Tax Court Rules Payments to Settle Possible Beneficiary's Claims Against Estate are not Deductible for Estate Tax Purposes

Distributions to beneficiaries are not deductible for Federal Estate Tax purposes while claims for estate expenses are deductible.  In Estate of Bates v. Comm'r, T.C. Memo 2012-314 (Tax Ct. 2012), the Tax Court ruled that a decedent's estate could not deduct payments made to a caregiver who was also a named beneficiary under the decedent's instruments.  The Tax Court opined that because the payments were made to settle the right to the caregiver's beneficial interests, rather than claims against the estate, they were therefore non-deductible payments.
This issue of whether a claim by a beneficiary is really a distribution or rather a payment of an expense is a fact sensitive question.  Proper planning and presentation of appropriate evidence is therefore necessary to attempt to succeed to permit the deduction.

Expiring Estate and Gift Tax Laws

Congress appears likely to battle over the estate and gift tax laws that are set to expire (sunset) by the end of this year.  It is quite possible that the status of various estate and gift tax laws may not be known until the final days of 2012 or possibly even into next year.  Keep in mind that if Congress does not act before year end, the following will occur.

Estate tax: The top tax rate goes up to 55% from 35%. A 5% surtax on the wealthiest of estates phases out the benefit of graduated rates.

  The unified credit exemption equivalent goes down to $1 million from $5,120,000.

  The deduction for family-owned businesses pursuant to Code Sec. 2057 is reinstated.

  The credit against state death taxes reverts to its prior credit.

Portability rules. The rules allowing a surviving spouse's estate to use a previously deceased spouse's unused exclusion amount will expire.

Generation skipping transfer (GST) tax. The GST tax is reinstated, with a top rate of 55% from 35%, and the GST exemption amount is set at $1 million (plus inflation adjustment) from $5,120,000.

Gift tax  The top rate increases to 55% from 35%.

Conclusion:  Accordingly opportunities may expire and taxpayers with large estates should be considering ways to utilize these reduced rates and higher exemptions now before they expire for good.

IRS rescinds two-year limitation period for equitable innocent spouse relief

The IRS in Notice 2011-70, 2011-32 IRB has just rescinded its position on a timeline within which to request equitable innocent spouse relief.  It will no longer deny an individual's request for equitable relief under Code Sec 6015(f) based upon it having  been filed more than two years after IRS first acted to collect the liability from the individual.  There are also transition rules for pending requests for relief, denied requests, and cases in litigation or where the litigation is final.

Background. Each spouse is jointly and severally liable for the tax, interest, and penalties stemming from a jointly filed income tax return. Code Sec 6015(f) allows relief to a requesting spouse if, among other conditions, taking into account all the facts and circumstances, it is inequitable to hold the individual liable.
To be eligible for relief under Code Sec 6015(b) (innocent spouse relief) or  Code Sec. 6015(c) (separate liability relief), the Code explicitly provides that the requesting spouse must elect relief not later than the date that is two years after the date that IRS has begun collection activities with respect to the individual making the election. ( Code Sec. 6015(b)(1)(E) , Code Sec. 6015(c)(3)(B) ) However, no such limitation is written in Code Sec. 6015(f) . The IRS had originally issued a regulation Reg. § 1.6015-5(b)(1)  that states that the two year rule also applies for equitable requests.
The Tax Court had repeatedly invalidated the regulation but the Third, Fourth, and Seventh Circuits have rejected the Tax Court's position holding the Regulation to be valid.
Until the Regulation is formally changed, taxpayers can rely on the IRS Notice.
The door is open for existing cases as well as previously denied cases to refile.
If however, payment was already made, no relief will be available.  
Innocent spouses rejoice!

Sole shareholder can receive employment agreement payment on sale of business rather than corporation because shareholder sold his good will

In H&M, Inc. v. Commissioner, T.C. Memo 2012-290 (2012), the United States Tax Court determined that where a corporation sold its insurance brokerage while its sole shareholder entered into employment with the buyer, the compensation under the employment agreement was not a disguised purchase price payment to the selling corporation.  The Tax Court determined that the shareholder's personal ability and other individualistic qualities were not a corporate asset (goodwill) that should be taken into account as part of the purchase price.

By way of background, the sale of a business often involves the transfer of intangible assets.  These assets can constitute the goodwill of the business, a corporate asset and the shareholder's agreement not to compete with the buyer along with an arrangement for the shareholder to provide future services.  Two seminal Tax Court cases permit payments to shareholders rather than corporations thereby precluding double tax treatment.  Martin Ice Cream Co v. Comm., 110 T.C. 189 (1998), (personal relationships of a shareholder-employee aren't corporate assets where the employee has no employment contract with the corporation); MacDonald v. Comm., 3 T.C. 720 (1944) (a corporation did not have any goodwill in the shareholder's personal ability, business acquaintanceship, and other individualistic qualities).

The Tax Court in H&M held that, in light of the shareholder’s personal relationships, his experience in running all facets of an insurance agency and his responsibilities as manager of the bank's insurance agency, the compensation that the bank paid him was reasonable. The employment agreement contained an extensive list of duties that the shareholder’s was required to perform. Not only was the shareholder an insurance salesman, he also had significant management and bookkeeping responsibilities. He went from working around 40 hours per week before the sale to double that afterward.  As such, the H&M Court found the case to be akin to MacDonald and Martin Ice Cream Co. The Court specifically found that when customers came to the shareholder’s agency, they came to buy from him. It was the shareholder’s name and his reputation that brought them there. The Court further found that he had no agreement with H&M at the time of its sale that prevented him from taking his relationships, reputation, and skill elsewhere.

The H&M case provides ammunition to attorneys who structure transactions to avoid double tax on the sale by the selling shareholder entering into an employment agreement with the purchaser.

Sometimes even with bad partnership documents, estate tax discounting may be possible

In a recent 5th Circuit case, Thomas Lane Keller et al. v. U.S., 110 AFTR 2d 2012-5312 (09/25/2012) affirmed the district court and held that even though certain documents were not completed by her death, a decedent capitalized a family limited partnership (FLP) before her death. A refund of over $315 million to the estate was the result.  The refund was principally the result of a valuation discount for the FLP interest.

By way of background, assets are often transferred to FLPs in the hope of achieving lack of marketability discounts and lack of control discounts. These discounts can result in substantial estate tax savings and in Keller, huge savings!   The area of FLP Law is often hotly contested by the IRS.  In Keller,  the FLP had been formed but the assets (bonds in this case) had not been transferred on the date of Decedent's death on May 15, 2000.  But, under Texas law, the Court ruled that Decedent's intent to transfer bonds into the FLP transformed those bonds into partnership property, eventhough she never formalized her intent.

Moral of the story - be sure to get competent legal counsel when engaging in transactions of this type.

Executors themselves can be personally liable for IRS Penalties

In a Chief Counsel Advice (201212020) recently announced, the IRS has set forth the situations whereby an executor can be found to be personally liable for the tax liabilities of an estate and the assets of the estate were already distributed to the estate's beneficiaries.  If the executor knew or should have known of the tax when the estate still had assets to pay it, her can be held liable for the tax and penalties.  He may also be liable as a transferee if he was also a beneficiary of the Estate pursuant to Sec. 6901 of the Internal Revenue Code.

Background - Executor Liability:  The United States Code provides that the IRS must be paid tax debts before beneficiaries receive distributions.  31 U.S.C. 3713(b).  An Executor who pays an Estate debt before paying debts due to the IRS “shall become answerable in his own person and estate” to the extent of the amount paid to preferred creditors. If an Executor pays other creditors before paying the IRS, the Executor can be held personally liable to the extent of the payments that he turned over to creditors other than the IRS.  An Executor is only liable if he had notice of the tax debt (or a reasonably prudent person would be on notice) before making a distribution to another creditor.

Background - Transferee Liability.  Sec. 6901(a) of the Code provides that the liability of a transferee of a taxpayer's property may be “assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred.”  The IRS is thus authorized to collect taxes from transferees of Estates that failed to pay taxes. 

Ruling. The Chief Counsel advice makes clear that the penalties asserted against the Decedent for failure to file the appropriate information returns required for foreign trusts can cause liability to the Executor if he paid out any money or assets to beneficiaries or other creditors.

Lesson. If you become an Executor / administrator of an estate with any foreign holdings or trusts, be certain that all information returns were properly filed and do not distribute to any beneficiaries or even pay other debts, until potential liability for failure by the Decedent to properly file all information returns is made.

Tax debt is not discharged in bankruptcy where taxpayer’s late return is filed after IRS already assessed the tax

In re Wogoman, --- B.R. ----, 2012 WL 2562323 (10th Cir. BAP (Colo.) 2012)

The United States Bankruptcy Appellate Panel (BAP) for the Tenth Circuit has held that a debtor's Form 1040 filed after IRS had assessed the tax liabilities for the year involved did not qualify as a return, as defined in 11 USC 523(a)(19). As a result, the tax debt relating to this return was excepted from discharge under 11 USC 523(a)(1)(B)(i).

Background:  A Bankruptcy filing can discharge taxes as long as the tax return is filed more than three years prior to the bankruptcy filing.  However, where the return was filed late and the Internal Revenue Service already assessed tax based upon no return being filed in that year, the 10^th Circuit determined the taxes for such year is not dischargeable in bankruptcy.

Thus, before filing bankruptcy, one should learn whether a late return was filed after an Internal Revenue Service assessment and be guided accordingly.

First Circuit Court of Appeals finds no abuse of discretion in the I.R.S.'s rejection of O.I.C.

First Circuit Court of Appeals finds no abuse 

of discretion in the I.R.S.'s rejection of O.I.C.

The Court of Appeal for the First Circuit, in reversing the Tax Court, determined that the Internal Revenue Service did not abuse its discretion in rejecting a taxpayers' offer-in-compromise (OIC).  The 1st Circuit based its ruling on the fact that the taxpayers had failed to include in their asset disclosure trust property in which they retained a beneficial interest. Applying a more deferential standard in reviewing IRS's determinations, the 1st Circuit held that IRS acted reasonably in determining that the taxpayers were the owners of the property.

Background:  An OIC is an agreement between the IRS and a taxpayer that settles the taxpayer's tax debt for less than the full amount owed. Pursuant to Treasury Regulations, OIC's will only be rejected by the IRS when the IRS determines that no basis for compromise is present or that the offer is unacceptable under IRS's policies and procedures. (Code Sec. 7122(d)(3)(A), Treas. Reg. § 301.7122-1(f)(3))

Facts in Dalton:  The IRS sought to collect trust fund recovery penalties from the Daltons but after a collection due process (CDP) hearing, the IRS rejected the Daltons' OIC because it failed to include in their asset disclosures a nominee interest in trust property.  The IRS determined that the Daltons retained a beneficial interest in the trust property under a nominee ownership theory and rejected their OIC.

In Court, the Daltons contended that IRS's determination was an abuse of its discretion because the Daltons did not retain a nominee interest in the trust property after the trust was created, and thus didn't need to include the trust property in their assets for purposes of the OIC.

Tax Court Decision:  The United States Tax Court determined that the trust wasn't a nominee of the taxpayers under Maine law so the Tax Court found that IRS had abused its discretion in rejecting the taxpayers' offer because it had premised that rejection on an erroneous view of the law. Dalton v. Comm., 135 TC 393 (2010).

1st Circuit decision. The First Circuit, reversing the Tax Court's ruling, found that IRS's nominee determination was reasonable and shouldn't be disturbed.

Preliminarily, the First Circuit concluded that the Tax Court had applied the wrong standard of review.  The First Circuit held that it was not a court's job to review IRS's CDP determinations afresh. Rather, its job was to decide whether: (1) IRS's factual and legal determinations were reasonable; and (2) the ultimate outcome of the CDP proceeding constituted an abuse of IRS's wide discretion.

The Court reasoned that the judicial review must be tailored to the purpose of the CDP process—that is, ensuring that IRS's determinations, whether of fact or of law, were not arbitrary. A court should set aside determinations reached by IRS during the CDP process only if they were unreasonable in light of the record compiled before the agency. Any more intrusive standard of review would result in the courts inevitably becoming involved on a daily basis with tax enforcement details that judges were neither qualified, nor had the time, to administer. The Court concluded that its analysis was applicable whether an IRS determination reached during the CDP process was based on a purely factual question, a purely legal question, or (as here) a mixed question of fact and law.

The 1st Circuit therefore held that the IRS acted within its discretion in refusing to accept the OIC because the evidence before the IRS was ample to justify its conclusion that the Daltons' valuable ownership interest in the property had to be considered when evaluating their OIC.

Import of decision:  The 1st Circuit teaches us two things:  First, failure to disclose assets in an asset disclosure can cause the IRS to reject an OIC.  Second, the determination by the IRS will rarely be disturbed by the Courts (at least those within the 1st Circuit.)

Tax Court states that timely proper receipts for charitable contributions from a charity are required for a donation to be deductible

Tax Court states that timely proper receipts for charitable contributions from a charity are required for a donation to be deductible

The United States Tax Court In Durden v. Commissioner, T.C. Memo. 2012-140 (May 17, 2012), held that an income tax deduction was properly disallowed by the Internal Revenue Service for a charitable contribution, because the charity did not provide a statement that no goods or services were provided in consideration for the contributions. The Tax Court had found that the first acknowledgement received by the taxpayer lacked a statement regarding whether any goods or services were provided in consideration for the contribution, and the second acknowledgment, which included that statement, was not contemporaneous.  I.R.C.  Sec. 170(f)(8)(A) provides: “No deduction shall be allowed under subsection (a) for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the contribution by the donee organization that meets the requirements of subparagraph (B).”  For donations of money, the donee's written acknowledgment must state the amount contributed, indicate whether the donee organization provided any goods or services in consideration for the contribution, and provide a description and good faith estimate of the value of any goods or services provided by the donee organization. I.R.C.  170(f)(8)(B) and Treas. Reg. 1.170A-13(f)(2). A written acknowledgment is contemporaneous if it is obtained by the taxpayer on or before the earlier of: (1) the date the taxpayer files the original return for the taxable year of the contribution or (2) the due date (including extensions) for filing the original return for the year. I.R.C.  170(f)(8)(C) and Treas. Reg. 1.170A-13(f)(3).  While the taxpayers argued they substantially complied, the Tax Court would have none of it holding:  Petitioners have failed strictly or substantially to comply with the clear substantiation requirements of section 170(f)(8), and their deduction for the charitable contributions in issue for 2007 must be disallowed.

 

Moral of the story: when making contributions to charities, obtain a statement from the charity indicating whether or not there was value received from the charity and maintain that receipt with your records in case you are audited.  This should be obtained before the tax return claiming the deduction is filed.

 

 

Clock is ticking on estate planning in 2012.

In estate planning, there is a “use it or lose it” situation which might need to be completed before the end of the year.  On December 17, 2010, President Obama, signed the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010.  The Act made significant changes to the estate, gift and generation-skipping tax regimes.  It reduced the rates of estate, gift and GST tax to 35% and increased the estate, gift and GST tax exemptions to $5,000,000.  It also reunified the estate and gift-tax exemptions where previously they were disparate.  These provisions of the Act, will remain in effect only through the end of 2012.  The Act is scheduled to sunset.  This means that it will no longer be effective and the estate, gift and GST law will revert to the old law with not nearly the advantages.  Unless Congress enacts new legislation prior to then, beginning in January of 2013, the law will revert to the laws in effect in 2001 and the top estate, gift and GST tax rates would revert to 55% with an exemption of only $1,000,000 and the GST exemption of $1,000,000 but the GST would be indexed for inflation.  Accordingly, in order to avail yourselves of the benefits available under the 2010 Act, clients must consider engaging in the planning techniques that are discussed below as soon as possible.  These techniques will significantly, likely reduce the taxable estate but only if they are taken advantage of during the period of the applicability of the 2010 Act.  The tools at our disposal this year, but not necessarily after this year is the ability to make a non-taxable gift of $5,000,000.00.  This amount is set to sunset back to $1,000,000.00.  Gifting can be accomplished through trusts where one is unwilling to divest full authority to the client.  Leveraging the full $5,000,000 can be accomplished through the use of LLC’s or Family Limited Partnerships.  Where the taxpayer is desirous of gifting more than $5,000,000 this can be done subject to gift-tax but at the lower 35% rates.  The sale to an intentionally defective grantor trust is also an available tool which is recommended in many circumstances.  GRATs are also possible under current law.  It is recommended that estate planning be taken advantage of during the year 2012.  Accordingly, take action now or perhaps lose this valuable opportunity forever.

 

IRS Has Invited Practitioners to Comment on the Tax Treatment of Decanting

Decanting is the estate planning practitioners term for pouring over (decanting so to speak) the assets of one irrevocable trust to another.  Typically this is done when a trust has a provision that no longer is consistent with the desires of the original parties and they wish to make changes to the Trust.  Since the original trust was irrevocable, the initial trust cannot be amended, so the concept of decanting the assets of the first irrevocable trust into a second irrevocable trust is considered.  The issue has become so popular that it is now on the radar of the Internal Revenue Service that is trying to figure out what tax consequences, if any, such decanting should cause.

In I.R.S. Notice 2011-101, 2011-52 IRB issued on December 27, 2011, the IRS requested that practitioners and any other interested parties provide comments on the income, estate, gift, and generation-skipping transfer tax treatment of the transfer of assets from one irrevocable trust to another irrevocable trust. The IRS asked for comments in writing by April 25, 2012.

 

IRA Charitable Rollover Expired on Dec. 31, 2011

Congress did not extend the IRA charitable rollover prior to Dec. 31, 2011, the date on which the rollover expired.  
In 2011, taxpayers age 70 ½ or older could make tax-free charitable gifts of up to $100,000 per year directly from their Individual Retirement Accounts to eligible charities, including colleges, universities and independent schools. I.R.C. 408(d)(8).  According to I.R.C. 408(d)(8)(F) that rollover expired at the end of 2011.
Earlier in 2011, Senators Charles Schumer (D-N.Y.) and Olympia Snowe (R-Maine) and U.S. Representatives Wally Herger (R-Calif.) and Earl Blumenauer (D-Ore.) introduced the Public Good IRA Rollover Act of 2011 (S. 557, H.R. 2502). The PGIRA would permanently extend and expand the IRA charitable rollover.  As of this writing, the PGIRA has yet to occur.  There is still a possibility that a short-term retroactive extension of the IRA charitable rollover will happen in 2012.
In the meantime, a taxpayer can still pull money out of an IRA as taxable income and receive a corresponding deduction for the amount given to the charity (assuming she meets the other criteria for deductibility).  Under pre-2012 law, the rollover to charity was neither taxable nor deductible.