Stretch IRAs to be Hit?

Presently, if an IRA owner does not fully withdraw the balance of his IRA during lifetime, his or her heirs may be able to spread the withdrawal of the inherited IRA over the life expectancy of the recipient. By being able to slow down the required distributions, the taxation of the income that has been deferred from income tax within the IRA will be deferred further and spread over an extended period of time. Such IRAs are referred to as “stretch IRAs.”

A provision of the Retirement Enhancement and Savings Act of 2016, which cleared the Senate Finance Committee in September by a vote of 26-0 and which was introduced to Congress in November, seeks to limit stretch IRAs. Under the proposed legislation, IRA balances of an individual that aggregate over $450,000 will need to be distributed within 5 years of the death of the account owner, except in regard to distributions to the surviving spouse of the owner, disabled or chronically ill individuals, individuals who are not more than 10 years younger than the owner, or children of the owner who have not yet reached the age of majority. The proposed Act has other provisions, some of which are taxpayer friendly – you can review a summary here.

Will this make it into law next year? Historically, there is a strong likelihood of passage when a bill clears the Senate Finance Committee by unanimous vote.

Applicable Federal Rates - January 2017

New Reporting Requirements for U.S. Disregarded Entities Owned by Foreign Persons

Code § 6038A imposes reporting and recordkeeping requirements on domestic corporations that are at least 25% foreign-owned. They are required to file an annual return on Form 5472 with respect to each related party with which the reporting corporation has had any reportable transactions.

In newly issued regulations, the IRS will treat U.S. disregarded entities, such as single member LLCs not electing to be taxed as a corporation, as U.S. corporations for this purpose. Thus, their foreign owners will now have to file a Form 5472 if the U.S. disregarded entity has any reportable transactions with related persons and entities.

To add insult to injury, a number of exceptions to some of these obligations for smaller reporting corporations and for de minimis transactions will NOT apply to these entities.

Bear in mind that financial transactions between the owner of the U.S. disregarded entity and the entity itself will constitute reportable transactions and trigger this reporting. For example, the regulations provide this example:

(i) In year 1, W, a foreign corporation, forms and contributes assets to X, a domestic limited liability company that does not elect to be treated as a corporation under §301.7701-3(c) of this chapter. In year 2, W contributes funds to X. In year 3, X makes a payment to W. In year 4, X, in liquidation, distributes its assets to W.

(ii) In accordance with §301.7701-3(b)(1)(ii) of this chapter, X is disregarded as an entity separate from W. In accordance with §301.7701-2(c)(2)(vi) of this chapter, X is treated as an entity separate from W and classified as a domestic corporation for purposes of section 6038A. In accordance with paragraphs (a)(2) and (b)(3) of this section, each of the transactions in years 1 through 4 is a reportable transaction with respect to X. Therefore, X has a section 6038A reporting and record maintenance requirement for each of those years.

Failing to file results in a $10,000 penalty, so failures to file will be painful. And yes, there will be plenty of failures to file. First, it will be awhile until the new filing obligation is disseminated and absorbed by accountants performing international tax compliance, Second, for taxpayers using tax preparers who are not well-versed in international tax compliance, a lot of those preparers will not be knowledgeable of this filing requirement. Lastly, there will undoubtedly be owners of disregarded entities who will not use third party tax preparers and thus will oftentimes remain in the dark about these filing requirements.

The new rules apply to tax years of entities beginning on or after January 1, 2017 and ending on or after December 13 (31??), 2017.

T.D. 9796, 12/12/2016; Reg. § 1.6038A-1, Reg. § 1.6038A-2, Reg. § 301.7701-2

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IRS FINALIZES REGULATIONS THAT LIMIT NONRECOGNITION ON CERTAIN OUTBOUND SECTION 367(a) TRANSFERS & OTHER OUTBOUND RULE CHANGES

U.S. persons transferring appreciated property to foreign corporations may be eligible for nonrecognition of gain using Section 351 or the corporate reorganization provisions. However, Code §367(a) and its regulations provide exceptions to nonrecognition for transfers of certain property based on the policy that it is appropriate for the U.S. to tax the gain in such items at the time they move to foreign corporate taxpayers.

Previously, foreign goodwill and going concern value were excepted from gain recognition under Code §367(a), based on legislative history that allowing such items to escape gain recognition would not adversely impact the U.S. Per more recent Treasury determinations that this exception was being abused, Proposed Regulations eliminated this exception, and now final Regulations have adopted such a rule.

Another change involves outbound transfers of intangible property in nonrecognition transfers. Under Code §367(d), the U.S. transferor is treated as having sold the property in exchange for payments that are contingent upon the productivity, use or disposition of the property, and as receiving amounts that reasonably reflect what would have been received annually in the form of such payment over the shorter of the property’s useful life or 20 years. Under the final regulations, when the useful life of the property is indefinite or more than 20 years, taxpayers can still apply the 20 year period - but the taxpayer has to include during the 20 year amounts that would have been required to be included over the useful life of the transferred property following the end of the 20 year period.

T.D. 9803

RECKLESS INDIFFERENCE IS ENOUGH FOR WILFULLNESS FINDING FOR PURPOSES OF FBAR NONFILING PENALTIES

A husband and wife had an accounting in Switzerland at UBS AG, into which they deposited commissions from camera sales and also directed some of their international customers to make deposits. In 2007, the tax year at issue, the taxpayers did not file the required Form TD F 90-22.1 (FBAR) form with the Department of Treasury which they should have filed to disclose their interest in the UBS account (such FBAR reporting now occurs on FinCen Form 114). They also did not file FBARs, nor U.S. income tax returns, for other tax years. In 2010, the taxpayers applied to participate in the Offshore Voluntary Disclosure Program (OVDP), and filed delinquent income tax returns and FBARs. The FBARs failed to report other non-U.S. accounts of the taxpayers, and the income tax returns failed to report certain commission income. The taxpayers were ultimately rejected from the OVDP program.

At issue was whether the 2007 failure to timely file an FBAR was “willful,” and the meaning of willfulness in this context. The civil penalties for failure to file an FBAR are substantially higher for a willful failure than a nonwillful failure. The willful failure penalty can be as high as the greater of $100,000 or 50% of the balance of the unreported account for each year.

31 USC §5321(a)(5), which imposes the willful penalty, does not provide a definition of willfulness. The taxpayers argued that willfulness means only intentional violations of known legal duties. The Government sought to expand the definition to include reckless disregard of statutory duties. The U.S. District Court noted that the position of the taxpayers was based on case law involving criminal liability, not civil liability. Regarding civil liability, it is true that that the IRS Chief Counsel, in Chief Counsel Advice 200603026, opined that the willfulness standard for purposes of 31 USC §5321 is the same as the criminal standard. But the U.S. District Court noted that IRS Chief Counsel Advice may not be cited as precedent. Noting that other cases have found reckless disregard to be enough to constitute willfulness under 31 USC §5321, the court joined the chorus and reached the same conclusion.

Upon analysis of the facts, the court went on to find that the taxpayers’ failure to file was willful per their reckless disregard of their statutory duties.

Note that the court also addressed the issue whether the government’s burden of proof on willfulness was a mere preponderance of evidence standard, or a higher clear and convincing burden of proof. The court determined that a mere preponderance of evidence was all that the government needed to meet.

The lack of a definition of willfulness has been problematic in this area. The District Court’s expansive reading to include reckless disregard is not favorable for taxpayers. A review of the facts leading to the finding of reckless disregard will be instructive to taxpayers and advisors looking for guidance in this area. No single fact was determinative here – a conglomeration of the following was enough to tip the scale in the government’s favor:

1. The taxpayers were found to be reasonably sophisticated business people.
2. The taxpayers failed to provide a home address to UBS, and kept the UBS account hidden from everyone (including their tax preparers) except their children.
3. The taxpayers made no inquiries of any lawyer, accountant, or banker about their reporting requirements as to the account.
4. On the Form 1040, there is a question that asks if taxpayers have an interest in or signatory authority over a financial account in a foreign country, and that question directs them to see instructions for the exceptions and filing requirements for Form TD F 90-22.1. In the opinion of the court, this provision rendered the taxpayers’ statements that they were unaware of, or did not understand, their reporting obligations as not credible. Other statements by the taxpayers that they believed no reporting was required because they intended to use the accounts for retirement were similarly held to be not credible.
5. The taxpayers’ bad behavior regarding their OVDP application was problematic, including misrepresenting that all the funds in the UBS account were after-tax proceeds from their camera business, their failure to disclose other foreign accounts, and their filing of false income tax returns that excluded taxable income earned by them.

Thus, there were a number of bad facts here. Whether the court would have found reckless indifference if less than these facts were present is unknown. Nonetheless, the listed items are useful as examples of facts that the government and the courts will take notice of in making the willfulness determination.

U.S. v. Bohanec, 118 AFTR 2d 2016-XXXX (DC CA 12/8/16)

Existence of Unpaid Tax Claim in Bankruptcy Opens the Door to Expanded Statute of Limitations on Fraudulent Conveyances

In bankruptcy proceedings, if the bankruptcy trustee seeks to gain access to assets that the debtor transferred prior to bankruptcy under fraudulent conveyance law, the trustee must act within the applicable state fraudulent conveyance law statute of limitations. For example, in Florida, this would mean transfers occurring more than 4 years prior to the bankruptcy could not be challenged by the trustee.

A recent Bankruptcy Court case demonstrates a large loophole in this limitation, In that case, the debtor owed a substantial sum to the IRS. Section 544(b) of the Bankruptcy Code provides that:

the trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim that is allowable under section 502 of this title or that is not allowable only under section 502(e) of this title.

What this means for the benefit of those who do not deal much with bankruptcy is that if the debtor owes money to a creditor for an unsecured claim, and the statute of limitations on collection for that claim has not yet expired, the bankruptcy trustee can effectively step into the shoes of the creditor and seek to collect on that claim using the statute of limitations that the creditor could use. Since the IRS generally has 10 years to collect on a tax assessment under Code §6502(a)(1), a statute of limitations far longer than most state statutes involving fraudulent conveyances, the issue in the recent case was whether the bankruptcy trustee could avail himself of the 10 year statute of limitations instead of the 4 years allowable under state law to proceed on a fraudulent conveyance claim. The bankruptcy court held the extended 10 year statute applied, noting that most of the other bankruptcy courts that have taken on the issue have similarly ruled for the extended statute.

The court noted that this use of Section 544(b) has not been widely availed of. It did note that “[the IRS is a creditor in a significant percentage of bankruptcy cases. . . If so, widespread use of § 544(b) to avoid state statutes of limitations may occur and this would be a major change in existing practice.”

For debtors with this issue, consideration should be given to paying the IRS before bankruptcy (without running afoul of applicable voidable payment rules), if that is a viable option.

Thanks to Elizabeth Bowers for reporting on this case at the recent RPPTL Florida Bar meeting (Asset Protection Committee).

In re Kipnis, ---- B.R. ----, 2016 WL 4543772, 118 A.F.T.R.2d 2016-5639 (S.D. Fla. 2016)

 

3 Strikes Against the IRS in Attempting to Impose Fiduciary and Beneficiary Liability for Estate Taxes

During her lifetime, Anna Smith established the Anna Smith Family Trust, a revocable trust administered for her benefit. Initially, Anna was initially a co-trustee with two of her children, but eventually became sole trustee. A significant asset of the trust was stock of a closely held company that owned a gaming license.

Anna later died, and her estate filed an estate tax return showing $15.958 million in gross estate assets, showing $6.631 million in estate tax, and the estate paid $4 million in taxes with the return. The estate made a Section 6166 election to pay the remaining taxes in installments. The trust provided for distributions of trust assets to limited partnerships owned by the heirs, and for direct distributions to heirs, after Anna’s death.

An additional $1 million was paid in estate taxes. Eventually, the closely-held stock was distributed to the beneficiaries due to issues with state law restrictions on a gaming license being owned by a trust – at that time, $1.46 million in estate taxes remained due. In conjunction with the distribution, the beneficiaries entered into an agreement to pay all unpaid estate taxes.

After an estate tax audit and settlement, the estate taxes were increased by an additional $240,381. The following year, an IRS agent sent a letter to the executor advising her of an alternative to continued personal liability for the deferred estate tax, which would be to provide a special lien under Code §6324A. Thereafter, the estate provided the IRS with an executed Agreement to Special Lien Under Section 6324A signed by all four children of the decedent, an agreement restricting the sale of the stock while the lien on the stock was in effect, and the additional information about the stock requested by the IRS.

Thereafter, the IRS agent advised that District Counsel had informed her that closely held stock should not be accepted as collateral because the IRS cannot publicly sell it without violating securities regulations. The parties agreed to revisit the issue in two years, but the IRS never contacted the fiduciaries.

Four years later the company filed for bankruptcy. As shareholders, the heirs never received any value for their stock ownership in the bankruptcy.

A year after that the IRS sent delinquent billing notices to the fiduciaries for the deferred estate taxes. Four years later, the IRS brought suit to collect the outstanding estate taxes against the fiduciaries and beneficiaries, asserting fiduciary liability under Code §6324(a)(2), fiduciary liability under 31 U.S.C. §3713, and beneficiary liability as transferees and to enforce the obligation of the beneficiaries to pay taxes under their promise to pay all unpaid estate taxes. The District Court initially ruled in favor of the government for partial summary judgment. Upon reconsideration, the IRS lost on all of its arguments.

A review of the avenues of liability and how the U.S. lost reveals some interesting aspects to these avenues. So how did the IRS lose on all of its attempts?

Code §6324 liability of trustees. Code §6324(a)(1) imposes a ten year general lien against all assets included in the gross estate for payment of estate taxes. Code §6324(a)(2) imposes personal liability on a trustee or transferee for taxes not paid when due for “property included in the gross estate under sections 2034 to 2042.” The trustees argued that the trust property was included under Code §2033 and thus did not come within this liability provision. The IRS claimed the trust property was included under Code §2036 and/or §2038 as a transfer with a retained life estate or because of the decedent’s ability to alter, amend, revoke or terminate the revocable trust. To resolve this, the court noted it must first analyze whether the trust assets were ever "given away" such that decedent lost the beneficial ownership of them during her lifetime, or in other words, whether a "transfer" for purposes of §§2036 and 2038 did or did not occur prior to decedent's death. The court found that while legal title did transfer to the trustee, there was no change in beneficial ownership of trust assets during the decedent’s lifetime. Thus, gross estate inclusion was under §2033 and thus no fiduciary liability under Code §6324(a)(2) arose. That the decedent was also sole trustee of the trust was a helpful, but not necessarily determinative, fact.

31 U.S.C. §3713 liability of fiduciaries. The federal claims statute will impose liability for taxes on a fiduciary who distributes assets under administration while there is an outstanding tax liability if that liability goes unpaid. A discharge of liability under Code §2204 will eliminate §3713 liability. Code §2204 relieves a fiduciary from liability for estate taxes if the fiduciary makes written application and posts bond – the granting of a special lien under Code §6324A qualifies as a bond for this purpose.

The principal issue here was that the fiduciaries never formally applied to the IRS for discharge under Code §2204 – at least not in the manner most practitioners are familiar with relating to such requests for relief when the estate tax return is filed. The court found that there are no authorities or regulations requiring a specific format, form, or working to make an application for discharge. It held “the government has only identified that the application should be made to ‘the applicable internal revenue officer with whom the estate tax return is required to be filed.’ 26 C.F.R. § 20-2204-1. The purpose of the application, according to the text of the statute and regulations, is for the government to provide the fiduciary with a determination of the amount owed.” Since the parties were aware of the tax due when the special lien was filed, the court did not believe a separate written application beyond the lien paperwork was required (and even if it was, the written correspondence between the parties would meet that requirement). Thus, the fiduciaries were protected by Code §2204 in regard to federal claims statute liability even without a formal application for discharge.

Third Party Beneficiary Theory. The government was on the right track with its argument that as a third party beneficiary of the agreement by the beneficiaries to pay the estate taxes, it could enforce that agreement. The problem, however, was that it sat on its hands and allowed the six year state statute of limitations on contract claims to expire. The court did not buy into the government’s argument that the 10 year federal tax collection statute of limitation applied, and not the state statute.

United States v. Mary Carol S. Johnson et al. (U.S District Court for Utah Central Division - Case No. 2:11-cv-00087)

Burden of Proof Issues in Gift Tax Matter

A recent case illustrates 3 important burden of proof issues.

The general facts of the case involved a merger of a company owned by parents with a company owned by children. The gift tax issue involved the relative value of the two companies to determine how much, if anything, was transferred to the children by the merger due to their resulting stock ownership in the merged company.

A rebuttable presumption of correctness cloaks an IRS notice of deficiency. Thus, the taxpayer typically bears the burden of proving by a preponderance of the evidence that the Commissioner's assessment is erroneous. However, there are some circumstances where the burden of proof shifts to the IRS.

One of these is if the deficiency notice is excessive and arbitrary - i.e., that the notice bears no factual relationship to the taxpayer's liability. In the case, the original deficiency notices assumed that the parents' company had no value. The IRS later conceded a portion of the original deficiency, allowing some value to the parents' company. The taxpayers argued that this backtracking from the original deficiency notice shifted the burden of proof to the IRS since the deficiency notice was thus excessive and arbitrary. The appeals court determined that the value shifting intent of the taxpayers, along with other associated documents, gave enough support to the IRS at the time it issued the deficiency notice so that its notice was not arbitrary and excessive. The issue here was a question of degree of a value shift, and not a lack of a rational foundation for the deficiency notice. The court noted that a finding of excessive and arbitrary usually arises when the IRS makes no evidentiary showing at all to support the deficiency notice.

The second burden of proof issue related to Rule 142(a) which allows a burden shift when a "new matter" is raised at trial. The taxpayers argued that the original theory in the notice of deficiency was that the parents' company was a worthless sham, and then the IRS later shifted to a theory that the taxpayers overvalued the parents' company - and thus, this involved a new matter. The notices of deficiency provided: "[U]nder IRC Section 2511[,] donor's merger of Knight Tool Co. into Camelot Systems, Inc. in return for 19% of the stock of Camelot Systems, Inc. resulted in a gift of $23,085,000.00 to the other shareholders of Camelot Systems, Inc. Accordingly, taxable gifts are increased $23,085,000.00." The appellate court did not read a sham argument into the notice of deficiency - instead, the issue originally was, and remained, the value of the parents' company - the taxpayers were on notice that the theory of liability was the valuation of the entities.

The last burden of proof issue involved a battle of the experts, and what a taxpayer must prove in challenging the government's expert. In the trial, the reports of the taxpayers' experts were rejected because they were based on the erroneous assumption (as determined by the Tax Court) that the childrens' corporation owned key business technology that the Tax Court determined to be owned by the parents' corporation. This left the only supported expert report with the government, which report treated the technology as owned by the parents' corporation.

Since the taxpayers had the burden of proof, the Tax Court placed on them the burden to show the proper amount of their tax liability. Since they had no valuations left standing to do so, the Tax Court did not allow the taxpayers to challenge the correctness of the government's expert and report, and adopted the valuation of that report in full, even while remarking on its arguably flawed analysis.

The appellate court found that the taxpayers did not have the obligation to prove the correct amount of their tax liability. Thus, they should have been allowed to challenge the government's expert report, and if successful, then the Tax Court should have determined for itself the correct tax liability rather than simply adopting the government's position. Thus, the appellate court remanded the case to the Tax Court to determine if the government's valuation has methodological flaws that makes it arbitrary and excessive, and if it does, the Tax Court should then determine the proper tax liability. In making that determination, it need not precisely establish the correct amount but can use reasonable approximations.

Cavallaro v. Comm., 118 AFTR 2d 2016-XXXX (CA1), 11/18/16