Tuesday, February 26, 2013


With the increase of the unified credit equivalent amount to $5.25 million and its indexing for inflation, clearly there will be a lot less fewer estates subject to estate tax than when exemptions were lower. The Congressional Research Service issued a report on February 15, 2013 that estimates the number of estates that will be subject to the tax, and these figures are REALLY LOW. They also apply an interesting “how many taxable estates are expected in a given state” analysis.

The conclusions of the report are:

a. The estate tax will affect less than 0.2% of decedents over the next decade.

b. The estate tax is concentrated among high income taxpayers: 96% is paid by the top quintile, 93% by the top 5%, 72% by the top 1%, and 42% by the top 0.1%.

c. About 0.2% of estates with half or more of their assets in businesses will be subject to the estate tax.

d. About 65 farm estates (or approximately one per state) are projected to be subject to the estate tax, and constitute 1.8% of taxable estates. Less than a fourth (0.4%) is projected to have inadequate liquidity to pay estate taxes. Less than 1% (0.8%) of farm operator estates are projected to pay the tax.

e. About 94 estates (about two per state) with half their assets in small business and who expect their heirs to continue in the business are projected to be subject to
the estate tax; they constitute 2.5% of total estates. Less than a half (1.1%) are projected to have inadequate liquidity to pay estate taxes.

The Estate and Gift Tax Provisions of the American Taxpayer Relief Act of 2012, Congressional Research Service, February 15, 2013

Saturday, February 23, 2013


I’ve made a few changes this month. I’ve changed some formatting, but more importantly I have added the §7520 rates to the chart. Also, I am including a new chart that shows 20 years of the long term AFR rate, to give some long term perspective on where rates currently stand.




Sunday, February 17, 2013


Code Section 2519 is a notoriously difficult section to apply. In 2009, I wrote on article on it for Estate Planning, and ever since I’ve been providing a lot of assistance to others on its operation. So I am always interested when a new Section 2519 opinion comes out.

In Estate of Kite, the Tax Court issued an erroneous opinion as to the applicability of Section 2519, at least in my opinion. In Kite, a husband passed away, and assets were funded into a QTIP trust for his wife. Before the wife’s death, some or all of the QTIP trust assets were transferred to a family partnership. Later, the trust was terminated, and all of its assets (including the family partnership interests) were transferred to the wife. She then sold those partnership interests to family members in exchange for a private annuity two days later. She later died before any annuity payments were received, and thus the sold QTIP assets avoided taxability in the wife’s estate based on applicable private annuity rules.

The case is helpful in context of deferred private annuities – the Tax Court upheld the exclusion of the sold assets from the wife’s gross estate. However, the Court also ruled that the distribution of the trust assets to the wife and the sale for a private annuity should be integrated under the step transaction doctrine. Once the transaction was combined, the Court found that the wife had disposed of her income interest in the QTIP trust in the private annuity sale, and thus triggered a Section 2519 gift tax on the value of the remainder interest in the QTIP.

This conclusion is suspect on more than one level:

a. First, if the Court was to disregard the transfer first to Mrs. Kite, then what occurred was a sale BY THE TRUST of its assets for a private annuity. The Court, in addressing both a reinvestment of trust assets into the family partnership and other sales of trust assets to family members, acknowledges that a sale by the trust itself is not a Section 2519 disposition of an income interest since the income interest continues in the newly acquired asset. To say that Mrs. Kite disposed of her income interest in the sale is somewhat specious, since the sale was of all of the trust assets without regard to the value of the income interest alone.

b. Second, and more importantly, the Court applies a technical and strained reading of the statute to achieve a result that was never intended under Section 2519. Section 2519 is intended to avoid a surviving spouse’s estate from avoiding estate and gift tax on assets received by that spouse in a QTIP that escaped taxation at the first spouse’s death by reason of the marital deduction. That is, the first spouse’s estate got an estate tax deduction (and thus no estate taxes were imposed) on assets going into the QTIP trust. However, Code Section 2044 imposes a cost of that tax avoidance – inclusion of the QTIP trust assets remaining at the death of the surviving spouse in his or her estate. Section 2519 was passed as a backstop to Section 2044 to trigger the tax in transactions that would in effect bypass the later taxation of the QTIP trust assets at the surviving spouse’s death. In this case, the Court has instead subjected the surviving spouse to double taxation. To illustrate this, assume that Mrs. Kite received all of the trust assets, and they were worth $1 million. Let’s also assume that the value of the remainder interest is $600,000, and that Mrs. Kite sold the $1 million in assets she received from the trust for $1 million. If Mrs. Kite had died while the $1 million was still in the trust, her gross estate would include the $1 million under Section 2044. When Mrs. Kite received the $1 million in assets, if she had died the day after the full value of the trust assets would still be in her gross estate under Section 2033 (per her direct ownership of them), and thus no estate taxes on the QTIP trust assets were avoided on the termination of the QTIP trust. This is why Section 2519 does not generally apply to principal distributions to a surviving spouse from a QTIP trust. The fact that Mrs. Kite then sells those assets for $1 million in cash does not change the result – she still has $1 million in assets subject to estate tax at her death. Now, if the termination of the QTIP trust and the sale results in gift tax on the $600,000 remainder interest as the Tax Court tells us it does, that $600,000 is taxed twice. First, under Section 2519, and then when Mrs. Kite dies. Something is very wrong here for that to happen.

Now, in Kite, there was no double taxation. But that is because the private annuity functioned to exclude the value of the sold assets and the annuity from Mrs. Kite’s gross estate. If instead Mrs. Kite had sold assets for cash or a promissory note valued at $1 million, or had lived long enough to receive the annuity payments that the actuarial tables predicted, and then she died, this double taxation would show up. The fact that the private annuity functioned to avoid estate tax on this instance is a function of the tax provisions that relate to private annuities and not Section 2519. Indeed, the Tax Court opinion gives no indication that the private annuity aspect of the sale would or should change the Section 2519 result it thought was proper, and Kite as written should apply to all sales in this circumstance, not just sales by deferred private annuity (although perhaps one could argue that it only applied to deferred private annuity sales).

The case is also bad news since it muddies the waters if a surviving spouse receives any distributions from a QTIP trust and then sells the received asset. At what point in time will the sale be far enough away from the distribution date to avoid Kite? Since Section 2519 applies to a disposition of any part of the income interest, the fact that the spouse did not receive and/or sell a substantial portion of the QTIP trust assets would not avoid the applicability of Section 2519.

There is also another facet of the case that raises a question for me. It appears that in 1997, distributions of QTIP trust assets were made to relatives of Mrs. Kite, and these were reported as gifts. If in fact such distributions were made, this should have been characterized as a disposition of a part of the income interest  of Mrs. Kite (via a reduction in trust assets that are there to produce income for the income interest holder) and triggered Section 2519 at that earlier time. If Section 2519 was triggered on that earlier date, it could not have been triggered again at the time of the distribution and sale to Mrs. Kite in 2001, and since a gift tax return was filed in 1997 it would appear that the statute of limitations for additional tax due in 1997 (as would be incurred in Section 2519 applies in 1997 to the full value of the trust) should likely be closed. Thus, Code Section 2519 should not have applied in 2001.

Kite is not all bad news for taxpayers. It provides some favorable findings and rulings on the use of deferred annuities to avoid estate taxes (assuming the annuitant does not live to his or her life expectancy). It also confirms that sales of assets by a QTIP trust do not trigger Section 2519.

I used to tell people raising questions whether Section 2519 applied to a particular set of facts that the best guide for Section 2519 is whether there is an opportunity in the current transaction to avoid estate tax on some or all of the remainder interest assets of the QTIP trust – if yes, then Section 2519 likely applies. By failing to take the purpose of Section 2519 into account in Kite, and even worse, subjecting similarly situated taxpayers to double taxation, the Tax Court did not make this “gut check” and thus may have missed the mark on this one.

Estate of Virginia Kite v. Comm., TC Memo 2013-43

Friday, February 15, 2013


Most entities operating as ‘S’ corporations are corporations formed under state law. However, under the check-the-box rules, a limited liability company (LLC) can elect to be taxed for federal tax purposes as a corporation. With such an election, the LLC can then elect to be taxed as an ‘S’ corporation, if it otherwise meets Subchapter S requirements.

But why would anyone want to do this? How is it done? Are there any pitfalls? A recent article by James R. Hamill addresses some of these issues. A summary of the key points follows.

WHY BOTHER? Probably the main reason why someone would go the LLC route to ‘S’ status is creditor protection. Many states limit the rights of creditors of a member of an LLC to obtaining a charging order. Stock of corporations (‘S’ or not) does not receive similar protection. Therefore, an LLC electing ‘S’ status provides superior creditor protection to its owners. Since ‘S’ status does not impact state law rights as to an entity and its owners, making an election to be taxed as an ‘S’ corporation does not impact creditor rights issues.

HOW IS IT DONE? The LLC and its members could file a Form 8832 to be taxed as a corporation, and then a Form 2553 to be taxed as an ‘S’ corporation. However, Treas. Reg. Section 301.7701-3(c)(1)(v)(C) and the form instructions allow this to be done just by filing a Form 2553, without the need for a Form 8832. However, an unsigned “dummy” Form 8832 election will be needed to be filed with the initial income tax return filed for the corporation as an ‘S’ corporation.

PITFALLS? The major pitfall in this area is to make sure that the operating agreement for the LLC is modified to comply with Subchapter S requirements. The key requirement that a plain vanilla operating agreement will often violate is that prohibiting a second class of stock.  Typical LLC operating agreement provisions such as special allocations of income, gain, loss, or expense (including substantial economic effect provisions under Section 704), Section 704(c) contributed property allocations, preferential returns or liquidation rights, and provisions regarding distributions in accordance with capital accounts, will typically violate the second class of stock rules and thus need to be modified out. The article also notes that while you are engaged in modifying the standard form operating agreement, provisions regarding ‘S’ corporations that are typically found in shareholders’ agreements, such as prohibitions on transferring ownership to nonqualified owners, should be included in the operating agreement.

AVOIDING TRAPS WHEN ELECTING S CORPORATION STATUS FOR AN LLC, by James R. Hamill, Practical Tax Strategies (WGL), Jan. 2013

Sunday, February 10, 2013


Previously, if you held assets in a 401(k) plan and you were under the age of 59 1/2, you were unable to transfer some or all of your plan assets to a Roth plan under the 401(k) plan. A Roth plan allows for later distributions from the plan to be made without income taxes to the plan participant (which is the opposite treatment of IRAs and other qualified pension plans, which are tax deductible on contribution and taxable when distributions are later made).

Under a provision of the 2012 Taxpayer Relief Act, these transfers are now permitted. Two provisos, however. First, your 401(k) plan must otherwise allow for a Roth account. Second, such a conversion will likely result in current income tax to the participant. Interest persons should consult with their plan administrators and tax advisors before making such a transfer.

Code Section 402A(c)(4)(E)

Thursday, February 07, 2013


Code §2501(a)(2) provides that, except as to certain expatriates, U.S. gift taxes do not apply to the transfer of intangible property by a nonresident not a citizen of the United States. This exemption is big enough to drive a truck through, though of course, a truck is TANGIBLE property so a gift of a truck in the U.S. would not be exempt under this rule. The Internal Revenue Code does not provide a definition of “intangible” property.

In a recent Private Letter Ruling, a nonresident income beneficiary of a trust disclaimed his interest in the trust. The disclaimer was not a qualified disclaimer (which would have exempted it from gift tax), because the beneficiary had already received distributions from the trust.

The taxpayer sought a ruling that the income interest was “intangible” property, and thus the gift of the interest via the disclaimer was exempt from gift tax under §2501(a)(2). While not explicit in the ruling, the essential question here was whether one should look through the trust to look at the character of the trust assets that produce income (to determine if the assets were tangible or intangible, and if tangible, to see where they are located), or whether an income interest is inherently an “intangible” regardless of what the trust assets are comprised of.

The IRS ruled that the income interest was intangible property. However, there are two aspects of the ruling that may limit its universal application.

First, the applicable state law was silent on whether a trust income interest is intangible (or not). If a state law has rules on this issue, this could help (or hurt) a similarly situated taxpayer in that state.

Second, there was also a favorable state case that found that an income beneficiary has no ownership interest in trust assets, when the beneficiary had no other powers or discretions over the trust. Different case law in other states may result in a different result. Also, it appears important here that the beneficiary has no other rights in the trust, including powers of appointment, rights to change the terms of the trust, rights to remove the trustee, or other powers. There is some sense to this – such rights over the trust will give some indirect control over principal, and thus makes the argument for look-through treatment more compelling. Since many income beneficiaries have some other rights, such as the right to remove or replace a trustee, or a power of appointment, reliance on this ruling will be more open to question in those situations.

PLR 201250001

Friday, February 01, 2013


Have you given any thought to how Obamacare’s new 3.8% tax on investment income and gains will apply to sales of interests in partnerships and Subchapter S corporations? No, I didn’t think so.

Here is a general overview, including information on a hidden, and frankly nauseating, compliance burden that may apply at times.

1. The starting point is that gains from such sales are subject to the tax. However, only individuals whose “modified adjusted gross income” (MAGI) exceeds certain thresholds will be subject to the tax – the “Gift of the Magi” for those of you with a literary bent. The joint filing threshold for married spouses is $250,000, $125,000 for married filing separately, and $200,000 for all others. As you can see, there is a substantial marriage penalty built into these thresholds. Over time, more and more taxpayers will be subject to the tax since the thresholds are NOT indexed for inflation.

2. Since gains (and other investment income) from trades or businesses are not subject to the tax, Code §1411(c)(4) and Proposed Reg. §1.1411-7 will allow a partner or stockholder to avoid the tax on gains from the sale of ownership interests in partnerships or S corporations that are engaged in business, at least in part. Before a partner or stockholder can use this exclusion, the following requirements must be met:

    a. The entity must be engaged in a trade or business (within the meaning of Code §162);

    b. The trade or business must not relate to the trading of financial instruments or commodities; and

    c. The selling stockholder or partner  must be engaged in at least one trade or business of the partnership or S corporation (generally applying definitions of “material participation” that are used in the passive loss rules.

If the taxpayer wants to use the above exception, this is where the compliance burden kicks in. To use the exception, a deemed sale by the partnership or S corporation of all of its assets (including goodwill) for fair market value must be undertaken, to determine what portion of the gain should be allocated to trade or business gains (as to which the partner or stockholder is deemed to materially participate and which will escape the 3.8% tax) and all other gains (which allocated portion will be subject to the 3.8% tax). Once the gains from such deemed sales are undertaken, adjustments to the amount of gain recognized by the selling owner for purposes of the tax are made.

Deemed sales mean the necessity of obtaining values for the corporate assets at the time of sale. Does this mean that appraisals and valuations of the entity assets will be needed? Probably not. The Proposed Regulations direct taxpayers to apply the principles of Treas. Regs. §1.743-1(d)(2) to make these computations. Such principles are complex and difficult to apply, but generally do not require appraisals. Instead, values of entity assets are obtained by working backwards from the purchase price for the sold ownership interest. However, if the sale is not an arms-length sale, perhaps appraisals will be needed.

How are taxpayers to make these computations if the entity does not cooperate? The IRS is concerned about that, too, and has asked for comments on that issue.

The above analysis and computations will be required all for a 3.8% tax. One can anticipate many circumstances when the accountants fees to undertake the analysis and computations come close to or exceed the tax savings from doing the analysis and computation.

The only saving grace here is that these computations will not be needed in many circumstances involving partnerships and S corporations because either all or none of the gain will be potentially subject to exclusion from tax due to:

a. All assets of the entity are used in the entity’s trades or businesses, and the selling owner materially participates in all of those trades or businesses,

b. None of the assets of the entity are used in the entity’s trades or businesses,

c. The selling owner does not materially participate in any of the entity’s trades or businesses, or

d. The selling owner is under the Obamacare MAGI thresholds.