2017 Inflation Adjustments

Rev. Proc. 2016-55 has provided adjusted figures for 2017 for tax items subject to inflation adjustments. Here are some highlights:

Standard deduction - married filing jointly	$12,700
Standard deduction - single persons	$6,350
Standard deduction for a dependent	$1,050
Standard deduction for aged or blind person	$1,250
Overall Limitation on itemized deductions (Section 68(b))	$313,800 (Married person)
Personal exemption	$4,050
Covered expatriate threshold based on average annual net income tax for preceding five years	$162,000
Covered expatriate gross income exclusion	$699,000
Foreign earned income exclusion	$102,100
Unified credit against estate tax and gift tax	$5,490,000
Maximum §2032A value reduction	$1,120,000
Gift tax annual exclusion	$14,000 (no change)
Gift tax annual exclusion for gifts to noncitizen spouse	$149,000
Tax on arrow shafts (my favorite tax)	$0.50 per shaft
Notice of large gifts received from foreign persons	$15,797
2% interest rate portion on estate tax payable in installments	$1,490,000
Penalty for failure to file a partnership return or S corporation return	$200

Overview of New Section 385 Regulations

The IRS has issued final and temporary regulations under Code Section 385. These provisions, intended to limit earnings stripping, will enhance the IRS' ability to characterize related party ownership arrangements, purportedly established as debt, as equity instead.

One set of rules provides prerequisite requirements that must be met before the IRS will entertain debt characterization. The second set challenges the debt treatment of debt instruments that are not issued for new capital.

The good news is that the new rules will only apply to large or publicly traded entities.

I have done a short summary mind map of the basics of the regulations. You can download it from http://gutterchaves.d.pr/DwHW and when you run the download it should be viewable in your browser.

T.D. 9790

Section 385 Regulations Issued - Not as Harsh as The Proposed Regulations

Earlier this year, the IRS issued proposed regulations on the conversion of purported related party debt to equity - see the discussion here. The IRS has now issued temporary and final regulations on the subject.

Taking into consideration the negative comments that came out against the proposed regulations, the IRS has eliminated or softened some of the more negative aspects of the proposed regulations.

The regulations are quite lengthy - the Treasury Decision is over 500 pages. More to follow, once I have given them a read through.

T.D. 9790

Executor Loses Out on Fees Due to Section 6166 Lien

A personal representative/executor for an estate granted a special estate tax lien under Code §6324A to the U.S. as part of a Section 6166 election to defer payment of federal estate tax. At the time, the executor had been paid only been part of his fees, leaving $486,265 unpaid. The IRS has the ability to demand a lien before allowing a Section 6166 election if adequate bond is not posted.

During the course of the lien period, the value of the liened property fell below the amounts still due to the IRS. The executor asserted his claim to fees was superior to the tax lien, and thus that he could use the liened property as a source of funds for his unpaid fee. The U.S. District Court granted  the executor’s motion for summary judgment on this issue. Because the statute was silent as to priority of administrative expenses, the court gave priority to the administrative expenses based on a “first in time is first in right” theory. On review, the 11th Circuit Court of Appeals overturned the lower court and ruled that the IRS lien has priority. Since the executor’s claim for commissions was not a lien, the “first in time is first in right” common law theory was found not to apply.

Note that under the general estate tax lien of Code §6324, administrative expenses take priority over the government lien. This is due to the express exception under Code §6324(a) that excepts out “such part of the gross estate as is used for the payment of charges against the estate and expenses of its administration.” The appellate court noted no such explicit exception under Code §6324A, and reasoned that if Congress had wanted one, it would have written one in.

The executor argued that his expenses should have superiority - otherwise, it may be difficult to obtain executors to serve. The appellate court rejected this. Their thought process was that the executor has the opportunity to make arrangements for payment of his fees before putting on the §6324A lien, and/or can leave other property for fee payment free of the lien (or not make the Section 6166 election).

The appellate court also noted that allowing the lien to be subject to administrative expenses could lead to partially unsecured deferred payment obligations. Also, since such administrative expenses would not take superiority in regard to any bond posted to secure the deferred tax, they likewise should not be granted superiority in regard to this alternate method for securing the tax.

Hopefully for the executor, he will be able to recoup his unpaid fees from distributions previously made to beneficiaries.

This decision is a trap for the unwary, and “make arrangement for payment of estate administrative expenses, including professional and executor fees outside of liened property” should be added to every practitioner’s checklist when making a Code §6166 election and related §6124A lien.

U.S. v. Spoor, 118 AFTR 2d 2016-xxxx (11th Cir 10/4/16)

Failure to Make Check-Off on Gift Tax Return Bars 5 Year Ratable Treatment for contribution to 529 Accounts

Contributions made to an education Section 529 plan are taxable gifts. However, such a gift will qualify for exclusion as an annual exclusion gift to the extent of the available exclusion for the donee in the year of the gift.

If the amount contributed exceeds the available annual exclusion, Code §529(c)(2) allows that gift to be spread ratably over a five year period for gift tax purposes, if the taxpayer so elects. The Form 709 provides a check box for electing such ratable treatment.

In a recent Tax Court case, the taxpayer made contributions that exceeded the available annual exclusion amounts, but did not make the ratable election on a gift tax return (in one year, he did not file a gift tax return, and in another year he filed but did not make the election). It appears that the taxpayer did not report these amounts as taxable gifts.

Would the taxpayer’s treatment of the gifts as nontaxable constitute a 5 year ratable election, even though the election was not checked on a gift tax return?

No, says the Tax Court. The legislative history to Code §529(c)(2) and the Form 709 instructions require a return to be filed and an election to be checked off. So, since there was no checkoff, the fundings constituted taxable gifts in the year made (less available annual exclusion).

Estate of Edward G. Beyer, et al., TC Memo 2016-183

Filing an Entity Income Tax Return Does Not Constitute a Check-the-Box Election

A single member limited liability company (SMLLC) is treated by default under the check-the-box rules as a disregarded entity. If a Form 8832 is filed, the owner can elect to treat it as a corporation/association.

A single owner corporation was merged into an SMLLC owned by the same person. The surviving SMLLC filed Forms 1120 as a 'c' corporation thereafter. The IRS processed the Forms 1120. No Form 8832 election was ever made to treated the SMLLC as a corporation.

The IRS sought to impose employment tax liabilities on the member of the SMLLC, asserting he was responsible as sole member of a disregarded entity. The member argued that the IRS should respect the SMLLC as a corporation, and not treat it as a disregarded entity. The case ended up in Tax Court.

The member made three arguments. First, he argued that the merger of the two entities was a reorganization under Code §368(a)(1)(F) and thus the SMLLC should be treated as a corporation for Federal tax purposes. The Tax Court determined that absent the filing of a Form 8832, the SMLLC could not be a corporation, regardless of the reorganization status.

The member then argued that the filing of Forms 1120 for the first year after the merger constituted a valid election to be taxed as a corporation. The Tax Court held that a taxpayer can't make a check-the-box election by filing any form it wishes - it must use the Form 8832.

Lastly, the member argued that the doctrine of equitable estoppel prevented the IRS from contending that the SMLLC was not a corporation. The Tax Court described the four requirements of equitable estoppel as (1) a false representation or wrongful misleading silence; (2) the error must be in a statement of fact and not in an opinion or a statement of law; (3) the person claiming the benefits of estoppel must be ignorant of the true facts; and (4) he must be adversely affected by the acts or statements of the person against whom an estoppel is claimed. The Tax Court rejected the equitable estoppel claim since the IRS made no false statement to the member, and it did not agree that the IRS' lack of rejection of the Forms 1120 was a wrongful misleading silence. Further, court advised the the member knew the SMLLC had never filed a Form 8832 to elect to be treated as anything other than a disregarded entity.

Heber E. Costello, LLC, et al., TC Memo 2016-184

U.S. Tax Competitiveness is Abysmal (and Economic Freedom is Trending Downward)

Capital, and all the benefits it provides (investment, innovation, jobs, creation of wealth), flows to where it is treated best. An important element of treatment is how it is taxed. So how does U.S. tax competitiveness measure up against the other OECD countries?

It comes in at a solid 5th worst  - way to go USA! An important contributing factor, according to Center for Federal Tax Policy that issued the rankings, is that the U.S has a " combined federal, state, and local corporate tax rate of 39 percent [that] is significantly higher than the average rate of 25 percent among OECD nations."

Another important international ranking was also recently released - the Index of Economic Freedom. Here, the U.S. ranks number 11. Not bad, but not great for a country touted as the land of the free. More bad news is that the U.S. scored declined by over 1% since 2015, while the world as a whole improved. The long term trend in the U.S. is depressing - in 2008, the U.S. was ranked 5th. You can see the full rankings here.

Business Protection from Payroll Provider Fraud

Many businesses rely on third parties to handle their payroll, including making withholding deposits with the IRS on behalf of the business. Way too often, the payroll provider will embezzle the funds and not pay them over to the IRS.

In this circumstance, the business is still on the hook for the unpaid employment taxes. To add insult to injury, if the IRS takes a hard line it will usually be successful in obtaining interest and penalties from the business. This is based on the view of the courts that a taxpayer's duty to file returns and pay taxes is nondelegable. For a recent example where the employer was held responsible for interest and penalties, see Kimdun, Inc. v. U.S., 118 AFTR 2d 2016-5508 (DC CA 2016).

So what can employers do to protect themselves? One thing that should be done is to check online with the IRS through the FTPS system on a regular basis to confirm that deposits are being made. While doing this may or may not help in a penalty dispute with the IRS, it will alert the business to problems before the tax and penalty liability builds up.

Here is an excerpt from the Internal Revenue Manual on this subject:

5.1.24.5.3  (08-15-2012)
Use of Electronic Federal Tax Payment System (EFTPS) for Payment Verification

An employer should ensure its PSPs are using EFTPS so the employer can confirm payments are being made on its behalf. An employer can register on the EFTPS system to get its own PIN and use this PIN to periodically verify payments. A "red flag" should arise the first time a payroll service provider misses or makes a late payment.

When an employer registers on EFTPS, it will have on-line access to its payment history for 16 months. In addition, EFTPS allows an employer to make any additional tax payments its third-party payer is not making on its behalf, such as estimated tax payments.

Updated Historical Transfer Tax Rates & Exemptions

I have updated this table (last updated in 2013) – you can download it from here.

No Later Voiding of Unnecessary QTIP Elections if Portability Elected

CITE	Rev. Proc. 2016-49
RELEVANT LAW	A QTIP election, once made, is irrevocable. The election has various implications, including: GOOD: Allowance of the marital deduction. ADVERSE: §2044 includes the QTIP trust property in the gross estate of the surviving spouse, and §2519 will take dispositions of the QTIP trust property. ADVERSE: Absent a "reverse QTIP" election under §2652(a)(3), the surviving spouse is treated as the transferor of the property for GST purposes under §2652(a). A decedent's estate should be able to make a QTIP election even though one is not needed (e.g., adequate unified credit would allow for no estate tax even without the election). See the discussion on this below. If unneeded, the above adverse consequences still apply. Rev. Proc. 2001-38 provides that the election will be void and the above adverse consequences will NOT apply if the election was not needed to reduce the estate tax liability to zero, and the procedures of the Revenue Procedure are followed. Note that the procedure does describe various circumstances when it will nonetheless not apply.
RULING PRONOUNCEMENTS	The voiding procedures of Rev. Proc. 2001-38 are not available if a portability election is made (unless the DSUE amount is zero, or in other limited circumstances). In estates in which the estate makes the portability election, QTIP elections will not be treated as void.
COMMENTS	The premise of Rev. Proc. 2001-38 was that no one would intentionally make an unneeded QTIP election, since the adverse effects are significant. With portability, this is not the case. For example, the adverse effects may be mitigated or eliminated - the surviving spouse may have an enhanced gross estate but is also now receiving the DSUE amount to reduce or eliminate future transfer tax on it. Therefore, with portability the adverse effects are ameliorated or eliminated, so it is no longer appropriate to allow for automatic voiding of the QTIP election when it was unneeded to reduce estate tax at the first spouse's death. With portability, at times it may be advantageous to make an unnecessary QTIP election for what would otherwise be an exempt credit shelter trust. For example, by including the bypass trust in the gross estate of the surviving spouse, its assets can now receive a basis step-up at the death of the second spouse - that would not be the case if the trust was an exempt bypass trust. This is more the case for lower value estates where growth in the QTIP trust is not projected to put the surviving spouse's estate into a taxable situation. The estate tax cost of inclusion under §2044 is offset, at least in part,  by the DSUE amount coming over. Thus, this ruling may be a boon to some taxpayers. By affirmatively making an unnecessary election in combination with portability, can the IRS nonetheless void the election of its own accord if it provides an advantage to the surviving spouse's estate, like the above basis step-up? Clearly, the IRS may want to void it, since it provides a basis step-up for what would otherwise have been a by-pass trust. Both the old and the new procedures are relief provisions for taxpayers, and require them to undertake steps to come within them to void the election - they really don't address what the IRS can do on its own motion. The procedures imply that if the taxpayer takes no action, then the QTIP election remains in force. Rev. Proc. 2001-38 was silent on the issue whether the IRS could void the election on its initiative  - that makes sense since there was little reason for it to do so. Now, however, the IRS may want to do so to remove the above basis step-up effect.  Can it do so, even though the taxpayer cannot? The 2016 procedure contains the language "In estates in which the executor made the portability election, QTIP elections will not be treated as void." Clearly, this means the taxpayers cannot use the voiding procedures to later take a second look at the situation and decide to void the prior QTIP election, and that makes sense. But should this be read as a commitment by the IRS that it won't void the election as unnecessary on its own initiative and motion - or just that the taxpayer cannot gain the relief of voiding an election in these circumstances? There are many who think the procedure is a statement by the IRS to not act on its own motion to void, but perhaps that quoted sentence applies only in context of the procedure - i.e., TAXPAYER requests for relief - since the IRS would not need to use the procedure to void then that statement may have no applicability? If the IRS does challenge such a QTIP election, could it prevail in its challenge? It would be difficult, since there are only 3 requirements to make a QTIP election, and none of them relate to whether it is needed to reduce estate tax. For more on this question see the article of Austin Bramwell, Brad Dillon and Lisi Mullen here. Note that taxpayers can still get the same basis step-up and transfer of DSUE without these issues by leaving the assets of the first spouse outright to the surviving spouse.  But they cannot do so when a trust for the surviving spouse is desired (e.g., for asset protection, spendthrift, or remarriage purposes), so the procedure is valuable for supporting this tax planning opportunity when a trust is desirable.  Of course, making a QTIP trust election for the bypass trust comes with other potential adverse consequences, and thus may not often be desirable. For example, if the bypass trust is expected to materially appreciate in value, making the QTIP election exposes that appreciation to estate tax at the second spouse's death if available unified credit amounts are exceeded, as well as potential generation skipping tax.
RESEARCH TAGS	QTIP, portability, marital deduction