MANAGEMENT FEES AS RETAINED INCOME RIGHTS UNDER SECTION 2036

Oftentimes, a taxpayer may transfer assets to a partnership or corporation, and either concurrently or later will gift interests in the entity to family members or trusts for family members. Sometimes, the transferor has no ownership interest in the transferee entity, and the funding transaction is treated as a gift. As part of the overall planning, the transferor will be employed by the transferee entity as a manager or some other function and thus will receive payments from the entity.

For some of these transactions, the IRS may interpret the compensatory income paid to the transferor as a retained income interest under Code Section 2036(a). If that is the case, at the transferor’s death the transferred assets may be subject to estate tax even though the transferor has no (or a reduced) ownership interest in them. The overall concern of the IRS is that the transferor gave away the assets to remove them (and future growth) from estate tax at his or her future death, but in effect retained the economic benefits from such transferred assets by being paid a management or other ongoing fee from the transferred assets or business.

To avoid Code Section 2036(a) inclusion, an effort should be made to establish the bona fides of the compensatory arrangement. As is often the case, some taxpayers do this better than others. A recent family limited partnership case provides instruction on how NOT to handle such arrangements.

In Korby v. Comm., 98 AFTR 2d 2006-8115, (CA8 2006), the taxpayer and his wife transferred assets to a living trust, and then into a limited partnership. The living trust was a 2% general partner, and the 98% limited partnership interests were eventually gifted to family members. Over time, the living trust received distributions from the partnership as ostensible “management fees.” The IRS challenged the arrangement, asserting that the compensatory arrangement was instead a retained Code Section 2036(a) right to income of the transferred assets, and sought to include the assets of the partnership in the estate of the taxpayer when he died.

Both the Tax Court and the appellate court agreed that the compensatory arrangement was not bona fide. The particular items that the courts noted in reaching their decision were:

a. The lack of a written management contract;

b. The lack of records as hours spent on managing the partnership;

c. The haphazard timing and amounts of payments; and

d. The failure of the recipient to report the payments as self-employment income.

Therefore, the case is instructive in reminding us about items that should be addressed in planning for bona fide compensation arrangements - a written agreement, proper record keeping, and reporting of such income as compensatory for employment tax purposes.

SPECIAL RULES FOR PAPER FORM 1040 FILERS

Under the recently enacted Tax Relief and Health Care Act of 2006, Congress revived and extended the income tax deductions for state and local sales tax, higher education tuition and fees, and educator expenses. Since these deductions were not in the law when the 2006 Forms 1040 were prepared, taxpayers who use paper forms must be diligent to avail themselves of these deductions since there will not be lines on the forms to remind them. Presumably, computer return preparation programs will be updated in a timely manner to assist their users in properly filing for these deductions.

For paper filers, the IRS is advising taxpayers to make the following modifications to their returns to properly file for these deductions:

STATE AND LOCAL GENERAL SALES TAX DEDUCTION. The deduction for state and local general sales taxes will be claimed on Schedule A (Form 1040), line 5, “State and local income taxes.” Enter “ST” on the dotted line to the left of line 5 to indicate you are claiming the general sales tax deduction instead of the deduction for state and local income tax.

HIGHER EDUCATION TUITION AND FEES DEDUCTION. Taxpayers must file Form 1040 to take this deduction for up to $4,000 of tuition and fees paid to a post-secondary institution. It cannot be claimed on Form 1040A. The deduction for tuition and fees will be claimed on Form 1040, line 35, “Domestic production activities deduction.” Enter “T” on the dotted line to the left of that line entry if claiming the tuition and fees deduction, or “B” if claiming both a deduction for domestic production activities and the deduction for tuition and fees. For those entering “B,” taxpayers must attach a breakdown showing the amounts claimed for each deduction.

EDUCATOR EXPENSE DEDUCTION. Educators must file Form 1040 in order to take the deduction for up to $250 of out-of-pocket classroom expenses. It cannot be claimed on Form 1040A. The deduction for educator expenses will be claimed on Form 1040, line 23, “Archer MSA Deduction.” Enter “E” on the dotted line to the left of that line entry if claiming educator expenses, or “B” if claiming both an Archer MSA deduction and the deduction for educator expenses on Form 1040. If entering “B,” taxpayers must attach a breakdown showing the amounts claimed for each deduction.

IR News Release 2006-195 12/22/2006

IRS AUDIT GUIDELINES ON MANUFACTURING DEDUCTION

Internal Revenue Code Section 199 provides a deduction to domestic manufacturers and producers. In 2006 this deduction is 3%, it increases to 6% for tax years beginning in 2007-2009, and will be 9% in later years, and is applied generally to net income from manufacturing and production (subject to a number of limitations, including that the deduction cannot exceed 50% of the taxpayer's W-2 wages for the taxable year). The IRS has issued a new Industry Director Directive, which, along with an associated document titled “Minimum Checks for Section 199; Law and Explanation,” details the minimum audit checks IRS examiners are expected to complete when reviewing a corporation's deduction.

While compliance with these guidelines will not ensure complete compliance with the requirements for the deduction, they are useful for taxpayers to make sure they are meeting the basic requirements and that they will clear the major audit hurdles. The following summarizes the guidelines and issues that the IRS will review on audit:

1. Does the taxpayer's business make sense with the activity requirements of the domestic production deduction? For example, most resellers (such as clothing stores and wholesalers) should not be claiming the deduction, nor should most professional service companies since they are selling their services even if in this process they provide a tangible item such as a legal document. Auditors are advised to review the corporation's web site and annual report, among other sources, in answering this question.

2. Compare the deduction to the gross receipts or sales less returns and allowances on line 1(c) of the Form 1120 (U.S. Corporation Income Tax Return). Gross receipts reported on line 1(c) of the 1120 should be greater then the deduction. If the gross receipts on the Form 8903 match the gross receipts on line 1(c) of the Form 1120, the taxpayer may have not allocated to non-DPGR nonqualified income amounts such as gross receipts for services or for resale items

3. Is the taxpayer required to allocate gross receipts to remove nonqualified embedded service income, or determine the qualified income portion of a component of an item? If so, how did the taxpayer determine an allocation method?

4. If the taxpayer is required to use the Code Sec. 861 method to allocate and apportion deductions has the taxpayer used it and is it consistent with the application of Code Sec. 861 for foreign tax credit purposes, if applicable? The Code Sec. 861 method must be used to allocate and apportion deductions if the taxpayer's average annual gross receipts exceed $100,000,000 or total assets at the end of the tax year exceed $10,000,000.

5. Has the taxpayer applied the wage and taxable income limitations? For example, under Code Sec. 199(b)(2)(B) , for tax years beginning after May 17, 2006, W-2 wages for Code Sec. 199 purposes only include amounts that are properly allocable to domestic production gross receipts.

While these issues apply only to the small subset of taxpayers who take the deduction, it is worth the effort of those that do to review these guidelines and assure compliance with them.