Supreme Court hears two days of oral arguments on the constitutionality of DOMA in an estate tax case

The United States Supreme Court, in the estate tax case of Windsor v. U.S., is considering the constitutionality of the Defense of Marriage Act (DOMA).  It is a highly anticipated case and is considered such a landmark important case that the Court heard two days of oral argument. The case concerns a surviving same-sex spouse who is seeking an estate tax refund.  An estate tax was paid because assets were left to a same sex spouse and the Internal Revenue Code under DOMA requires that no marital deduction is available for the estate. Although DOMA is not generally a tax law, it carries tax consequences for same-sex couples by requiring that they be treated as unmarried for Federal law purposes. The Court's decision may potentially have a major impact on the administration of the IRC.

By way of background, in 1996, Congress enacted, and President Clinton signed DOMA which in Section 3 defines marriage as the “legal union between one man and one woman as husband and wife.”

 

The district court and the Second Circuit Court of Appeals both found in favor of the Taxpayer and ruled the provision of DOMA requiring a man and a woman for a marriage to be unconstitutional. 

 

While waiting to see if the Supreme Court follows the lower Courts, it is generally recommended that same-sex couples in domestic partnerships or civil unions or marriages file protective claims for refund in the event that DOMA is invalidated.  The impact of the decision may affect income tax as well so stay tuned for the result of what could be a monumental decision.

 

 

The American Taxpayer Relief Act of 2012 (“ATRA 2012”) made substantial estate, gift and generation skipping changes and these changes are ostensibly permanent.  These changes are summarized as follows:
The exemption amount is now $5 million per person, indexed for inflation after 2011. (For transfers in 2013, the exemption is $5.25 million.)  The rate of tax is a flat 40% above the exemption.  Portability is preserved meaning if the surviving spouse files a timely election on the Estate Tax return of the first spouse to die, the surviving spouse inherits any unused portion of the exemption from the predeceased spouse.
There are still many opportunities for tax reduction including using grantor retained annuity trusts (“GRATs”) and discounting through family limited partnerships (“FLPs”) and family limited liability companies (“FLLCs”).
According to a recently issued Congressional Research Service (CRS) report these “permanent” changes may be changed soon. It notes that there are some lingering proposals to crack down on perceived abuses.  These changes include:
GRAT reform - A proposal would impose a minimum annuity term of 10 years, disallow any decline in the annuity, and require a non-zero remainder interest. 
FLP and FLLC reform - Another proposal would disallow discounts for interests in FLPs and FLLCs. Courts will generally allow estates to reduce the fair market value when assets, including marketable securities, are left in FLPs or FLLCs.
Consistent valuation requirement. Currently, there is no explicit rule requiring the same valuation of fair market value of an estate asset for estate tax purposes versus for purposes of stepped up basis in the hands of the heir. A proposal would require the same value for both purposes.
Limit duration of GST trusts. A proposal would limit the life of a Generation Skipping Trust to 90 years.
Coordination of grantor trust and transfer tax rules. And finally, another proposal would cause inclusion of the assets of a grantor trust in the grantor's estate or cause there to be a gift tax if the grantor ceased being owner.

Conclusion:  There are still techniques available to reduce estate, gift and GST taxes, but they may be fleeting, so planning now is very important.

Fiscal Cliff Fallout – The New Investment Income Tax

Fiscal Cliff Fallout – The New Investment Income Tax

 

Much has been said about the level of income at which there would be tax hikes coming out of the fiscal cliff negotiations around year end.  We know President Obama had pushed for tax increases for “wealthy” individuals with income over $250,000 annually.  The Republicans (who control the House of Representatives) wanted no increase for “wealthy” individuals.  We all have read that there was a compromise and the higher tax bracket of 39.6% does not hit until income exceeds $450,000 for married couples filing jointly or $400,000 for unmarried filers.  But what appears lost in all of this is the 3.8% income tax increase on investment income for wealthy individuals. 

 

Background:  In 2010, Congress passed P.L. 111-152 to become effective 1/1/13.  This law imposes a tax on investment income at the rate of 3.8% imposed against married individuals with income over $250,000 annually or unmarried individuals with income over $200,000 annually.  The tax is imposed on the following types of income: interest, dividends, annuities, royalties, rents and business income from passive activities and businesses trading financial instruments. 

 

While the increased 4.6% (over the 35% highest bracket)  tax on income will not kick-in except for wealthy taxpayers above the $450,000 level (for married individuals), for purposes of the new investment tax, this new tax kicks-in at a much lower income level - $250,000 (for married individuals).

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.