannot reasonably determine a value for a contingency, then it will likely be ignored. The opinion cited Robinette v. Helvering, 318 US 184, wherein the Supreme Court disregarded a contingency when the factors to be considered in fixing the values of the contingent remainders on the date of the gifts included: (1) whether a daughter would marry; (2) whether a daughter would have children; and (3) whether those children would reach the age of 21. The Supreme Court noted: "[W]e have no reason to believe from this record that even the actuarial art could do more than guess at the value here in question.”

     e. The computation here is not beyond the reach of actuarial science. The court noted:

In this case, as in McCord, the contingency in issue is whether petitioner would survive three years after the date of the gift. Like the contingency in Smith, this contingency is simple and based on the possibility of survivorship; it is not complex like the contingency in Robinette, which depended on multiple occurrences.

     f. The fact that estate tax rates and exemption amounts may fluctuate over the three year term of Code §2035(b) does not create enough uncertainty as to make it impossible to value the contingent tax payment obligation.

     g. One of the theories applied in a net gift situation is the ‘estate depletion theory.’ Under the estate depletion theory, a donor receives consideration in money or money's worth only to the extent that the donor’s assets have been replenished. The IRS argued that the donor obtained no replenishment, only the donor’s estate. The Court equated the donor and the donor’s estate for this purpose, rejecting the IRS argument.

     h. The dissenting opinion did make an interesting policy argument that favors the IRS. Code §2035(b) was intended to put a donor who makes a gift subject to gift tax the day before he dies on the same footing as he would be if he did not make the gift and thus the gifted assets are instead subject to estate tax. By allowing a reduction in the amount of the gift for the contingent payment obligation, the amount of the gift tax is reduced, and thus the amount of the add-back under Code §2035(b) is effectively reduced. Thus, there is still a benefit to making a death bed gift notwithstanding Code §2035(b) if a net, net gift is made – and as such, the operation and purposes of Code §2035(b) can be partially subverted.

Steinberg v. Comm., 141 TC No. 8 (9/30/13)

DEDUCTIBLE CHARITABLE CONTRIBUTIONS CAN BE MADE THROUGH AN AGENT

Most taxpayers making charitable contributions will transfer their own funds or property to the charitable recipient. What happens if another person or entity makes the actual transfer to the charitable recipient?

Prior case law will allow a charitable deduction to a taxpayer, if the funding of the charitable contribution is made by an agent of the taxpayer acting for the taxpayer.  Skripak, 84 TC 285 (1985) ; Weitz, TC Memo. 1989-99.

A recent Tax Court Memorandum decision expands on these principles. The key take-always from the decision are:

a. For the taxpayer to be able to deduct the contributions, the taxpayer will need to show that he or she bears the economic burden of the contributions.

b. A written agency agreement establishing the agency relationship is not required. However, there must be some evidence of the agent’s asset to act on the taxpayer’s behalf.

c. Agency will be easier to establish when the agent has property of the taxpayer and uses that property to make the contribution.

d. However, and contrary to the desire of the IRS, if the agent uses its own funds with the understanding that the taxpayer will reimburse the agent, the taxpayer will be treated as bearing the economic burden of the contributions. An actual failure to reimburse, however, will open the door to denial of the deduction.

Zavadil, TC Memo 2013-222