DISREGARDED ENTITIES ARE NOT ALWAYS DISREGARDED

Under the check the box rules, entities owned by one person can often be disregarded for federal tax purposes. Such entities are referred to as "disregarded entities."

As time has progressed since the passage of the check the box rules, the IRS has created more and more exceptions to the disregarded treatment. For example, disregarded entity status is ignored or modified in regard to employment and withholding taxes of a disregarded entity.

The IRS has now issued final treasury regulations that provide that an entity whose disregarded status is ignored for employment tax purposes will be treated as a corporation. Treas. Regs. §301.7701-2(c)(2)((iv)(B).

It would be helpful to put in one place the several exceptions that now exist to disregarded entity status. The following is a summary of the principal exceptions, but is not intended to be exhaustive. If any readers think I have missed anything major, please feel free to comment to this posting and let us know what the item is.

     A. Status is modified if the single owner of the entity is a bank. Treas. Regs. §301.7701-2(c)(2)(iii).

     B. Status is modified for certain tax liabilities. Treas. Regs. §301.7701-2(c)(2)(iii). These include:  (1) federal tax liabilities of the entity with respect to any taxable period for which the entity was not disregarded; (2) federal tax liabilities of any other entity for which the entity is liable; and (3) refunds or credits of federal tax.

   C. Disregarded status ignored or modified for taxes imposed under Subtitle C—Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24, and 25 of the Internal Revenue Code) and taxes imposed under Subtitle A, including Chapter 2—Tax on Self-Employment Income. Treas. Regs. §301.7701-2(c)(2)(iv)(A).

     D. Status is modified for certain excise taxes, as described in Treas.Regs. §301.7701-2(c)(2)(v). Although liability for excise taxes isn't dependent on an entity's classification, an entity's classification is relevant for certain tax administration purposes, such as determining the proper location for filing a notice of federal tax lien and the place for hand-carrying a return under Code §6091 .

     E. Conduit financing proposed regulations will treat a disregarded entity as separate from its single member. Code §7701(l).

     F. Special rules will apply in hybrid situations. Hybrid situations are circumstances where an entity is not disregarded in one jurisdiction but is disregarded in another.

          (1) Hybrid payments made between a CFC and its hybrid branch, or between two hybrid branches of a CFC, would be recharacterized as subpart F income in the same amounts, if the conditions of the regulations are met. Those conditions are as follows: (1) the hybrid branch payment reduces the foreign tax liability of the payer; (2) the payment would have been FPHC income if paid between two CFCs; and (3) a disparity exists between the effective rate of tax on the payment in the hands of the payee and the hypothetical rate of tax that would have applied if the payment had been taxed to the payer. If no tax rate disparity exists, no recharacterization would occur. Proposed Regulations under TD 8827, 1999-30 IRB 120.

          (2) In certain cases, payments made by domestic reverse hybrid entities to related foreign interest holders are recharacterized as a dividend. Such payments are recharacterized as dividends to the extent of the interest holder's proportionate share of payments by the domestic entity to the domestic reverse hybrid entity that are treated as dividends by either jurisdiction. The recharacterization as a dividend means that the payments cannot be deducted by the domestic reverse hybrid entity. This prevents the use of a domestic reverse hybrid entity to make deductible payments to the foreign interest holder that are taxed at lower withholding tax rates. Treas.Reg. §1.894-1(d)(2)(ii)(B).

          (3) Special rules relating to allocation of foreign tax credits. Prop.Regs. §1.901-2(f)(3).

NO SURPRISE HERE

There has been quite a bit of buzz about a recent bankruptcy case involving an Alaska asset protection trust. However, the case merely confirms a weakness in the use of domestic asset protection trusts that was obvious even before this case.

Domestic asset protection trusts (DAPTs) promise the holy grail of creditor protection – a trust where the settlor/grantor can transfer assets to, be a discretionary beneficiary of, but still have the assets of the trust be protected from the settlor’s/grantor’s creditors. Alaska, Delaware, and Nevada are three popular jurisdictions for these trusts.

There are open questions about the effectiveness of the trusts for creditor protection purpose, including enforceability across state lines under the U.S. Constitution. A major issue is the 10 year voidability provision of 11 U.S.C. §548(e) that entered the U.S. Bankruptcy Code in 2005. That provision provides that a trustee in bankruptcy can reach the assets a debtor transferred to a trust:

that was made on or within 10 years before the date of the filing of the petition, if –

(A) such transfer was made to a self- settled trust or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar device; and
(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

A transfer to a DAPT will typically meet the requirements of (A)-(C) above. The big question is whether a transfer to a DAPT demonstrates the requisite “actual intent to hinder, delay or defraud” under (D). Since DAPTs were created to address creditor issues, and are marketed as providing that benefit, a reasonable person would suspect that the use of one demonstrates the actual intent to hinder, delay or defraud, even if the settlor was not rendered insolvent by reason of the transfer. Note, however, that Alaska law expressly provides that a settlor’s expressed intent to protect trust assets from a beneficiary’s potential creditors is not evidence of an intent to defraud.

In Battley v. Mortensen, a bankruptcy court in Alaska found that a transfer to a DAPT could run afoul of 11 U.S.C. §548(e), even though the debtor was solvent at the time of creation of the trust. The court noted:

when property is transferred to a self-settled trust with the intention of protecting it from creditors, and the trust’s express purpose is to protect that asset from creditors, both the trust and the transfer manifest the same intent. In this case, I found that the trust’s express purpose could provide evidence of fraudulent intent.

The court did not give any effect to the provision of Alaska law that indicated the trust language could not be used as evidence of an intent to defraud. There were other factors that the court found that evidenced intent to defraud, so it is uncertain how the court would have ruled absent those other factors.

Nonetheless, the case confirms the exposure that the use of a DAPT leaves the door open to the reach of a trustee in bankruptcy within 10 years of the funding of the trust. Since a debtor can be placed in bankruptcy by his creditors on an involuntary basis, one cannot simply avoid this exposure by not filing for bankruptcy protection.

DAPTs are still useful for those that do not expect to have significant creditor issues within the next 10 years, but are in a high risk field and thus still desire its protections over an extended period beyond 10 years. Further, DAPTs can provide tax benefits via moving assets out of the taxable estate of a grantor while still allowing a discretionary beneficiary interest to the grantor. Nonetheless, in these circumstances, the constitutional issues regarding DAPTs still remain.

Battley v. Mortensen, Memorandum Decision & Memorandum on Defendant’s Motion for Reconsideration (Case No. A09-00565-DMD, United States Bankruptcy Court, D. Alaska)

DETAILED PROTECTIVE REFUND CLAIM GUIDANCE RELEASED

The IRS has released detailed guidance to taxpayers on how to file and administer protective refund claims for amounts that are not currently deductible under Code Section 2053 when the Form 706 is filed (such as contested or uncertain claims and expenses that have not yet been paid). As part of its guidance, the IRS announced that it will create a Schedule PC to be attached to the Form 706 to assist taxpayers in filing these protective claims at the time of filing of the Form 706.

FACTS

Final regulations under Code Section 2053 were published on October 20, 2009 to provide guidance in determining the deductible amount of a claim against a decedent's estate, particularly in regard to contested or uncertain claims and expenses. The final regulations provide, with certain exceptions, that the amount deductible for a Code Section 2053 claim or expense is limited to the amount actually paid in settlement or satisfaction of that claim or expense. For amounts not paid or otherwise deductible by the time the Form 706 is filed, the Regulations allow a protective refund claim to be filed. This allows for a refund to be sought later if amounts are paid or become deductible after the expiration of the estate tax statute of limitations. Rev.Proc. 2011-48 provides details on how to file and administer protective refund claim.

TIMING. The protective refund claim must be filed before the expiration of the Code Section 6511(a) statute of limitations. This is 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid.

CONTENT OF PROTECTIVE CLAIM. The protective claim must be a written declaration that is executed under penalties of perjury, listing each ground upon which a refund is claimed and facts sufficient to apprise the Commissioner of the exact basis of the claim. Required information includes:

a. An explanation of the reasons and contingencies delaying the actual payment to be made in satisfaction of the claim or expense.

b. Information on whether other protective claims for refund are being filed or were previously filed and the approximate date on which each was filed.

c. If the claim is being contested, specified information about the contested matter and the potential liability of the estate.

EVIDENCE OF AUTHORITY. The protective claim must be accompanied by documentary evidence, including certified copies of the letters testamentary, letters of administration, or other similar evidence, to establish the legal authority of a fiduciary or other person to file and pursue a protective claim for refund on behalf of the estate of a decedent. However, if the protective claim is filed by same person that submitted the Form 706, the only thing needed is a statement affirming that the fiduciary or other person filing the protective claim for refund also filed the Form 706 and that such fiduciary or other person is still acting in a representative capacity.

WHICH FORM TO USE. For decedents dying after October 19, 2009, and before January 1, 2012, the claim is filed using Form 843. For decedents dying on or after January 1, 2012, the claim can be filed on a Form 843, or on a Schedule PC filed with Form 706. This Schedule does not yet exist, but should simplify the process for making a protective claim if made at the time of the Form 706 filing.

SEPARATE CLAIM REQUIREMENT. A separate claim filing is required for each claim or expense for which a deduction may be sought. Multiple Schedules PC should be used, if making the claims with the Form 706 filing.

Related and ancillary expenses relating to resolving, defending, or satisfying the identified claim or expense as well as certain expenses relating to pursuing the claim for refund for the identified claim or expense are not considered separate claims for this purpose, but are included in the separate claim to which they relate.

REJECTION PROCEDURES. If a protective claim filing is rejected by the IRS, a corrected (and signed) protective claim for refund can be refiled before the expiration of the period of limitation or within 45 days after the date of the Service's notice of the defect, whichever occurs later. Thus, a defective election filed shortly before the expiration of the statute of limitations should have an opportunity to cure even though the statute runs out before receiving the Service’s rejection.

FOLLOW-UP REQUIREMENTS. The IRS will generally accept or reject filed protective claims, and notify the taxpayer. The taxpayer should contact the IRS if no IRS acknowledgment of the protective claim filing is received within 180 days of filing a Schedule PC or 60 days of filing a Form 843. If such taxpayer contact is not made within 30 days of the applicable deadline, an estate will lose the ability to correct a defective claim if the statute of limitations has expired (even if the estate has proof of mailing the protective claim to the IRS).

NOTIFICATION OF RESOLUTION OF CONTINGENCIES. To obtain a refund, the taxpayer must notify the IRS when the claim is ready for consideration (that is, once deductibility is permitted by reason of payment or otherwise meets the regulatory requirements for deduction). The notification generally should describe the relevant facts that support, and provide evidence to substantiate, a deduction under Section 2053 and should claim a refund of the overpayment of tax based on the deduction under Section 2053 and the resulting recomputation of the estate tax liability.

This notification must be submitted within a "reasonable period" after the item becomes deductible. There is a 90 day safe harbor that will meet the “reasonable period” requirement. If filed later, a reasonable cause explanation must be submitted. Special rules apply for multiple or recurring payments.

The Revenue Procedure provides specific information on what must be included in the notification, and whether the notification must be made on a Supplemental Form 706 or a Form 843.

MISC. The existence of a protective claim will not affect Form 706 audits. The new rules are applicable with respect to protective claims for refund filed on behalf of estates of decedents dying on or after October 20, 2009.

COMMENT

The drafters of the Revenue Procedure should be commended for providing detailed and precise rules to address most of the basic protective claim filing issues.

The ability to make a protective claim on a Schedule PC on the Form 706 is especially welcomed. This will make it easier for taxpayers to comply with the requirements. Also, it will help taxpayers avoid inadvertently missing the statute of limitations deadline for submitting the protective claim. Presently, many estates will defer filing a protective refund claim, instead adopting a wait-and-see attitude to see if claim and expense issues resolve themselves before the statute of limitations expires and hopefully avoiding the bother of a Form 843 filing. By easing the process for filing the protective claim, more taxpayers should take advantage of the procedure at the time the estate tax return is filed and thus avoid missing the deadline later. Indeed, the existence of the Schedule PC will likely educate some preparers that might not be knowledgeable of the protective claim procedure of its availability.

Note that some claims are deductible, even if not paid when the Form 706 is filed. These include executor and attorney fees (Treas. Regs. §20.2053-1(d)(4)), claims against the estate relating to property or claims included in the gross estate (Treas. Regs. §20.2053-4(b)), and claims not totaling more than $500,000 (Treas. Regs. §20.2053-4(c)). Taxpayers may still want to file a protective claim for additional amounts not reported on the Form 706 or that do not meet the foregoing statutory requirements. There is a trap, here, since the Revenue Procedure requires that such protective claims, in addition to meeting the regular protective claim requirements, the taxpayer must also disclose the amount of the deduction already claimed on the Form 706 for the subject claim or expense and must reference the regulatory provision under which the deduction was claimed. See §4.05(4) of the Revenue Procedure.

For more information regarding when uncertain or contested claims and expenses can be deducted under the Code Section 2053 regulations, I refer readers to my article on the subject in the March 2010 Journal of Taxation.

Rev. Proc. 2011-48

[This article will also be published on Leimberg Information Services, Inc.]