Discretionary Trust Interest Held Subject to Federal Tax Lien

Code Section 6321 imposes a federal tax lien for unpaid taxes upon “all property and rights to property, whether real or personal” that belong to the delinquent taxpayer. Is a beneficiary’s interest in a trust a property right that the IRS can lien?

This turns on state law, and the rights of a beneficiary and the obligation of the trustee under that law. However, there are some general rules. If amounts are distributable only in the discretion of the trustee, the lien will not usually attach. If the trust provides for mandatory distributions or distributions required under a discretionary standard, then the lien probably applies.

Oftentimes, trusts will be halfway between a wholly discretionary trust and one that requires distributions under an ascertainable standard. In a recent case, the distribution language provided:

The Trustee shall pay to DENNIS MASAKI ENOMOTO so much or all of the net income and principal of the trust as in the sole discretion of the Trustee may be required for support in the beneficiary's accustomed manner of living, for medical, dental, hospital, and nursing expenses, or for reasonable expenses of education, including study at college and graduate levels.

So the trustee is obligated to distribute under an ascertainable standard, but only in his or her “sole discretion.”

The court noted that the case law is mixed on whether a lienable property interest arises from such a clause. In the end, it concluded that there was an interest that could be liened.

The court noted some criteria in these cases that favor the finding of a lien. The first is that there is mandatory language in the clause, such as use of the word “shall.” More particularly, courts note that such clauses often require payment (“shall pay”) and then leave the amount up to the discretion of the trustee. While I do not follow the logic, somehow this favors a lien arising more than if the trustee was given discretion on whether to pay – although the practical result as to the trustee’s authority is probably about the same. Having more than one current beneficiary is a fact that does not support the imposition of the lien.

If there is a lien, how can the IRS enforce it? Some possibilities include waiting around until the trustee makes a distribution and then attaching the distribution, compelling the trustee to make regular distributions under the standard and then attaching those, or attempting to attach and receive the entirety of the trust corpus immediately. The IRS sought the latter. Noting the difficulty of this question, the court did not fully resolve the issue – at this point it only denied the IRS motion for summary judgment on the issue.

Duckett v. Enomoto, U.S. District Court, D. Arizona (April 18, 2016)

Foreign Financial Asset Reporting - Coming Soon to a Domestic Entity Near You

When Form 8938 reporting for foreign financial assets of U.S. taxpayers was first imposed a few years, only U.S. individuals were subject to it. The IRS has now issued final regulations that will commence reporting by domestic corporations, partnerships and trusts owning such assets. Nothing to worry about for this tax season - but next year will be different as this reporting commences for tax years starting after 12/31/15.

This reporting is imposed on "specified domestic entities." Tax preparers and advisors will have the joy of determining each year whether a domestic entity meets the new definitions.

So what is a "specified domestic entity?" For those with an interest, click here for a summary chart to help you with the analysis.

TD 9752

Applicable Federal Rates - May 2016

 

Post-Death Action Reduced Amount of Estate Tax Charitable Deduction

Decedent died and left a majority stake in a real property management corporation to a private foundation. The estate tax value of the stock was $14.182M.

After the decedent’s death, but before the stock was transferred to the foundation, certain things happened, including:

     a. The corporation elected Subchapter S status;

     b. The corporation redeemed from the decedent’s trust a large portion of the company shares for a value far less than the estate tax value.

At least part of the difference in value was attributed to changes in business climate after the date of death and before the 7th month date after death when the stock was appraised for the redemption. The Tax Court, however, found that there was insufficient evidence to support the large decrease in value. There was also concern that the redemption price was calculated on a minority basis even though the decedent owned a majority interest in the company.

Both parties acknowledged that the value of the charitable contribution deduction is based on the date-of-death value of the contributed property.

The Tax Court indicated because of the intrafamily transactions involved in this circumstance (including that family members may have benefited from the reduced transfer to charity), the transaction was subject to hightened scrutiny. It further noted that Congress did not intend “to allow as great a charitable contribution deduction where persons divert a decedent's charitable contribution, ultimately reducing the value of property transferred to a charitable organization.” The court further noted that this concept finds support in the regulations which provide that if a trustee “is empowered to divert the property *** to a use or purpose which would have rendered it, to the extent that it is subject to such power, not deductible had it been directly so bequeathed *** the deduction will be limited to that portion, if any, of the property, or fund which is exempt from an exercise of the power.” Sec. 20.2055-2(b)(1), Estate Tax Regs. Finding that the decedent’s testamentary plan was thwarted by altering the date-of-death value of the intended donation through the redemption, the court reduced the amount of the charitable deduction.

The Tax Court did not say that a mere decline in value of contributed property prior to post-death funding is going to reduce the charitable deduction. What it is saying that in circumstances where a diversion of the property going to the charity is effectively undertaken, then in that circumstance the deduction is subject to reduction.

Estate of Victoria E. Dieringer, et al., 146 T.C. No. 8 (2016)

New Regulations Issued to Expand the Reach of Anti-Inversion Rules

Code Section 7874 seeks to remove the U.S. tax benefits that can apply by inserting a non-U.S. holding company into the ownership structure of businesses formerly conducted through a U.S. holding company. This is a big political issue as several large U.S. multinationals have shifted into a foreign holding company structure in ways that have skirted these rules. Many in the U.S. want to stop such corporate expatriations, and thus the IRS is beefing up the reach of Section 7874 to disincentivize such transfers.

Taxpayers have attempted to work around the technical rules of Section 7874 by breaking up the transactions into numerous steps or conducting ancillary transactions that purport to make the provision inapplicable. New treasury regulations have now been issued to address this planning and to bring such planning into the reach of Section 7874. Both Section 7874 and its existing regulations are quite complex - the new temporary regulations even more so.

The temporary regulations provide new rules under Section 7874 and related provisions: (i) for identifying a foreign acquiring corporation when a domestic entity acquisition involves multiple steps; (ii) that disregard stock of the foreign acquiring corporation that is attributable to certain prior domestic entity acquisitions; (iii) that require a controlled foreign corporation (CFC) to recognize all realized gain upon certain Code Sec. 351 transfers of assets that shift the ownership of those assets to a related foreign person that is not a CFC; and (iv) that clarify the definition of group income for purposes of the substantial business activities test.

T.D. 9761, 04/04/2016

The IRS Is Looking to Recharacterize Related Party Debt as Equity Simply for Failing to Meet on a Timely Basis New Contemporaneous Written Documentation Requirements

In the early 1980's, the IRS issued regulations on the question of when loans to corporations would be recharacterized under Code Section 385 as equity. The conversion of purported debt can have significant adverse income tax effects for the borrower and lender. Those regulations were withdrawn and we have been without regulations since then. The IRS has now issued new proposed regulations on the subject.

Below is a short overview of the new regulations and some observations. The proposed regulations are lengthy and complicated, so there will surely be a lot written about the as they are digested by the tax community.

The good news is that unless I am missing something, these rules only apply to purported debt between affiliated corporations, using an expanded definition of affiliation. Thus, purported debt issued to individuals and noncorporate entities should not be subject to these rules.

The bad news is that if the regulations are put into effect, bona fide debt may be recharacterized as equity by the IRS simply because the debt was not put in writing quickly enough, or the taxpayers did not document in writing the ability of the obligor to repay the debt at or around the time of the loan. That is, the IRS will strip away the benefits of debt simply because new regulatory compliance obligations are not timely observed.

Proposed Section 1.385-1 prescribes general definitions and operating rules. -1(d) allows for the IRS to treat purported debt as part equity and part debt - that is, an all or nothing approach is not required.

Proposed Section 1.385-2 imposes documentation and information that taxpayers must prepare and maintain within required timeframes to substantiate the treatment of an interest issued between related parties as indebtedness for federal tax purposes. Such substantiation is necessary, but not sufficient, for a purported debt interest that is within the scope of these rules to be characterized as indebtedness. Even if these rules are complied with, the IRS can still apply general federal income tax principles on the question of debt vs. equity to make a determination to treat debt as equity.

These requirements will be a new burden on taxpayers, and also a trap for the unwary. Such documentation includes a written obligation to pay a sum certain (that is, unwritten promises to pay will not satisfy these rules). Thus, taxpayers who do not document their debt in writing will not be able to get debt treatment.

The proposed regulations also require written documentation containing information establishing that the issuer's financial position supports a reasonable expectation that the issuer intends to, and would be able to, meet its repayment obligations. I don't like this at all - it is a new requirement and a trap for those that don't know about it. Examples of this new documentation include cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity and other relevant financial ratios of the issuer in relation to industry averages, and other information regarding the sources of funds enabling the issuer to meet its obligations pursuant to the terms of the applicable instrument.

Making matters even worse, the proposed regulations require that these items be prepared within certain short time frames (30 days and 120 days of the transaction, depending on the particular items). This ignores (intentionally or otherwise) that documentation of loan transactions between related entities often doesn't occur until the parties eventually get around to it, or are advised by tax professionals to prepare such documentation after such professionals later learn of the transaction or arrangement. These requirements appear as "gotcha" requirements that will deny taxpayers debt treatment for bona fide debts simply for not meeting regulatory documentation requirements. Is the IRS authorized to do this? Is this good tax policy - that is, denying the anticipated tax character of purported debt, not because it doesn't meet the characteristics of debt but because the IRS issues regulations that require taxpayers to prepare contemporaneous reports demonstrating ability to repay and not allowing taxpayers to prove such ability to repay if the reports were not timely prepared?

This whole regulatory trend of changing basic tax characteristics of items without regard to the substance of transaction or situation because taxpayers do not meet regulatory reporting or documentation requirements is both unfair and disturbing. Another recent example of this is the removal of tax basis from assets that are not properly reported under the new basis reporting rules for assets held in estates required to file an estate tax return - where does the IRS find the authority to remove tax basis from assets? Similar rules also apply in the area of Section 482 where taxpayers must prepare arms-length pricing reports at the time of transactions between related parties if they want to later avoid certain penalties if the IRS does not respect the pricing under Section 482. 

Proposed §1.385-3 provides additional rules that may treat the interest, in whole or in part, as stock for federal tax purposes if it is issued in a distribution or other special types of transactions that are identified as frequently having only limited non-tax effect, or is issued to fund such a transaction.

Proposed §1.385-4 provides operating rules for applying proposed §1.385-3 to interests that cease to be between members of the same consolidated group or interests that become interests between members of the same consolidated group.

The big take away here: if these regulations are put into effect, related party debt between related corporations will not be treated as debt if not in writing, and a written analysis of ability to repay is not undertaken, all within a short time of period of the establishment of the debt. This "penalty" is all without regard to whether the debt meets or does not meet traditional debt elements. If these documentary requirements are met, the IRS can still attack debt under more traditional debt vs. equity elements.

REG-108060-15. Treatment of Certain Interests in Corporations as Stock or Indebtedness

A Death Abroad - Assistance and Issues

The death of a loved one is obviously a difficult time and process for family and friends. If the decedent dies outside of the U.S., the family and friends have the additional burden of dealing with local law and requirements.

The legal and practical process varies by country. So while not comprehensive, below is a list of key practical and legal concerns and information.

• Notification of death to the local authorities.
• Obtaining a local death certificate (which can often take awhile).
• Engagement of a funeral home.
• Cremation vs. repatriation of body decision.
• Preparing for disposition of remains, including transport back to the U.S.  Documentation is likely required both by the U.S. and the local jurisdiction (e.g., local transit permit and notarized Consular Mortuary Certificate required by U.S. Customs.).
• Consular Report of Death Abroad (CRDA).
• Countries can vary on whether embalming is allowed,or who can perform the procedure.
• Autopsy necessity and procedures.
• Travel insurance claims (including coverage for return of remains to the U.S.).

The local U.S. embassy or consulate can provide significant assistance. Items they can help will include:

• Notifying next-of-kin.
• Confirming death, identity and U.S. citizenship of decedent.
• Providing information regarding personal effects and disposition of remains.
• Guidance on forwarding of funds to cover costs.
• If required, serving as provisional conservator of the estate in the foreign country.
• Preparing documents for disposition of remains, and overseeing the process.
• Transmitting the CRDA after foreign death certificate is issued.

See 22 USC 4196; 22 CFR 72.1.

Source: The Final Journey: What Hapens When Your American Client Becomes Seriously Ill, Injured or Dies Outside the U.S., by M. Katharine Davidson