Keith Codron's Law Blog

Tuesday, August 23, 2011

For 2010 Decedents, IRS Issues Guidance to Executors on Election to Apply Carryover Basis Rules

For estates of decedents dying in 2010, the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGGTRA”), commonly referred to as the Bush tax cuts, repealed the federal estate tax and substituted a modified carryover basis regime for a step-up basis regime for purposes of determining the cost basis of inherited assets in the hands of an estate beneficiary.  As a result, a beneficiary wishing to sell or otherwise dispose of a highly appreciated asset inherited from the estate of a decedent dying in 2010 might be faced with a substantial capital gains tax on the portion of that appreciation which occurred prior to the decedent’s death, a tax which the beneficiary would have avoided under the step-up basis rules.  The carryover basis rules, codified in Section 1022 of the Internal Revenue Code of 1986 [“IRC”], are said to be modified insofar as the executor is allowed to allocate to certain assets additional basis consisting of a general increase of $1.3 million, plus a spousal property increase of $3 million.

Tax legislation passed at the end of 2010, formally known as the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 Tax Relief Act”), which was made retroactive to January 1, 2010, reinstated a 35% estate tax rate for decedents dying in 2010, subject to a $5 million exemption, but allows the executor to elect out of the estate tax by agreeing to have the modified carryover basis rules of IRC §1022 apply to the estate’s assets in lieu of the (generally more favorable) step-up basis rules of IRC §1014. This election by the fiduciary is referred to as a “Section 1022 election.”

Now, 8 months after the passage of the 2010 Tax Relief Act, IRS has finally released its much-anticipated guidance on the time and manner governing an executor’s election to opt out of the federal estate tax. The guidance is set forth in IRS Notice 2011-66, to be published at page 2011-35 of the Internal Revenue Bulletin on August 29, 2011.  The §1022 election, which is irrevocable, may only be made on Form 8939 [“Allocation of Increase in Basis for Property Acquired from a Decedent”], and must be filed on or before November 15, 2011.  IRS has cautioned that no extensions of time to file Form 8939 will be granted and that it will not accept any Form 8939 filed after the due date, except in the event of conflicted filings or under certain very limited situations as described in the notice.

An executor may not file both an estate tax return [Form 706] and a conditional Form 8939 which would become effective only if an estate tax audit resulted in an increase in the gross estate above the $5 million exemption amount; IRS will not allow executors of large estates to play that wait-and-see game.  The executor must report and value, on Form 8939, all property belonging to the estate, excluding cash. Further, the executor must report all appreciated property acquired from the decedent, valued as of the decedent’s date of death, required to be included on the donor’s federal gift tax return, Form 709, if such property was acquired by the decedent by way of a gift or other lifetime transfer for less than an adequate and full consideration in money or money’s worth during the 3-year period ending on the decedent’s date of death.  An exception for spousal gift applies to this 3-year rule.

If an executor of the estate has not been appointed, any person in actual or constructive possession of property acquired from the decedent may file Form 8939 with respect to the property of which such person is in actual or constructive possession. In addition, if a Section 1022 election is made to apply the modified carryover basis rules, the decedent’s available generation-skipping transfer (GST) tax exemption is to be allocated to direct skips, taxable distributions and taxable terminations by attaching Schedule R of Form 706 to Form 8939.

For further information please contact the Law Offices of Keith Codron at (949) 622-5450, or visit the firm’s website, www.codronlaw.com.  Mr. Codron also may be reached by email at keith@octrustlawyer.com.

Monday, April 18, 2011

IRS Again Encourages Taxpayers with Offshore Accounts to Come Clean and Tell All

It is perfectly legal for a U.S. citizen or resident to hold money, securities, real estate, insurance policies, annuities, business interests or other lawful property or investments outside the territorial jurisdiction of the United States, individually or through the medium of a trust, corporation, partnership or LLC, in any one or more financial accounts and in any one or more countries, provided, in all such cases, that the source of the money or other property is fully disclosed to the Treasury Department, and, further, that all of the worldwide income, gains and profits from the foreign accounts, property or entities are reported annually to the Treasury Department to be taxed in accordance with the internal revenue laws of the United States.  Many affluent taxpayers have legitimate, non-tax reasons for maintaining financial accounts overseas, chief among them being protection of their hard-earned, lawfully-derived earnings and assets from the claims, liens or judgments of future potential creditors or plaintiffs, including but not limited to disgruntled employees, former business partners and associates, ex-spouses, disinherited relatives, accident-prone tenants and household guests, feuding neighbors, overreaching homeowners’ associations, buyers and sellers of property, and “victims” (real or imagined) of this or that type of physical or psychological harassment, undue influence, discrimination, oppression or unfair treatment.

Convinced that U.S. taxpayers with offshore accounts, particularly those with foreign trusts, are cheating the tax man, or worse, that they may be involved somehow in money laundering, terrorism financing or narcotics trafficking, and in its never-ending quest to reduce the amount of underreported income by affluent taxpayers availing themselves of sophisticated estate and asset protection planning through the use of offshore financial structures, IRS has launched a 2011 sequel to its original blockbuster hit, the 2009 Offshore Voluntary Disclosure Program [“2009 OVDP”], that netted 15,000 voluntary disclosures. According to IRS Commissioner, Doug Shulman, “as we continue to amass more information and pursue more people internationally, the risk to individuals hiding assets offshore is increasing.”  In this regard it should be noted that the purpose of asset protection planning is not to hide or deny the existence of income or assets, nor to avoid one’s bona fide debts or obligations, but rather to legally and ethically reposition capital holdings in a tax-neutral structure that is designed to make one a less attractive target of those who might possibly seek to abuse the civil justice system by playing the litigation lottery game.

The new program is referred to as the 2011 Offshore Voluntary Disclosure Initiative [“2011 OVDI”]. It runs through August 31, 2011, and it is sure to top the 2009 OVDP in total receipts for the U.S. Treasury. As stated on IRS’s official website, the first such disclosure program, which ended on October 15, 2009, “demonstrated the value of a uniform penalty structure for taxpayers who came forward voluntarily and reported their previously undisclosed foreign accounts and assets,” and that, therefore, “it was determined that a similar initiative should be available to the large number of taxpayers with offshore accounts and assets who applied to IRS Criminal Investigation’s traditional voluntarily disclosure practice since the October 15 deadline.”  The government loves to pitch these programs as being voluntary, notwithstanding the fact that the penalty for tax evasion or fraud is often a multiyear change of address to a federal prison and the confiscation of most, if not all, of one’s worldly possessions. 

The 2011 OVDI has a penalty structure which is significantly higher than the 2009 OVDP, which means that people who did not come forward in 2009 will not have been rewarded for waiting.  In general, the 2011 initiative requires individuals with previously undisclosed foreign accounts to combine the value of all such accounts and pay a penalty equal to 25% of the highest aggregate account value attained during the eight calendar years, 2003 through 2010, inclusive, covered by the program.  Some taxpayers will be eligible for a reduced 12.5% penalty rate if the highest aggregate account value did not exceed $75,000 at any time during the years in question.  Further, an even smaller number of taxpayers will qualify for the special 5% penalty rate applicable to accounts which the taxpayer (A) did not open or cause to be opened, and with respect to which the taxpayer (B) has exercised minimal, infrequent contact and (C) not withdrawn more than $1,000 in any of the years covered by the initiative.  This “offshore penalty,” as it is referred to in the 2011 OVDI, is in addition to the 20% accuracy-related penalty for understated income and the requirement to pay all of the back taxes and accrued interest.

If IRS has already initiated a civil examination, regardless of whether it relates to undisclosed foreign accounts or entities owned or controlled by the taxpayer, the taxpayer will be ineligible to participate in the 2011 OVDI program.  The same is true, of course, for taxpayers already under criminal investigation.

Participants in the 2011 OVDI program will have to provide copies of previously filed federal income tax returns for the years covered by the initiative.  They also must file amended federal income tax returns for such years, detailing the amount and type of previously unreported income from the undisclosed offshore account or entity.  They are also required to submit Treasury Department Form 90-22.1 (Report of Foreign Bank and Financial Accounts), commonly known as the “FBAR” form.

In summary, the 2011 OVDI program represents a fair and reasonable way for those taxpayers with undisclosed foreign accounts or entities, who are not currently being audited by IRS, to bring themselves into tax compliance and thereby avoid substantially greater civil penalties and possible criminal prosecution in the future.  Because IRS has increased its examination personnel with additional funding to combat the “tax gap” (the difference between that which is owed to the U.S. Treasury and that which is actually collected), it is doubtful that the government will extend the olive branch to noncompliant taxpayers beyond the August 31 deadline this year.

For further information please telephone the Law Offices of Keith Codron at (949) 622-5450, or visit the firm’s website, www.codronlaw.com. Mr. Codron may also be reached by email at keith@octrustlawyer.com.

Thursday, February 24, 2011

Foreign Financial Account Reporting


Final rules have just been issued by the Treasury Department’s Financial Crimes Enforcement Network [FinCEN] concerning the reporting requirements for U.S. citizens or residents who, directly or indirectly, hold a beneficial interest in or exercise control over certain financial accounts in a foreign country.  Various amendments to the long-standing foreign financial account reporting regulations were originally proposed by FinCEN in February, 2010, as part of its implementation of the 1970 Bank Secrecy Act [BSA].  The final rules focus on those persons who are required to file reports and the types of accounts which are reportable, while adopting provisions intended to prevent persons subject to the rules from avoiding their reporting obligations.  With respect to foreign financial accounts maintained at any time during calendar year 2010, the new rules apply to reports required to be filed by the deadline, June 30, 2011.  The rules also apply to reports required to be filed for all subsequent calendar years.

Who Must File

Generally speaking, any individual who is subject to the territorial jurisdiction of the United States, whether as a citizen or permanent resident, and any entity created, organized or formed under the laws of the United States, its territories or insular possessions, or of any state or the District of Columbia (hereinafter collectively referred to as a “U.S. person”), must provide certain information to the IRS with respect to any calendar year in which that person held either a

                [1] financial interest in, or

[2] signature or other authority over

any bank, security or other financial account in a foreign country, provided that, at any time during such year, the account had a value in excess of ten thousand dollars ($10,000).  The form used to report the information to IRS is Treasury Department Form 90-22.1, also known as the “FBAR” form.  In addition to the June 30 filing deadline, records must be kept for each such foreign account for a period of 5 years.

A “financial interest” exists where a U.S. person is the owner of record or holds legal title to an account in a foreign country.  In addition, a U.S. person has a financial interest in each bank, securities or other financial account in a foreign country for which the owner of record or holder of legal title is a trust that was established by such person and for which a trust protector has been appointed.  A trust protector is a person who is responsible for monitoring the activities of a trustee, with the authority to influence the trustee’s decisions or to replace (or recommend the replacement of) the trustee.  Further, a U.S. person has a financial interest in each bank, securities or other financial account in a foreign country for which the owner of record or holder of legal title is a corporation, partnership or limited liability company, if such person owns, directly or indirectly, more than fifty percent (50%) of the voting power of the entity.

Which Accounts are Reportable

An “account” includes any formal relationship with a foreign financial agency to provide regular services, dealings or other transactions, and may exist for a short period of time, such as an escrow account, but is not established by simply wiring money or purchasing a money order.

Only foreign accounts are reportable on the FBAR.  An account is not a foreign account if it is maintained with a financial institution located in the United States, even though the account may contain assets or holdings of foreign entities.  For example, stock or other securities of a foreign corporation held by a U.S. person in an account at a U.S. brokerage firm does not render the account “foreign” for FBAR purposes. Similarly, a U.S. person would not have to file an FBAR for assets held in a typical omnibus account maintained by a U.S. global custodian in which the U.S. person does not have any legal rights in or to the account and can only access the foreign assets through the intervention of the U.S. global custodian.  However, if the specific custodial arrangement allows the U.S. person to directly access foreign assets maintained at a financial institution located outside the United States, then the U.S. person would be deemed to have a foreign financial account subject to the FBAR reporting rules.

Signature or Other Authority

The term, “signature or other authority” refers to the authority of a U.S. person, whether acting alone or in conjunction with another, to control the disposition of money, funds or other assets held in a financial account by means of direct communication with the person maintaining the financial account.  The critical test for determining whether a U.S. person has signature or other authority over an account in a foreign country is whether the foreign financial institution will act on a direct communication from that person regarding the disposition of assets from that account (not to be confused with investment powers or similar management authority over assets within the account).  The phrase, “in conjunction with another,” is aimed at addressing situations in which a foreign financial institution requires a direct communication from more than one individual regarding the disposition of assets from the account.

Individuals Employed in a Foreign Country

The new rules clarify that U.S. individuals employed in a foreign country who must file an FBAR because of their having a signature or other authority over their employer’s foreign financial accounts are not expected to personally maintain records of these accounts.  This recordkeeping exemption does not extend, however, to U.S. individuals employed in the United States with signature or other authority over their employer’s foreign financial accounts.


Contact the writer, Keith Codron, toll-free, at (800) 497-0864, or online at keith@octrustlawyer.com, for further information about this article. Mr. Codron’s website is www.codronlaw.com.

Thursday, September 16, 2010

When is a Non-Refundable Deposit Refundable?


Recently, a California appellate court, in reversing the Orange County Superior Court, held that a seller may not retain the earnest-money deposit of a buyer who breached a real estate purchase and sale agreement by unilateral cancellation, notwithstanding that the deposit is specifically declared to be “non-refundable” under the contractual terms, where the seller sustained no actual damages as a consequence of the buyer’s breach.  Kuish v. Smith (2010), 181 Cal. App. 4th 1419 [105 Cal. Rptr. 3d 475].

In December 2005, Bradford Kuish (“Buyer”) offered to buy the Laguna Beach residence of William W. Smith (“Seller”).  On January 7, 2006, the parties entered into a written agreement in which Buyer agreed to purchase the property for $14 million.  The purchase agreement did not contain a liquidated damages provision, nor did it constitute an option contract for the purchase of real property.  Escrow instructions, dated March 24, 2006, required Buyer to make two “non-refundable” deposits into escrow, totaling $620,000, and stated that escrow was to close on or before September 15, 2006.  Buyer paid the required $620,000 earnest-money deposit, of which $400,000 was immediately released out of escrow to Seller.

On September 18, 2006, Buyer’s legal counsel sent a letter to the escrow company, requesting that the escrow be cancelled.  The unilateral cancellation represented a breach. The parties signed cancellation escrow instructions, dated October 17, 2006, at which time Seller turned to a backup offer it had received from a third party who was interested in purchasing the home.  Seller then proceeded to sell the Laguna Beach residence to the third party for a higher price -- $15 million -- which represented the fair market value of the property on both September 18 and October 17, 2006.  Seller refused to return any portion of Buyer’s earnest-money deposit which had already been released, and refused also to allow the escrow company to return any portion of the deposit still held in escrow.

The Orange County trial court held that Seller was entitled to retain almost all ($600,000) of Buyer’s $620,000 deposit, reasoning that such a result did not constitute an unlawful forfeiture “because both parties were ‘big boys,’ that is, sophisticated business people, [who] understood all the ramifications of their actions in freely negotiating to make the deposits non-refundable.”  In the trial court’s view, Seller was entitled to keep a portion of the deposit “on the basis that it constitutes separate and additional consideration for extending the time and length [of] keeping escrow open for nine months.”  The court went on to find that such “separate and additional consideration” was valued at $620,000.

The Court of Appeal (4th District, Division 3) reversed the trial judge, holding that insofar as Seller made a $1 million profit on the resale to the third party, there were no damages sustained by Seller as a consequence of Buyer’s breach of the purchase contract, and that, therefore, Seller’s retention of the deposit was an invalid forfeiture.  In a rising real estate market, as existed in 2006, Civil Code §3307 limited Seller’s damages to the recovery of consequential damages and interest, notwithstanding a willful breach having occurred.  The appellate court held that in the absence of a valid liquidated damages provision, the term “non-refundable” is to be interpreted to mean that Seller may retain the deposit only to the extent of actual damages incurred.

The result?  Seller had to give back $600,000 of the $620,000 deposit to Buyer.

About the Author
Keith Codron is an estate planning attorney based in southern California, specializing in the design, implementation and administration of advanced asset protection and wealth preservation strategies for small business owners, executives, investors and professional practitioners. Mr. Codron is licensed to practice law in California, Florida and New York. He graduated from the University of Chicago (B.A. 1976), John Marshall Law School (J.D. 1979), and University of Miami Law Center (LL.M. 1980).  Mr. Codron can be contacted, toll-free, at (800) 497-0864, or by email at keith@octrustlawyer.com.

Thursday, July 22, 2010

Estate Tax Update

On June 17, 2010, the U.S. House of Representatives passed H.R. 5297, the Small Business Jobs and Credit Act of 2010 (commonly referred to as the "Small Business Jobs Bill").

In the last few weeks, since H.R. 5297 was passed, Senate Minority Whip Jon Kyl (R-Arizona) and Senator Blanche L. Lincoln (D-Arkansas) have been working on a plan concerning the future of the estate tax.  Together they have advanced a proposal requiring the Senate Finance Committee to amend H.R. 5297 so as to permanently set the federal estate tax rate at thirty-five percent (35%) and raise the estate tax exemption amount to five million dollars ($5,000,000), the exemption level to be phased in over a 10-year period and indexed for inflation.

The Kyl-Lincoln proposal would also provide for a "stepped-up" cost basis for inherited assets, as existed in prior tax years, and would instruct the Senate Finance Committee to offset the difference in revenue loss resulting from their proposal as compared to the Obama administration's proposal. [The administration has proposed a 45% estate tax rate coupled with a $3.5 million exemption amount.]

Yesterday, July 20, 2010, the U.S. Senate prepared to resume consideration of H.R. 5297, with the goal of completing work on the Senate version by the end of this week. However, Senate Majority Leader Harry Reid (D-Nevada) is expected to disallow most amendments to the House bill, specifically including the estate tax proposal of Senators Kyl and Lincoln. Senator Kyl told reporters yesterday that, whereas Senator Reid did not want to address any estate tax issues at this time, he (Kyl) and Senator Lincoln were looking at other options for moving their proposal forward. Stay tuned.


For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.

Mr. Codron, whose office is located in Orange County, California, welcomes your comments and questions.


Saturday, July 3, 2010

New IRS Regulations Coming for Foreign Trusts

Fearful that foreign trusts are being used by "the rich" for tax evasion purposes, IRS is hard at work drafting new proposed regulations covering income tax reporting and filing requirements involving offshore trusts.

This disclosure was just made, on June 22, at a Washington, D.C. Bar program dealing with international tax issues pertaining to high net worth individuals. At the meeting, an IRS official, M. Grace Fleeman, who is a senior technical reviewer in the international division of the Associate Chief Counsel's office, admitted that the regulations will be aimed squarely at foreign trusts having U.S. beneficiaries who are taxable on the trust's distributable net income. 

Earlier this year Congress passed Public Law 111-147, the Hiring Incentives to Restore Employment ("HIRE") Act, which was signed by President Obama on March 18, 2010. Although mostly focused on creating domestic jobs, this law includes several provisions on foreign trusts and foreign financial accounts. While many of the foreign trust tax issues date back to 1996 legislation, and have been on the government's enforcement radar screen for more than a decade, IRS, in light of the 2010 legislation, has decided to include the foreign trust provisions of the HIRE Act in its pending regulations project. The tax official told the group of lawyers in Washington, D.C. that she hopes the IRS will have finished drafting the proposed regulations within the next six months.

The HIRE Act added a presumption, under Internal Revenue Code Section 679(d), which treats a foreign trust receiving property from a U.S. person as automatically having a U.S. beneficiary.  Another provision of the HIRE Act, codified at IRC §643(i), provides for the taxation of trust property used without compensation. Thus, by way of example, a loan of cash or marketable securities from the foreign trust to a U.S. grantor or U.S. beneficiary of that trust would be treated as a taxable distribution.

In response to questions from the program participants, the IRS official stated that the new regulations will address requirements for preparing Form 3520 [Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts], and for withholding, as well as the tax consequences of a distribution by a trust which has no distributable net income.  Furthermore, she said, the regulations will discuss foreign trust reporting requirements under IRC §6048, penalties for inadequate reporting under IRC §6677, and, under IRC §6039F, the reporting of large gifts received from foreign persons.

We will have to wait and see how the new regulations unfold, but one thing is very clear: IRS, in particular, and the Obama administration, in general, strongly dislike the use of offshore trusts by high net worth individuals residing in the United States and wish to discourage the use of such trusts by making tax compliance as burdensome and onerous as possible.

For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron, whose main office is located in Orange County, California, welcomes your comments and questions.


Thursday, May 20, 2010

Inconsistent Testamentary Instruments

A recent case from Alameda County, California, highlights why it is so important to be clear and unambiguous when drafting testamentary instruments, especially where there are inconsistent dispositive provisions between the documents.

In September, 2002, Bud Krusi, a widower, executed a revocable trust and pour-over will. Bud was the father of four adult children: Paul, Peter, Karl and Joan. Bud nominated his son, Paul, to serve as successor trustee of the trust. Attached to the back of the trust instrument was an Exhibit 'A' which referenced the following assets owned by the trust: (1) Bud's 100% interest in the closely-held corporation operating the Krusi family business; (2) a parcel of commercial real estate on which the family business was located; (3) a parcel of residential real estate; and (4) various investment accounts at financial institutions. The assets listed on Exhibit 'A' were properly transferred to the trust at the time of its creation. The trust instrument provided that after Bud's death the residential real property and its furnishings were to be distributed to his son, Paul, and one, Sarah Gersper, and that the remaining trust assets were to be distributed in equal shares to Paul, Peter and Joan (or to their surviving issue by right of representation).  Bud's son, Karl, and all of his lineal descendants were expressly disinherited. As settlor Bud retained the right to revoke the trust, in whole or in part, or to amend any of its provisions, in either case by means of a signed written instrument delivered to the trustee during Bud's lifetime.

Under the contemporaneous pour-over will, Bud devised to the trust the remainder of his estate, including tangible personal property, such as household goods, automobiles or personal effects, to be added to the trust corpus and thereafter held, administered and distributed in accordance with the terms of the trust.

In September, 2007, just seven months prior to his death, Bud executed a new will, the preamble of which contained boilerplate language stating that all of Bud's previous wills and codicils were thereby revoked.  Under the 2007 will, Bud's business partner, Barbara Simi ("Bobbie"), was named as executor and given a 51% interest in both the family business and the parcel of commercial real estate on which the business was located, making her the largest single beneficiary under the 2007 will.  The 2007 will explained that it was Bud's intention to give Bobbie a controlling interest in the family business in the event that any disagreements might later arise with respect to the conduct of the business. In a separate provision of the 2007 will, Bud stated his intention to give the remainder of his estate to his surviving issue by right of representation.  The 2007 will made no reference to the 2002 trust.

Bud died on March 7, 2008. Four days later, on March 11, 2008, Bobbie filed a petition with the probate court seeking a declaratory judgment that Bud, by making the 2007 will, intended to dispose of all his assets as part of a new estate plan and effectively revoked the 2002 trust in its entirety (not merely carving out the 51% interests in the business assets), and that, as a consequence, the record titles of the various assets held in the trust should be ordered changed to show title in Bobbie's name as executor of the 2007 will.  Decedent's son, Paul, in his capacity as trustee of the trust, filed an objection to Bobbie's petition, contending that the 2007 will did not revoke the 2002 trust in its entirety. Paul argued that, notwithstanding that the 2007 will was inconsistent with the 2002 trust in certain particulars (i.e., the disposition of a 51% interest in the family business and associated real estate), that fact did not, by itself, constitute clear and convincing evidence that Bud intended to revoke the trust as to those assets.  

The trial court held that Bud's 2007 will amended, modified or revoked the 2002 trust, but only with regard to a 51% interest in the family business and a 51% interest in the associated real estate, finding that the 2007 will did not contain a clear and unambiguous manifestation of Bud's intent to revoke the trust in its entirety. In other words, the court held that the effect of the 2007 will on the 2002 trust was limited to the amendment, modification or revocation required with respect to the specific trust assets mentioned in the 2007 will; the other assets in the 2002 trust, including the remaining 49% interest in the family business and associated real estate, were unaffected by the 2007 will and thus were to pass equally to Paul, Peter and Joan (except for the residential real estate, which was devised to Paul and Sarah). Bobbie appealed the trial court's ruling.

The appellate court affirmed the trial court's decision, stating that the pivotal question in this case is the extent to which the distribution provided for under the 2002 trust should be deemed to have been changed by the provisions of the 2007 will. Like the lower court, the appellate court could not find any clear and unambiguous manifestation of Bud Krusi's intent to revoke the 2002 trust in its entirety.  The words of the boilerplate preamble in the 2007 will, regarding revocation of all prior wills and codicils, do not, by themselves, reflect an intention to revoke any other kind of testamentary instrument, such as a trust.

Had the terms of the 2002 trust stated that the instrument could only be amended, modified or revoked by a signed written instrument other than a will or a codicil, Bobbie would have been entitled to take nothing and decedent's children would have been entitled to the entire estate. This, in my opinion, is how the 2002 trust should have been drafted.  Just a few words inserted at the right place in the document by a careful draftsman can mean the difference between your heirs receiving millions of dollars or receiving best wishes.

For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron, whose main office is located in Orange County, California, welcomes your comments and questions.


Wednesday, May 12, 2010

New 3.8% Medicare Surtax on Unearned Income

The Health Care Care and Education Reconciliation Act of 2010 (H.R. 4872), was passed by Congress on March 25, 2010, and signed into law by President Obama on March 30, 2010. H.R. 4872 amended the previously enacted Patient Protection and Affordable Care Act of 2010 (Public Law 111-148), which President Obama signed on March 23, 2010. Taken together, the two laws represent a massive overhaul of the nation's health insurance and delivery systems, and include more than $400 billion in new taxes on employers and individuals. In this posting I will examine one of the more controversial provisions of the health care reform package, namely, the 3.8% surtax on unearned income which is to be used to help fund Medicare benefits in the future. It is estimated that, when the 3.8% unearned income Medicare surtax is added to the new law's additional 0.9% Medicare payroll tax, fully $210.2 billion in extra taxes will have been raised by the federal government over the period, 2013 to 2019, inclusive. The new provision, which takes effect in 2013, is officially known as the Unearned Income Medicare Contributions Tax ["UIMCT"].

The UIMCT broadens the Medicare tax base for higher-income taxpayers by imposing a 3.8% surtax on the lesser of: (1) "net investment income"; or (2) the excess of adjusted gross income [AGI], increased by any foreign earned income otherwise excluded from AGI, over the taxpayer's threshold amount. For single and head-of-household taxpayers the threshold amount is $200,000. For married couples filing a joint return, and surviving spouses, the threshold amount is $250,000.  For a married person filing a separate return the threshold amount is $125,000. Neither the $250,000 threshold amount nor the $200,000 threshold amount is indexed for inflation.

The term, "net investment income," includes interest, dividends, royalties, rents and capital gains, less deductions properly allocable thereto. However, the term does not include income earned from a trade or business unless the business is considered a passive activity for income tax purposes. Furthermore, net investment income does not include distributions from qualified retirement plans, such as employer-sponsored defined benefit plans, profit sharing plans, money purchase plans, ESOPs, 401(k) plans, 403(b) plans or 457(b) plans, nor does such term include distributions from an individual retirement account (IRA) or tax-exempt municipal bond.

Inasmuch as the UIMCT applies only to taxable income, the tax-deferred nature of annuities and cash value life insurance will not be affected by the new law until such time as the taxpayer receives a distribution from the annuity contract or insurance policy which would otherwise constitute taxable income, and may not be subject to the UIMCT at all if the individual's income does not exceed the applicable threshold amount.  By contrast, income from savings accounts or portfolio investments which are not tax-deferred will be impacted immediately to the extent that interest, dividends or capital gains cause an individual's AGI to exceed the applicable threshold amount.

The UIMCT will also apply to estates and trusts, except for charitable remainder and other tax-exempt trusts. Taxable estates and trusts will pay the 3.8% UIMCT on the lesser of: (1) their undistributed net investment income for the tax year; or (2) any excess of their AGI over the dollar amount at which the highest tax bracket for estates and trusts begins for the tax year (currently $11,200), but subject to inflation adjustment each year.

For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron, whose main office is located in Orange County, California, welcomes your inquiries and comments.

Tuesday, May 4, 2010

Whose Mortgage Deduction Is It, Anyway?


As a general rule, in order for interest payments on a home mortgage loan to be deductible, the indebtedness must be the taxpayer's own obligation and not that of another person.  Section 1.163-1(b) of the federal income tax regulations states: "Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness."  Where the taxpayer acquires real property "subject to" a mortgage and is thus not personally liable for repayment of the indebtedness, a deduction is still allowable as long as the taxpayer can establish a legal or equitable ownership interest in the encumbered property.  Legal or equitable ownership rests, in turn, on whether one has assumed the "benefits and burdens" of property ownership.

In a recent memorandum decision of the United States Tax Court, Anthony J. Adams v. Commissioner (4/13/2010), TC Memo 2010-72, 99 T.C.M. 1305, a taxpayer was found to have assumed the benefits and burdens of ownership of real property held in the name of an irrevocable, short-term trust created by unrelated third-party trustors for the benefit of taxpayer and others as part of a promotional easy-financing and asset protection arrangement.  Accordingly, taxpayer was entitled to deduct home loan interest payments made by the trustee with respect to the trustors' mortgage obligation.


In 2003, sellers, Michael and Zina Gedz, conveyed their residence to an irrevocable 5-year trust, assigning beneficial interests therein to the taxpayer and certain others.  Trustors named an independent corporate trustee to hold legal title to the property, along with the proceeds and profits therefrom, for the use, possession and enjoyment of taxpayer and the other beneficiaries. The trust agreement provided that the beneficiaries' interests were to consist solely of the following: (1) a power of direction to authorize the trustee to deal with the trust property; (2) the right to receive or direct the disposition of proceeds from the property, such as from rents, mortgage refinancings or sales; (3) the right to purchase, lease, manage and control the property; and (4) the obligation to pay for expenses and disbursements relating to the property, including homeowners' insurance.  All earnings, gains, proceeds and expenses of the trust were to be allocated among the beneficiaries in accordance with their respective percentages of beneficial interests.

The trust agreement further provided that the beneficiaries' rights to the proceeds from the trust property were to be deemed personal property, and that the beneficiaries would not possess any right, title or interest in or to the real property itself, neither legal nor equitable. However, the beneficiaries did have a right of first refusal to purchase the real property, a right which taxpayers did not exercise due to a decline in the property's market value. Furthermore, no beneficiary could assign its beneficial interest in the trust without the consent of a majority of the beneficiaries.  

This arrangement was promoted to the taxpayer as a way to realize the benefits of home ownership without having to qualify for a bank loan and without the property's being subject to creditors' claims.  An upfront payment of $320,000 was required from taxpayer for the purchase of a 50% beneficial interest in the trust.  Taxpayer occupied the residence pursuant to an occupancy agreement which required him to pay monthly rent to the trustee of $2,900, an amount equal to the sum of principal and income payments owing monthly on the property's mortgage.  By contrast, the fair rental value of the residence was only between $1,500 and $1,600 per month during this time.  While living at the home, taxpayer made substantial repairs and improvements to the property, which he paid for out of his own pocket, including landscaping, replacing the home's cedar deck, and installing a new garage door opener and glass block windows.

The escrow account statements from which the mortgage payments were made showed the trustors, Mr. & Mrs. Gedz, as the mortgagees (borrowers) on the loan, and so did the annual tax statement for Mortgage Interest Paid, IRS Form 1098.  Nevertheless, for the years of his occupancy, taxpayer claimed the mortgage interest deduction for the portion of his "rental" payments to the trustee attributable to the mortgage interest paid by the trust to the bank.  On audit, IRS, relying on the above-cited income tax regulation, disallowed taxpayer's mortgage interest deduction based on the fact that the loan giving rise to the interest payment was not the legal or equitable obligation of the taxpayer's, but rather that of the trustors.


The Tax Court disagreed with IRS, holding that, on balance, taxpayer had indeed assumed the benefits and burdens of ownership with respect to the real property owned by the trust.  The Tax Court based its decision on the following findings: (1) taxpayer had a duty to repair or maintain the property; (2) taxpayer was responsible for keeping the property adequately insured; (3) taxpayer had a duty to pay taxes, assessments and other charges levied on the property; (4) taxpayer had a right to the property's proceeds from rents, refinancings and sales; (5) taxpayer had a right to obtain legal title at any time by paying the balance of the purchase price; (6) taxpayer bore some risk of loss if the property declined in value, which it did; and (7) taxpayer agreed to pay the mortgage's principal and interest under the occupancy and beneficiary agreements entered into with the trustee.  The Court reasoned that these 7 factors outweighed the factors against establishing taxpayer's benefits and burdens of ownership, which included the following: (1) taxpayer could elect not to exercise his right of first refusal to purchase the property, choosing instead to simply walk away from the property at the end of the 5-year trust term; (2) taxpayer had to enter into an occupancy agreement with the trustee in order to use, possess or enjoy the property; and (3) under the terms of the beneficiary and occupancy agreements, taxpayer was prohibited from making any material alterations or improvements to the property without first obtaining certain consents.


For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.  Mr. Codron welcomes your inquiries and comments.


Sunday, April 18, 2010

Valuation Discounts for Gifts of Limited Partnership Interests Reduced

The U.S. Court of Appeals for the Eighth Circuit has affirmed a decision of the U.S. Tax Court in sharply reducing valuation discounts claimed by a married couple with respect to the transfer of limited partnership (LP) interests gifted to their daughters. Holman v. Commissioner (8th Cir. 4/7/2010), 2010-1 USTC ¶60,592, aff'g 130 TC 170. The 8th Circuit agreed with the Tax Court's holding that, in calculating the value of the gifted LP interests, only small discounts were allowable for lack of control and lack of marketability, even though the limited partnership agreement contained significant limitations on the power of the limited partners to manage the LP or to transfer their interests, including a restrictive buy-sell provision permitting the general partners (parents) to redistribute LP interests if an impermissible transfer were to be made.


Taxpayers, Thomas H. Holman, Jr. and Kim Holman, owned a large number of shares of common stock in Dell, Inc., a publicly traded corporation ("Dell"), this as a result of Tom's having been an employee of Dell for many years. Tom and Kim created an LP and funded it with Dell stock. Thereafter, in 1999, 2000 and 2001, the couple gifted minority interests in the LP to their daughters, as limited partners, retaining management control over the entity as general partners.

In filing their gift tax returns for the years in question, the couple discounted the value of the transferred LP interests by 49%, claiming lack-of-marketability and minority-interest adjustments based on the restrictive provisions set forth in the LP agreement, including the transfer restriction, and asserting that such restrictions would depress the value of the LP interests relative to the value of the underlying assets of the LP, the Dell stock. In doing so, taxpayers claimed a value for the gifted interests which was substantially below the market value of the underlying Dell stock.

On audit, IRS challenged taxpayers' gift tax returns for the years in question. IRS characterized the intrafamily transfers as gifts of Dell stock rather than as gifts of LP interests, and disregarded the LP agreement's transfer restrictions for valuation purposes based on §2703 of the Internal Revenue Code. IRS conceded that lack-of-marketability and minority-interest discounts were applicable, but argued that the overall discount should be much smaller than that claimed by taxpayers: 28% relative to the then-prevailing market price of Dell stock.

The Tax Court held that the gifts were indeed gifts of LP interests, not of Dell stock, and that IRS had correctly applied Tax Code §2703 in disregarding the LP agreement's transfer restrictions. However, the Tax Court applied much smaller lack-of-marketability and minority-interest discounts than those claimed by taxpayers, noting that the LP held only highly liquid, easy-to-value assets and that the LP agreement contained a consensual dissolution provision.  As a result, the Tax Court accepted lack-of-marketability valuation discounts for each of the years in question of just 12.5%, and minority-interest valuation discounts of just 4.63% to 14.34% (i.e., discounts that were even lower than those proposed by IRS). Taxpayers' stated purposes in creating the structure, to wit, estate planning, tax reduction, wealth transference, spendthrift protection and money management education, were held not to be bona fide business purposes for the transfer restrictions provided for in the LP agreement. The Court of Appeals took notice of the fact that the Tax Court, when it determined the appropriate discount for the LP interests, had considered what a rational economic actor would deem appropriate and had not ascribed personal or noneconomic motivations to the hypothetical purchaser; the Tax Court did not base its determination of the valuation discount on what might be acceptable to a family member.

For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron welcomes your inquiries.


Tuesday, April 13, 2010

9th Circuit Holds ERISA Spousal Protection Requirements Inapplicable to IRAs

According to a recent federal appeals court decision, a surviving spouse who was not named as a beneficiary of her deceased husband's IRA had no rights in or to that IRA, notwithstanding that the IRA was funded by an indirect rollover from an ERISA-qualified retirement plan providing for spousal protection, where the rollover from the qualified plan occurred prior to the spouse's marriage to decedent.  Charles Schwab & Co., Inc. v. Debickero (9th Cir. 2010), 593 F.3d 916, 2010-1 USTC ¶50,180.

Section 205 of the Employee Retirement Income Security Act of 1974 ("ERISA"), as amended by the Retirement Equity Act of 1984, provides that "in the case of a vested participant who dies before the annuity starting date and who has a surviving spouse, a qualified preretirement survivor annuity shall be provided to the surviving spouse of such participant." [29 U.S.C. §1055(a)(2)].  As applied to a 401(k) plan, this requirement generally means that the surviving spouse is entitled to the entire plan balance as a matter of right, absent the spouse's written consent to waive that right.

Wayne Wilson ("Wilson") was employed by Siemens/GTE and participated in the company's 401(k) plan, an ERISA-qualified retirement plan.  Wilson's participation in the plan terminated when he left Siemens, in 1992, to work for another company.  In 1994, Wilson elected to close his Siemens 401(k) account and take a lump sum distribution, which he rolled over to an IRA with the investment firm, Smith Barney. In 2000, Wilson married Katherine Chandler ("Chandler"), a woman with whom he had been living since 1990.  In 2002, Wilson opened another IRA, this time with Charles Schwab & Co. ("Schwab"). Wilson funded the Schwab IRA by transferring to it approximately half of the proceeds from his Smith Barney IRA. Despite his marriage to Chandler, Wilson named his four adult children from his previous marriage as primary beneficiaries of the Schwab IRA, telling Schwab personnel that he was divorced. In 2005, at the age of 65, Wilson unexpectedly died, survived by his children and Chandler. Because he died at the age of 65, Wilson had not yet reached the required beginning date for taking required minimum distributions from his IRA.

Decedent's adult children and Chandler asserted competing claims to the Schwab IRA. As a result, Schwab filed an interpleader action in federal district court naming Chandler and the children as co-defendants.  Chandler then filed a cross-claim against the children, asserting that the surviving spouse protections under ERISA continued to apply to the 401(k) benefits even after they were rolled over to the IRA, and that, therefore, she, alone, as Wilson's surviving spouse, was entitled to the Schwab IRA. On cross-motions for summary judgment the trial court ruled in favor of Wilson's children, finding it significant that Wilson and Chandler were not married until several years after Wilson ended his participation in the Siemens 401(k) plan, and rejecting Chandler's argument that the surviving spouse protections under ERISA continued to apply even after the funds were rolled over to an independently managed IRA.

The trial court's ruling was affirmed by the U.S. Court of Appeals for the Ninth Circuit, which held as follows: "Although Wilson was at one time a participant in an employee benefit plan subject to ERISA's protections and limitations, ERISA ceased to apply when, long before his marriage to Chandler, Wilson terminated his participation in the employee benefit plan and transferred the proceeds to an independent IRA." [593 F.3d at 919].  The appellate court reasoned that insofar as the Schwab IRA was established and maintained by Wilson personally, and not by his former employer or any employee organization of his former employer, the IRA fell outside the spousal protection rules of ERISA.  The court noted that IRAs are specifically excluded from ERISA's participation and vesting provisions, which include the joint and survivor annuity requirements, and concluded that "it is beside the point that the IRA proceeds originated as employee benefits within an ERISA-qualified plan." [Id.]

For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron welcomes your inquiries.

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