IRS WILL NOT EXTEND SECTION 118 CAPITAL CONTRIBUTION CONCEPTS TO NONCORPORATE ENTITIES

Gross income generally includes all income from whatever source derived. At times, entities may receive amounts from nonowners that enhance its capital. For example, local government or groups may make contributions to encourage an entity to set up or expand business in a locality. Are such transfers gross income to the entity?

Code §108 provides that in “the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.” Thus, such capital contributions are not gross income to a corporation.

Contributions to noncorporate entities, like partnerships or LLC’s, are not expressly covered by Code §118.  Outside of the statute, there are common law cases that provide situations when a capital contribution is not taxable. For example, in Edwards v. Cuba Railroad, 5 AFTR 5398 (S.Ct. 1925), third party contributions to capital of a corporation were not considered income.

This would lead one to believe that in the appropriate circumstances, similar contributions to capital by nonowners in noncorporate entities should not be taxable. However, IRS Appeals, in an Appeals Technical Guidance Program Settlement guidelines manual effective on March 2, 2011, has indicated that Code §118 exclusion concepts should not be applied to noncorporate entities.

There are several justifications given for this position. First, it is asserted that the common law rules were replaced by Code §118, and thus the exclusion applies only so far as Code §118 goes. Second, expanded definitions of gross income have effectively voided prior case law precedent of exclusion, such as in Cuba Railroad. Third, the IRS indicated that it is a taxpayer choice as to what form of entity to operate under, and they should be bound by the particular tax provisions that relate to the chosen entity.

Such positions are not law but are only the IRS’ opinion in regard to analyzing its litigation strategy. Given the prior precedent, one can expect some taxpayers to challenge these positions in court even the the manual indicates that the chances of taxpayer success are “remote” and the government’s hazards of litigation are de minimis.

Appeals Technical Guidance Program Settlement, March 2, 2011

DYNASTY TRUSTS IN THE CROSS-HAIRS

A dynasty trust is a trust that provides for an existence that may span many generations. Once upon a time, the rule against perpetuities limited the term of a trust to 2 or 3 generations at most. Now, many states have no limits on the term of a trust, or have very long limits (such as Florida). For transfer tax planning purposes, if the trust is exempt from generation skipping tax by reason of the allocation of the grantor’s GST exemption, the trust assets can be held to benefit many generations without being subject to estate or generation skipping taxes as each generation dies off and new beneficiaries arise.

President Obama’s 2012 budget includes a provision that would limit the GST exemption benefits to a maximum of 90 years. 90 years is still a long time to be exempt from transfer taxes, but it still is a lot shorter than “forever.”

The proposal does not apply to existing trusts – that’s a good thing. Further, with the House of Representatives in the control of the Republicans, it is unlikely that this provision will make it into law in the near future.

However, like a bad penny, once these type of proposals are out there, they tend to show up again and again. This doesn’t mean it will ever pass - just that it will be hanging out there like the Sword of Damocles waiting for the winds of political fortune to shift so as to improve its chances of passage.

Just another reason to giving strong consideration to making gifts during 2011 and 2012 under the favorable gift-giving transfer tax environment.

FINCEN FINALIZES FBAR REPORTING REGULATIONS

FinCEN has issued final regulations addressing various FBAR reporting issues. These rules are effective as of March 28, 2011 for reported due by June 30, 2011 for 2010 years and thereafter.

The new regulations do not address all reporting issues, but they do provide a fair amount of clarification. Per my initial reading of the regulations and the issued comments and explanations, some key points include:

--The use of IRC residency test for U.S. residents subject to reporting has been adopted.

--Clarification has been provided that the U.S. status of entities for reporting purposes is determined by where they are formed.

--Signature authority over an account that triggers reporting now includes ability to control disposition of assets by non-written communication, not just written communications.

--Officers or employees who file an FBAR because of authority over accounts of their employers are not expected to personally maintain records of the accounts.

--Omnibus accounts with U.S. financial institutions that hold assets thrugh a global custodian are generally not reported, so long as the u.s. person cannot directly access the foreign holdings maintained at the foreign institution.

--Domestic trusts with foreign accounts must file FBARs - the test is not the §7701(a)(3) definition of a domestic trust, but whether the trust has ben created, organized or formed under the laws of the U.S.

--Domestic corporations do not include  Section 897(i) electing corporations, per the focus on jurisdiction of formation and not tax elections to be treated as domestic entities.

--There is no mention of foreign persons doing business in the U.S. as persons that must file, notwithstanding prior proposals on that score.

--"Bank accounts" include certificate of deposit and other time deposits.

--Life insurance and annuities are "accounts" but only if they have a cash value. Presumably these rules should not capture term policies, but that is not 100% clear, unless it is established that unearned premium is not cash value.

--Clarifies that determining whether a trust is a grantor trust for purposes of reporting by a U.S. grantor occurs under Internal Revenue Code rules.

--Fully discretionary trust beneficiaries do not have a "present income interest" that will subject them to reporting. Nor do remainder beneficiaries by reason of that status alone.

--The former trust protector provision that could have given rise to reporting has been removed, but it may still have application under the anti-abuse rule when appropriate.

--Anti-avoidance rules have been added.  A United States person that causes an entity, including but not limited to a corporation, partnership, or trust, to be created for a purpose of evading this section shall have a financial interest in any bank, securities, or other financial account in a foreign country for which the entity is the owner of record or holder of legal title.

--Relief for beneficiaries is granted when the trust already reports.

--If someone has more than 24 accounts to report, they need only provide certain basic information.

--Consolidated reports allowed if domestic entity own more than 50% of another reporting entity.

Of course, the 2009 HIRE Act will also require similar reporting Code §6038D reporting of foreign financial assets. Why Congress could not direct FinCEN and the IRS to come up with one filing and one set of rules for foreign financial asset reporting borders on the ridiculous – taxpayers now will have to struggle with two sets of complex and overlapping reporting requirements.

Amendments to the Bank Secrecy Act Regulations – Reports of Foreign Financial Accounts, Federal Register, Vol. 76, No. 37, p. 10234