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the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGGTRA”), commonly referred to as the Bush tax cuts, repealed the federal estate tax and substituted a modified carryover basis regime for a step-up basis regime for purposes of determining the cost basis of inherited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.

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.


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.


Wednesday, March 31, 2010

Too Restrictive Operating Agreement Leads to Loss of Gift Tax Exclusion

A federal district court in Indianapolis recently held that the annual gift tax exclusion did not apply to taxpayers' gifts to their children of membership interests in a family-owned limited liability company. The court found that, based on certain restrictive provisions in the LLC's operating agreement, the membership interests represented "future interests" rather than "present interests" in the entity's assets.

The distinction between a present interest and a future interest lies in whether the donee has an unrestricted and unqualified right to the immediate use, possession and enjoyment of the gifted property, or the income therefrom (i.e., a substantial present economic benefit in the gifted property), or, on the contrary, whether such right is postponed or limited in its effectiveness to some future date or time. Gifts of remainders, reversions, executory interests and similar beneficial rights, whether vested or contingent, the use, possession and enjoyment of which, or the income from which, can only be had at some future date or time, represent gifts of future interests in property.

Under federal law, a taxpayer is entitled to an exemption from gift tax with respect to the first $1 million of taxable gifts made over the course of one's lifetime, computed cumulatively on a calendar year basis. Once the $1 million exemption is fully depleted, the tax rate is a flat 35% of a gift's value. Unlike the federal estate tax, the gift tax is not repealed for 2010 or any other year. In determining the amount of a donor's "taxable gifts" for each calendar year period, the first $13,000 of money or other property given to a donee in that calendar year is excluded, provided that the gift is of a present interest. [The annual exclusion amount is indexed for inflation.] A future interest in money or other property does not qualify for the annual gift tax exclusion under §2503(b) of the Tax Code. As a result, a gift of a future interest is deemed a taxable gift in its entirety and causes a depletion of the donor's $1 million lifetime exemption, in whole or in part, whereas a gift of a present interest is deemed a taxable gift only to the extent that the value of the gift exceeds $13,000 per donee per calendar year.

In the Indiana case, Fisher v. United States [S.D. Indiana, 2010-1 USTC ¶60,588 (3/11/2010)], a married couple transferred minority, non-controlling membership interests in their LLC to each of their 7 children.  The taxpayer-donors retained full management control over the LLC, the principal asset of which was an extremely valuable parcel of undeveloped beachfront land bordering Lake Michigan. When taxpayers filed their gift tax returns they claimed the annual exclusion pertaining to each such transfer. However, upon audit of those returns IRS claimed that the gifts were of future interests and assessed the Fishers a gift tax deficiency in the amount of $625,986! The Fishers paid the deficiency and filed a claim for refund in federal district court, alleging, among other things, that the transferred interests in the LLC were gifts of present interests.

The district court held in favor of IRS, stating that the membership interests received by taxpayers' children constituted a future interest, not a present interest, and that, consequently, no annual exclusion would be allowed.  The court based its decision on the following three factors: (1) the children's membership interests did not confer on them a substantial present economic benefit in the LLC's property because, under the operating agreement, the children's right to receive distributions of capital proceeds, whenever such distributions might occur, was subject to a number of contingencies, all of which were within the exclusive discretion of taxpayers as general managers of the LLC; (2) under the operating agreement there was no indication that an unrestricted right to use, possess or enjoy the LLC's property was in fact transferred to the children, and, in any event, the children's right to use, possess or enjoy beachfront land, without more, did not confer on them a substantial economic benefit in the LLC; and (3) although it was claimed that the Fisher children had the right to unilaterally transfer their membership interests in the LLC, under the operating agreement they could do so only if certain conditions were satisfied (such as the fact that the LLC had a right of first refusal if any purchase offers were made), conditions which effectively prevented the children from transferring their interests for immediate value, even to their own family members.

For further information about this or any other blog on this web site, please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.

Friday, December 11, 2009

Taxation of Employer-Owned Life Insurance

Life insurance proceeds are generally received by the beneficiary free of income tax. However, as part of the Pension Protection Act of 2006 ["PPA 2006"] , proceeds from employer-owned life insurance ["EOLI"] contracts issued after August 17, 2006, are taxable to the beneficiary as ordinary income to the extent that such proceeds exceed the sum of the premiums and other amounts paid by the policyholder (cost basis).  This PPA 2006 legislation affects all businesses, regardless of size or type, where the employer is the owner and beneficiary of the contract and the employee is the insured. Specifically, it includes key-man coverage, buy-sell agreements and nonqualified deferred compensation plans.

Fortunately, there are certain exceptions to the general rule of tax inclusion. The first test which must be met in order for EOLI death benefits to remain tax-exempt is that, prior to issuance of the policy, the employer must provide written notice to the insured-employee stating that a policy is to be issued on the employee's life which will be owned by and payable to the employer. Further, the employer must obtain the employee's written consent to such policy's being issued, and the notice and consent form must satisfy the requirements set forth in Section 101(j)(4) of the Internal Revenue Code ["IRC"].

The second test to be met is that one or more of the following "safe harbors" must apply: (1) the insured is an employee of the employer at any time during the 12-month period preceding death; (2) at the time of policy issuance the insured is a director of the employer-corporation or a highly compensated employee thereof, as defined in IRC §414(q); or (3) the death benefit is either (i) payable to the insured's family members, estate or designated beneficiaries, or (ii) used to purchase an equity or capital interest in the employer from any of the persons described in clause (i), above.

If both the notice & consent and one or more of the safe harbor requirements are met, the EOLI death benefit will be received income-tax free, provided the policy's death benefit is otherwise eligible for favorable income tax treatment under IRC §101(a).

As a result of the PPA 2006 legislation, many of the EOLI policies issued after August 17, 2006, will be subject to income taxation when the employee dies, unless corrective measures are taken.  IRS requires reporting of all EOLI policies by the "applicable policyholder" (i.e., the employer), on Form 8925. That form is used to report whether the notice and consent requirements have been met for each and every employee whose life is insured under an EOLI contract held by that employer.

In order to bring a post-August 17, 2006 EOLI policy into compliance and thereby avoid income taxation on the portion of the proceeds in excess of cost basis, a new policy must be issued or an existing policy must be reissued with a "material change" to the death benefit (in either case, after the proper notice and consent form has been obtained from the insured-employee).  New guidance issued by IRS, in Notice 2009-48, states that if a Section 1035 exchange is made which includes a material modification of the policy, the notice and consent requirements will apply to the new policy. Thus it may be possible to bring a noncompliant policy into compliance by making a 1035 exchange to a policy with an increased death benefit or other change which constitutes a material modification. However, a death benefit increase made merely to meet the requirements of Section 7702, dealing with modified endowment contracts ["MECS"], will not be considered a material modification by IRS.

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