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The IRS in Notice 2011-70, 2011-32 IRB has just rescinded its position on a timeline within which to request equitable innocent spouse relief.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.