Treasury Makes Life Easier for Holders of Canadian Retirement Account Interests

Summary: Treasury automates the process for U.S. taxpayers making an election to defer taxation of Canadian RRSPs and RRIFs and to eliminate some information reporting requirements as to those accounts.

U.S. persons are generally not subject to U.S. income tax on individual retirement accounts ("IRAs") until distributions are taken. Canada has retirement accounts similar to IRAs. These are known as Canadian registered retirement savings plans (“ RRSPs” ) and registered retirement income funds (“ RRIFs” ). Similar to U.S. treatment, Canada does not impose its income tax on these accounts until distributions are made from them.

If the beneficiary of an RRSP or an RRIF is a U.S. citizen or resident for U.S. income tax purposes, the deferral of U.S. income tax on earnings of the funds that applies to U.S. IRAs does not apply under U.S. income tax law because these are not U.S. IRAs. This can leave the beneficiary in the unhappy situation of being taxed by the U.S. on the earnings of the Canadian retirement accounts as those earnings accrue but are not distributed, and then being taxed by Canada when distributions are made from the account. Since these events may occur in different tax years, foreign tax credits may not be available to eliminate this double taxation.

The Income Tax Convention between the U.S. and Canada provides a relief mechanism for U.S. taxpayers who are beneficiaries of RRSPs and RRIFs. Under Article XVIII(7) of the Convention, as amended by the 2007 Protocol, a natural person who is a citizen or resident of the United States and who is a beneficiary of a trust, company, organization or other arrangement that is a resident of Canada, generally exempt from income taxation in Canada and operated exclusively to provide pension or employee benefits, may elect to defer taxation in the United States, subject to rules established by the competent authority of the United States, with respect to any income accrued in the plan but not distributed by the plan, until such time as and to the extent that a distribution is made from the plan or any plan substituted therefor.

In Rev.Proc. 2002–23, a procedure for making the treaty election was established, which required the filing of a statement each year with the beneficiary's income tax return. In 2004, the IRS released Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans. This Form facilitated the required reporting and the making of the election.

In Rev.Proc. 2014-55, Treasury has now further simplified the treaty election and reporting process. Essentially, qualified taxpayers are treated as having made the treaty election simply by including in gross income distributions made from the RRSP or RRIF. There is no other notice or filing requirement necessary.

This is a little confusing, since most tax elections require some type of statement or filing with the IRS. Here, while the plan is being held and no distributions are being made, no income is reportable pursuant to the election. But the election itself is not made until a later distribution is made that is reported as income. Even that election itself is odd because no statement is made or boxes checked  - the reporting of the income on the return is the whole election. Such election is then given retroactive effect per the statement in the Rev.Proc. that provides the taxpayer "will be treated as having made the election in the first year in which the individual would have been entitled to elect the benefits under Article XVIII(7) with respect to the plan." The election procedures under Rev.Proc. 2002-23 or under Form 8891 no longer apply.

There are 4 requirements before this automatic, retroactive election applies. These are that the beneficiary:

        A) is or at any time was a U.S. citizen or resident (within the meaning of section 7701(b)(1)(A)) while a beneficiary of the plan;

        B) has satisfied any requirement for filing a U.S. Federal income tax return for each taxable year during which the individual was a U.S. citizen or resident;

        C) has not reported as gross income on a U.S. Federal income tax return the earnings that accrued in, but were not distributed by, the plan during any taxable year in which the individual was a U.S. citizen or resident; and

        D) has reported any and all distributions received from the plan as if the individual had made an election under Article XVIII(7) of the Convention for all years during which the individual was a U.S. citizen or resident.

Once made, the election cannot be revoked without the consent of the Commissioner.

If a beneficiary has previously reported the undistributed income of the Canada plan in his or her U.S. gross income, this election is not available without the consent of the Commissioner.

The Rev.Proc. also simplifies the U.S. information reporting in regard to these accounts. Regardless of whether the beneficiary is eligible to make the above election, Forms 8891, 3520 and 3520-A need no longer be filed for these accounts. However, information reporting on Form 8938 and on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR) will still apply. Previously, there was an exception for Form 8938 reporting if Form 8891 reporting occurred - but since Form 8891 is now obsolete this exception should not apply anymore.

Rev. Proc. 2014-55, 2014-44 IRB, 10/07/2014

Hidden Gift in Merger Transaction

Summary: Disguised gifts found in a merger transaction, along with an interesting story on how the gifts came about.

Most tax practitioners are trained to look behind the transfers occurring in family corporate transactions to determine if a disguised gift is being made. A recent Tax Court case provides a real world example of such gifts

In the case, the parents' manufacturing company was merged with another company owned by their sons. The Tax Court found that the parents' company was substantially undervalued in the merger. Therefore, the parents received less stock in the resulting entity (and the sons received more) than was appropriate based on the relative values of the two companies. This resulted in a taxable gift of $29.6 million from the parents to the sons.

We could stop here and view this as an instructive case on how, if the IRS can successfully challenge values in mergers involving family entities, gifts can arise. However, this case has another interesting aspect.

This is that it is possible that this taxable gift would not have arisen but for the involvement of estate planning attorneys. At a point in time prior to the merger, estate planning attorneys determined that it would be more beneficial for the family if certain intellectual property relating to a manufacturing process for computer circuit boards belonged to the sons' company and not the parents' company. This is because the value of the process would thus not need to be transferred from the parents to the sons during their lifetime or at death in a taxable gift or taxable transfer at death. Factually, however, there was no transfer documentation showing a transfer of ownership of the process from the parents' company where it had been originally developed. Nonetheless, through interviews with the principals and other review of available evidence, the estate planning law firm believed there was enough support to treat the process as having previously been transferred to the sons' company at the time of the formation of that company. They were able eventually to convince the CPAs of the same, even though prior tax returns did not support such a change in ownership of the process. To have some documentation for the ownership in the event of a later IRS examination, the law firm prepared a bill of sale to memorialize a prior transfer of the process to the sons' company.

In valuing the companies in the merger, the position was taken that the ownership of the process was in the sons' company. The Tax Court determined that such a transfer of ownership to the sons' company never took place and thus that the parents' company was worth a lot more in the merger (per the substantial value of the process) than the parents received stock for. This was the source of the large gift found by the Tax Court. One has to wonder whether this gift would have arisen if the estate planning attorneys had not gotten involved.

This case was just resolved. However, the merger and resulting gift occurred in 1995. Thus, in addition to the large gift tax liability, there will be a substantial interest amount due on that gift tax liability. Luckily for the taxpayers, the Tax Court found that based on their reliance on counsel they had reasonable cause for their underpayments of gift tax and are not liable for accuracy -related penalties.

William Cavallaro et ux. v. Commissioner, T.C. Memo. 2014-189

Court Grants 44.75% Fractional Discount in Artwork, but Don't Get Too Excited

SUMMARY: An appellate opinion granting a 44.75% discount for a fractional ownership interest in artwork has limited precedential value.

The Fifth Circuit Court of Appeals recently overruled the Tax Court's 10% fractional interest discount allowed for artwork in an estate tax valuation case. Instead, the appellate court allowed in full the 44.75% discount taken on the Form 706.

The case is of benefit to taxpayers because it does affirm the Tax Court's conclusion that a fractional interest discount is allowable for divided family ownership interests in artwork. The IRS had argued (and lost) before the Tax Court that no fractional interest discount was appropriate. After determining that some fractional discount was appropriate, the Tax Court crafted its own appropriate discount of 10%.

However, the case is not an endorsement the 44.75% discount is appropriate. Instead, the appellate court allowed the full discount taken based more on procedural issues than an objective determination that such a large discount is sustainable in a bona fide valuation dispute. This is because in the Tax Court proceeding, the IRS offered no testimony or evidence on value other than its zero discount position. Once the Tax Court determined that the zero discount position was incorrect, the Tax Court had to determine the value based on the evidence before it. Since the only evidence before it was evidence of the taxpayer supporting the 44.75% discount, the appellate court found that the Tax Court was obligated to accept that 44.75% discount because there was no contrary testimony or evidence offered by the government.

So what does this case offer us? It does sustain a fractional interest discount in artwork in a family situation, but only provides limited guidance as to what an appropriate discount should be. Also, the Tax Court opinion conclusion that restrictions in a co-tenancy agreement that limited the sale of the co--owned art only upon agreement of all owners was not a restriction that could be considered in valuing the fractional interests (i.e., it could not be used to reduce value) is an item to consider in transfer tax valuations. The Tax Court's conclusion was that Code Section 2703(a)(2) prevented the consideration of such a restriction. That Code provision provides that "[f]or purposes of this subtitle, the value of any property shall be determined without regard to... any restriction on the right to sell or use such property." Interestingly, the Tax Court did not hold that the unanimous consent provision was a restriction on sale per se, because cotenants cannot sell the jointly owned property without the consent of all joint owners even without such an agreement. Instead, the unanimous consent provision was interpreted as a waiver of the right of partition of the cotenants, which restriction was nonetheless still described under Code Section 2703(a)(2) and thus was not allowed to enter into the valuation equation.

Estate of Elkins, Junior V. Comm., 114 AFTR 2d 2014-5985 (CA5), 09/15/2014