EisnerAmper PWA Tax and Wealth Management Planning Update Winter 2006
Personal Wealth Advisors Practice
Tax and Wealth Management Planning Update For Financial Advisors
Volume I – Winter 2006
This Outline contains a summary of planning matters that can be used by financial advisors, and family offices and their advisors, to identify appropriate opportunities.
EisnerAmper LLP provides tax and other services and support to family offices, investment advisors, law firms and their attorneys, and other advisors. EisnerAmper is an independent member of Baker Tilly International, a prestigious global network of more than 128 firms in approximately 85 countries, with global revenues of $1.82 billion and 21,000 staff worldwide. Baker Tilly is the 8th largest accounting network in the world. Like EisnerAmper, every affiliate firm in the Baker Tilly International group has earned a reputation for exceptional work and close personal attention to client needs.
Any tax advice in this communication is not intended or written by EisnerAmper LLP to be used, and cannot be used, by a client or any other person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer, or (ii) promoting, marketing, or recommending to another party any matters addressed herein.
The comments in this Outline are limited to the observations and conclusions specifically set forth herein and are based on the completeness and accuracy of any stated facts, assumptions and representations. With this Outline, EisnerAmper LLP is not rendering any specific advice to the reader. The outline is based on the applicable provisions of the Internal Revenue Code of 1986 and ERISA, as amended, and the relevant state and foreign statutes, the regulations thereunder, income tax treaties, and judicial and administrative interpretations, thereof. These authorities are subject to change, retroactively and/or prospectively, and any such changes could affect the validity of the enclosed observations. EisnerAmper LLP will not update our Outline for subsequent changes or modifications to the law and regulations or to the judicial and administrative interpretations thereof.
Tax and Wealth Management Planning Update For Financial Advisors
Contents and Page Reference
I. Legislative Issues and Treasury Priorities in 2006………………………………..4
II. Selected Planning Topics………………………………………………………...17
III. Case Law Developments: Partnerships, Valuation, and Other Matters………….22
IV. Revenue Rulings and Notices: Broad Applications Regarding Qualified Plans,
Deferred Compensation and Other Matters…...................………..………..……...33
V. Proposed 2006 Charitable Contribution Provisions…………………….………..41
VI. Heckerling Institute on Estate Planning: Topics From the 2006 Session..………44
VII. Articles and Publications……………………………………………………...54
1. Federal Tax Legislation Update
In his January 31 State of the Union Address, President Bush “urged this Congress to act responsibly, and make the (2003) tax cuts permanent.”
Against this backdrop, EisnerAmper’s Personal Wealth Advisors Practice continues to monitor emerging federal tax legislation for our individual clients, including the status of the President’s Tax Advisory Panel reform recommendations, AMT reform, estate tax reform, the extension (or not) of the 15% dividend and capital gains rate presently set to expire in 2008, and other matters.
Many commentators are proposing there may be no progress in 2006 on certain of these initiatives due to continuing domestic and international issues presently occupying the Administration. However, the Administration began 2006 emphasizing its view of the positive impact of reduced taxes on dividends and capital gains when it comes to business investment, economic growth and job creation. During the week ended February 17, Treasury Secretary John Snow told U.S. House members “it would be a mistake not to fully repeal the Death Tax.” Secretary Snow cited the President’s fiscal year 2007 budget which establishes a Dynamic Analysis Division which will study big tax changes to help gain a better understanding on how to score tax bills within the Treasury department. The Death (estate) Tax will be one of the tax policies analyzed. Secretary Snow has also repeatedly endorsed a permanent extension of the current capital gain tax, and in a February 15 Wall Street Journal editorial he cited “the tax reductions on capital have been at the heart of the progress we have seen (referencing the improved performance of the U.S. economy).” And, in a statement January 17, Secretary Snow emphasized the impact of reduced taxes on dividends and capital gains when it comes to business investment, economic growth and job creation; he said:
"The Jobs and Growth Act of 2003 was especially effective at encouraging investment because it lowered the cost of capital: the lifeblood of a free market economy. Business investment literally turned around overnight when those tax cuts took effect, ending nine quarters of investment dearth and spurring ten quarters – so far – of outstanding business investment, which has then led to growth and job creation. Raising taxes on capital carries the risk of reversing this trend in business investment, and this is not an option in my eyes, or in the eyes of the President. On the contrary, making the President's tax cuts permanent is essential to continuing a strong, positive trend in business investment and in our economy overall. With more Americans working than ever before, more Americans owning stock than ever before and with federal tax revenues at an alltime high to boot, there is no reason why Congress should not see the benefits of furthering tax relief by making the tax cuts permanent. And I know the President and I will do everything we can to ensure Congress moves forward in doing so."
Many economic and related financial and governmental policy developments are well underway and will define the 2006 legislative agenda. The House returned for legislative business on January 31 and we are closely watching the federal tax issues pending from 2005, to be addressed in 2006; these issues are summarized below.
The 15% Tax Rate on Qualifying Capital Gains and Dividends
On February 2, 2006 the U.S. Senate passed an amended version (S. 2020) of H.R. 4297 (“The Tax Relief Act of 2005”). S. 2020 removed all of the provisions of H.R. 4297 passed by the House in 2005. As more fully cited below, S. 2020 includes charitable reforms, clarification of the economic substance doctrine, and of most significance AMT relief in the form of increasing 2006 AMT exemptions ($62,550 for joint filers), and the allowance of nonrefundable credits against regular tax and AMT in 2006 and 2007. After the House considers S. 2020, a Conference Committee will reconcile Senate (S. 2020) and House (H.R. 4297) differences. In a letter to Conferees, Senate Majority Leader Bill Frist (R-Tenn.) said he “wants the Conference Report to contain the extension of capital gains and dividends tax relief that are in the House bill.” Leadership says they hope to have the Conference Report completed before March 2006 Congressional recess.
In December 2005 the House voted to approve a measure that extends the 15% income tax rate on qualifying dividends and capital gains until 2010 (H.R. 4297); this provision is currently set to expire in 2008. The Senate was not in favor of the House extension because the related tax revenue reduction attributable to the 15% tax rate was not offset by cuts in budget expenditures. A House and Senate compromise may result in a one year extension to 2009 of the 15% tax rate.
Charitable incentives were also added to the Senate bill, including allowing IRA rollovers to charity and allowing charitable deductions for non-itemizers; donor-advised funds reforms were also included. Interestingly, due to donor benevolence demonstrated in 2005 on behalf of Katrina and Tsunami victims, certain commentators believe 2006 may be a difficult year for fundraising by cfharities.
AMT reform remains in the forefront of 2006 legislation. The 2005 House provision increased the AMT exemption amount for inflation, and the Senate provision increased the minimum exemption fixed dollar amount (S. 2020). Without any AMT exemption level increase, 20 million taxpayers will be subject to AMT in 2006 compared to 4 million taxpayers in 2005, according to the Treasury Department. The Senate AMT “patch” excludes approximately 600,000 additional taxpayers from AMT compared to the House version.
The origins of AMT date to January 1969, when Treasury Secretary Joseph W. Barr reported to Congress that 155 individual taxpayers with incomes over $200,000 paid no income tax as reflected on their 1967 income tax returns. As a consequence, the Tax Reform Act of 1969 created a minimum tax (“AMT”) designed to ensure that individuals with high incomes did not take what was deemed unfair advantage of tax laws to reduce or eliminate their federal income tax liability. Thus, while the original scope of the AMT only applied to a small minority of high-income taxpayers as a “class tax” AMT is now on the verge of becoming a “mass tax.”
According to the Urban Institute and Brookings Institution, in 2001 only 2% of taxpayers paid AMT; under current law, by 2010 it is estimated that one third of all taxpayers will be subject to AMT. According to the President’s Tax Reform Panel, AMT repeal would cost the Treasury approximately $1.3 trillion and agreed upon provisions to replace the foregone tax revenue or attain simplification has not been identified by Congress, and is not likely to be addressed in 2006. The AMT rates are 26% for taxable income up to $175,000 and 28% for additional taxable income. The 15% qualified capital gains and dividends rate remains constant for AMT purposes.
Simplification and the President’s Tax Advisory Panel
William Thomas (R-California) who chairs the House Ways and Means Committee has announced 2006 hearings on tax reform independent of the recommendations cited in the 2005 President's Tax Advisory Panel (“Panel”). Therefore, while the Administration does not appear ready to act on Panel recommendations, the House Ways and Means and Senate Finance committees have expressed the importance to work on tax simplification. The Panel recommended two alternative federal individual income tax reform plans, both of which would limit or eliminate almost all existing tax deductions, including those for state and local income and property taxes. Under the individual plans generally, AMT is repealed, the top income tax rate is 33%, no deduction will exist for state and local tax deductions, there will be no limit on charitable deductions, and the home mortgage interest deduction will be repealed and replaced with a home credit. Regarding corporate taxes, all dividends paid from U.S. corporations will be deemed tax-free to recipients, entities with under $10 million in receipts will be taxed on a cash basis and all expenditures will be deductible currently except building and land acquisitions (which will be depreciated), the top income tax rate is 32%, AMT is repealed, and pass through entities (LPs, LLCs, S corps) will be taxed at the entity level.
The Panel report also proposed eliminating 401(k), 457(b) and 403(b) retirement plans, flexible spending accounts, health savings accounts and 529 plans, and replacing them with two simplified savings accounts and eliminating the tax break for employerprovided health insurance. The Panel's proposal to cut the popular health insurance tax break was met with strong opposition by employer groups. Instead of allowing employers and employees to pay an unlimited amount of health insurance premiums tax-free, the Panel wants to cap the tax break at the average cost of premiums, estimated to be $5,000 for individuals and $11,500 for families. Bonnie Whyte, president of Employers Council on Flexible Compensation, says the tax panel's recommendations amount to "a tax increase for middle-income workers and will only increase the out-of-pocket health expenses for Americans." While capping the health insurance tax break is politically unpopular now, Whyte notes, employers are worried that such proposals will appear in future legislation. American Benefits Council President James Klein says, "We are concerned that taxing health benefits will lead many workers to drop coverage or demand much higher wages to offset the additional tax burden."
The Panel's other major benefit rollup recommendation has received less attention. The Panel proposed to combine 401(k), Simple 401(k), 403(b), 457, SARSEP and Simple IRAs into a streamlined "Save at Work" accounts. "Save for Family" accounts would replace 529 plans, HSAs, and FSAs. A third category, called "Save for Retirement" accounts, would substitute for IRAs, Roth IRAs and deferred executive-compensation plans. "The Panel's proposals for retirement savings are intriguing, but unproven as to whether they would result in greater savings," said Klein.
The Estate Tax
Senate Republicans remain at odds over a vote to fully repeal the estate tax. In 2005 Senate Majority Leader Frist (R-TN) repeatedly promised legislation that would repeal the estate tax, while Senate Finance Committee Chair Grassley (R-IA) called the chances of achieving full repeal "zero," because a repeal will need 60 votes to overcome any objection or filibuster; it is unclear whether the 60 repeal votes exist in 2006. Compromise efforts include boundaries of a possible deal likely encompassing an estate tax exemption of between $4 million and $6 million and a 15% to 35% tax rate. Sen. Jon Kyl (R- Ariz.) has proposed a rate tied to the 15% capital gains tax rate and an exemption of $8 million while Senator Grassley has cited a possible compromise containing an exemption closer to $5 million with a 15 percent tax rate.
Because of Katrina and other disaster-relief legislation, there has been no further action and there will not be until later this year, and possibly not until 2007.
Additional Legislative Provisions To Be Addressed in 2006
Additional major provisions in the 2005 House and Senate proposed tax legislation (H.R. 4297 and S. 2020) to be addressed in 2006 include extending the state sales and use tax deduction; extending 15 year depreciation deductions for leasehold improvements; extending the increased Sec. 179 expensing for small businesses from $25,000 to $100,000; extension by the Senate of the New York Liberty Zone Incentives for transportation infrastructure; elimination by the Senate of the language “gains from a sale or exchange of securities” from the definition of passive investment income, and elimination of the rule terminating an S election for S corporations with passive income for three consecutive tax years; and allowing an itemized deduction for the cost of
acquiring mortgage interest on a qualified residence.
In the area of charitable incentives and reforms, as cited above, the major provision is the allowance of tax-free deductions from IRAs for charitable purposes. A Senate provision would clarify the application of the economic substance doctrine and apply a new penalty for not meeting stated doctrine standards; changes are proposed to the inversion regimes; numerous provisions in the area of IRS penalties and interest applications including underpayment of estimated income tax; requiring mark to market on the unrealized gain of property held by certain U.S. citizens who relinquish U.S. citizenship and/or residency; and increasing the age of minors to 18 for purposes of the kiddie tax. Senate provisions that clarify foreign-based stock option plans that are substantially similar to U.S. incentive stock options, and provisions that certain deferred compensation plans should be given the same treatment as U.S. plans as described under the nonqualified deferred compensation regulations are also proposed.
2. Summary of Treasury Department and the Internal Revenue Service’s Trust, Estate and Gift, and GST Items: 2005-2006 Priority Guidance Plan
At a 2005 fourth quarter meeting of the American Institute of Certified Public Accountants Estate and Gift Tax Technical Resource Panel (TRP), representatives of the IRS cited seven items on the Priority Guidance Plan, as follows:
- Final regulations under IRC Sec. 671 regarding the reporting requirements for widely-held fixed investment trusts. Proposed regulations were published on June 20, 2002, and the finalization of those regulations is proposed.
- Guidance regarding the consequences under various estate, gift, and generationskipping transfer tax provisions of using a family-owned company as the trustee of a trust. The IRS has ceased issuing private letter rulings in this area because the paperwork with respect to each ruling request is voluminous and, as a result, issuing the ruling is too time-consuming. Therefore, the IRS plans to publish guidance that taxpayers will be able to rely upon in the absence of obtaining their own private letter ruling. The guidance may take the form of a revenue ruling.
The project is in the very early stages.
- Guidance under section 2053 regarding the extent to which post-death events may be considered in determining the value of a taxable estate. This project will take the form of proposed regulations that will attempt to establish some consistent rules to be followed, rather than the current state of the law with cases going in several directions.
- Revenue procedures under sections 2055 and 2522 containing sample charitable lead trust provisions. Documents similar to the ones on charitable remainder annuity and unitrusts will be published for charitable lead trusts. Unlike charitable remainder trusts, no previous sample documents have ever been issued by the IRS for charitable lead trusts. The project will consist of probably three or four revenue procedures.
- Guidance under section 2056 regarding qualified terminable interest property where a marital trust is the named beneficiary of a decedent’s individual retirement account. This guidance will take the form of a revenue ruling and will address the application of the new definition of income rules to a situation in which a QTIP election is made for an IRA. This project is fairly far along and probably will be the first of the seven projects published.
- Final regulations under section 2642 regarding the definition of, and procedures for making, a qualified severance of a trust. Proposed regulations were published on August 24, 2004. This project is also fairly far along so that they are expected to be out fairly soon.
- Guidance under section 2704 regarding restrictions on the liquidation of an interest in a corporation or partnership. Nothing was really said about the scope or status of this project. In response to a question about whether this project was an effort to overturn the Kerr decision, an IRS representative stated “not necessarily.”
IRS representatives also stated that they are contemplating no new streamlined procedures under 9100 for extensions of time to make elections regarding the allocation of GST exemption. They also said that any regulations addressing the definition of a GST trust are not on the horizon. A member of the TRP asked about a situation in which the attorney or accountant refuses to sign an affidavit admitting fault for failure to make a GST election and the taxpayer is unwilling to sue the attorney or accountant for malpractice. The response was that a few requests for 9100 relief have been granted in similar situations. Their advice was to supply the IRS with as much information as possible, especially any in information to show that making the election always made sense, not just from the standpoint of hindsight.
Members of the TRP expressed concern about the March 15 due date for Form 3520A. The penalties for late filing are so severe that they force people to continue to be noncompliant. TRP members also expressed concern about the different treatment of the IRC Sec. 67 haircut for investment advisory expenses incurred by trusts depending on which Circuit Court of Appeals the trust resides in.
With regard to Rev. Proc. 2005-24 (2005-16 I.R.B. 1; the safe harbor requiring a spousal waiver upon the creation of a charitable remainder trust if the trust assets may be included in the spouse’s elective share under state law), the Treasury stated that the revenue procedure has served the purpose of educating people that there is a potential problem and did provide a way for taxpayers to solve that problem. Treasury is actively looking at regulatory guidance in this area, and their concern is only with charitable remainder trusts, and not pooled income funds or other scenarios that have the same effect and same potential problem.
An IRS representative in the Estate and Gift Tax Program discussed current issues affecting that program. The number of federal estate tax returns (Form 706) filed in 2002 was 114,000, while the number estimated to be filed for 2005 is only 70,000. An estimated 262,000 gift tax returns (Form 709) will be filed for 2005. A new Form 8892 will allow taxpayers to request an automatic 6-month extension of time to file the gift tax return if they do not obtain an extension to file their income tax returns.
IRS estate tax attorneys will once again start examining the estate’s income tax returns (Form 1041) in conjunction with their examination of the Form 706. They have started a project to match the executor’s commissions taken as a deduction on the Form 706 with the corresponding income inclusion on the executor’s Form 1040. Because around 40% of the estate tax attorneys in the nation are already eligible to retire, audits may be done in a different part of the country than the area of residence of the donor or decedent. Once they finish their audits of the estate or gift tax returns, they will be making referrals to the income tax examiners concerning family limited partnerships that are reported on those returns.
The Patent Office has requested assistance from the IRS concerning the requests to patent estate tax planning devices. Apparently, at least one estate tax planning idea has received a patent. In theory, the holder of a patent owns the rights to the transaction and can prevent others from trying to use the transaction. Under the “prior art” doctrine, patent applications should be rejected if the transaction is neither new nor original. Patent Office staff may not have adequate background in tax law and estate planning to determine whether a transaction is new or original and so the IRS estate tax attorneys have agreed to advise them.
3. Highlights of 2005 Tax Law Changes
Filing Deadlines and Six-Month Automatic Extensions
Regulations released in November 2005 allow individual income taxpayers (and certain other taxpayers) to obtain an automatic six-month extension of time to file certain returns by filing a single request.
With the regulations, individual taxpayers are no longer required to sign the extension request or to explain why an extension is needed in order to receive the automatic sixmonth extension of time. However, the rules do not extend the time for payment of tax, and although no payment of tax is required to obtain an extension, failure to pay any tax by the original due date may subject the taxpayer to penalties and interest. The IRS release reiterates this change, and notes that extensions to file will be through October 16, 2006, for most taxpayers.
New Rules for Donating Vehicles, Boats, and Aircraft
Beginning in 2005, the charitable contribution deduction for a vehicle donated to charity,is generally limited to the gross proceeds from its sale. This rule applies if the claimed value of the donated vehicle is more than $500.
Form 1098-C (or other form of written acknowledgment of the donation) from the organization must be attached to the taxpayer’s return. Among other things, the acknowledgment generally must include the gross proceeds of the sale, the vehicle identification number, and a statement certifying the vehicle was sold in an arm's length transaction between unrelated parties. This acknowledgment must be provided within 30 days after the date of the sale of the vehicle. Taxpayers generally can deduct the vehicle’s fair market value (FMV), if:
- The organization makes significant intervening use of or materially improves the vehicle,
- The organization gave or sold the vehicle to a needy individual at a price significantly below FMV in direct furtherance of its charitable purpose of relieving the poor and distressed or underprivileged who are in need of a means of transportation, or
- The claimed deduction is $500 or less.
For donations made after June 3, 2005 the FMV cannot exceed the private party sales price listed in a used vehicle pricing guide.
If the organization had a significant intervening use of or materially improved the vehicle, the acknowledgment must include a certification of the intended use of or material improvement to the vehicle and the intended duration of that use and a certification that the vehicle will not be transferred in exchange for money, other property, or services before completion of that use or improvement. The acknowledgment must be provided within 30 days after the date of the contribution.
If the organization gave or sold the vehicle to a needy individual at a price significantly below FMV, the acknowledgment must include a certification that the donee organization will sell or transfer the qualified vehicle to a needy individual at a price significantly below fair market value and that the sale (or transfer) will be in direct furtherance of the donee organization's charitable purpose of relieving the poor and distressed or the underprivileged who are in need of a means of transportation. The acknowledgment must be provided within 30 days after the date of the contribution.
These rules do not apply to donations of inventory.
Income-Based Limits Lifted for Cash Donations Made in Late 2005
Most cash contributions made to charity after August 27, 2005 and before January 1, 2006 are exempt from the income-based limits that normally apply. Thus, individual taxpayers who make large contributions during this period may be able to deduct them up to 100% of their adjusted gross income (AGI), instead of 50% of AGI — the limit that usually applies. Also, the phase-out of the charitable contribution deduction that affects higher-income taxpayers is suspended for cash donations made during this period.
Contribution Limits Raised for IRAs and other Retirement Plans
For 2005, the contribution limit for Roth and traditional IRAs is $4,000 or $4,500 for those age 50 or over ($5,000 in 2006). In 2004, the comparable limits were $3,000 and $3,500, respectively. There is no minimum age for making a traditional IRA contribution for tax purposes.
The $10,000 phase-out range for IRA deductions for those covered by a retirement plan begins at income of $50,000 ($70,000 if married filing jointly or a qualifying widow(er)). It still begins at zero for a married person filing a separate return. Use the worksheet in the tax package to figure the IRA deduction
The elective deferral (contribution) limit for employees who participate in 401(k), 403(b) and most 457 plans rose to $14,000 ($15,000 in 2006) ($17,000 for 403(b) plan participants for whom the 15-year rule applies). For SIMPLE plans, the limit rose to $10,000. The catch-up contribution limit for persons age 50 or older rose to $4,000 for 401(k), 403(b) and 457 plans and to $2,000 for SIMPLE plans.
Qualified defined contribution plan employee deferrals can be increased by employer contributions so long as total contributions (account additions, and ignoring investment income or investment appreciation) per participant do not exceed the lesser of of 100% of compensation or $42,000 for 2005 and $44,000 for 2006.
Standard Mileage Rates Increased
For 2006, the standard business mile rate is 44.5 cents per mile. In 2005, for the first time ever, the IRS adjusted the standard mileage rate during the year to reflect increases in the price of gasoline. From January 1 to August 31, the standard mileage rate for business use of a car, van, pick-up or panel truck was 40.5 cents a mile, compared to 37.5 cents a mile in 2004. Effective September 1, 2005 the rate increased to 48.5 cents a mile. From January 1 to August 31, 2005 the standard mileage rate for the cost of operating a vehicle for medical reasons or as part of a deductible move was 15 cents a mile, up from 14 cents in 2004. On September 1, the rate rose to 22 cents. The rate for providing services to charitable organizations is set by law and remains at 14 cents a mile.
Uniform Definition of a Qualifying Child
Beginning in 2005, a new definition of a qualifying child ordinarily applies for the dependency exemption, head of household filing status, earned income tax credit (EITC), child tax credit and credit for child and dependent care expenses. Relationship, residency, age and support tests are used to determine if someone is a qualifying child. In general, all four tests must be met. However, the support test does not apply to the EITC.
Under the relationship test, a child must be the taxpayer’s child (including an adopted child, stepchild or foster child), brother, sister, stepbrother, stepsister or a descendent of one of these relatives. An adopted child includes one lawfully placed with the taxpayer for legal adoption, even if the adoption is not final. A foster child is one placed with the taxpayer by an authorized placement agency or by court order.
Under the residency test, a child must live with the taxpayer for more than half of the year. Temporary absences for special circumstances (such as for school, vacation, medical care, military service, or detention in a juvenile facility) count as time lived at home.
Under the age test, a child must be under a certain age, which varies with the tax benefit.
For the dependency exemption, head of household and EITC, the child must be under 19, under 24 if a student (enrolled full time during any part of five calendar months), or any age if permanently and toTilly disabled. For the child tax credit, a child must be under 17.
For the credit for child and dependent care expenses, a child must be under 13 or any age if permanently and totally disabled.
Under the support test, a child cannot have provided over half of his or her own support.
A child who meets the tests to be a qualifying child of more than one person can be claimed by only one person (unless the exception for divorced or separated parents applies). If more than one person claims the same qualifying child, the IRS will use the tie-breaker rule to determine who gets the tax benefit.
If only one of the persons is a child's parent, the parent gets the benefit. If both are parents, it goes to the parent with whom a child lived longer. If a child lived with each parent for the same amount of time, the parent with the higher AGI gets the benefit. If no parents are involved, the person with the highest AGI receives the tax benefit.
Inflation Adjustments for 2005 Tax Filing Purposes
Personal exemptions and standard deductions rose, tax brackets were widened, and more than three dozen individual and business tax provisions were adjusted to keep pace with inflation.
Popular items adjusted include the following:
- The value of each personal and dependency exemption is $3,200, up $100 from 2004. Most taxpayers can take personal exemptions for themselves and an additional exemption for each eligible dependent. An individual who qualifies as someone else’s dependent cannot claim a personal exemption, and personal and dependency exemptions are phased out for higher-income taxpayers.
- The standard deduction is $10,000 for married couples filing a joint return and qualifying widow(er)s (a $300 increase over 2004), $5,000 for singles and married individuals filing separate returns (up $150) and $7,300 for heads of household (up $150). Higher amounts apply to blind people and senior citizens. The standard deduction is often reduced for a taxpayer who qualifies as someone else’s dependent. Nearly two out of three taxpayers take the standard deduction, rather than itemizing deductions, such as mortgage interest, charitable contributions, and state and local taxes.
- The maximum earned income tax credit is $4,400 for taxpayers with two or more qualifying children, $2,662 for those with one child, and $399 for people with no children. Available to low and moderate income workers and working families, the EITC helps taxpayers whose incomes are below certain income thresholds, which in 2005 rose to $37,263 for those with two or more children, $33,030 for people with one child and $13,750 for those with no children. One in six taxpayers claim the EITC, which unlike most tax breaks, is refundable, meaning that taxpayers can receive it, even if they owe no tax and even if no tax is taken out of their paychecks.
4. Foreign Assignments for Executives and Employees: Common Issues To Consider
As multinational corporate employees continue to undertake international assignments, there are many questions and pre-departure issues that should be explored in a face-toface meeting with advisors who are knowledgeable of corporate and individual tax and financial planning matters. Following is a summary of issues (not all-inclusive) to identify and discuss in advance of an assignment:
- Review current and long-term after tax compensation amounts (consider incentives and cost of living adjustments, housing allowances and living expense reimbursements and travel to the U.S., moving cost reimbursement, other compensation components);
- Understand housing arrangements and the party responsible for property leases or other real estate costs;
- Determine the disposition of U.S. property during the assignment;
- Income sourcing and pre-departure receipts, post-departure payments, U.S. and foreign country treaty issues and definitions, the sourcing and taxation of equity compensation;
- Understand net tax income liabilities, foreign tax credits and tax gross up considerations, tax equalization policies, hypothetical tax calculations, state income tax planning issues;
- Determine the availability of employer-provided tax compliance services during the foreign assignment;
- Understand retirement plan contributions and accumulations and U.S. social security equalization and foreign pension and retirement benefits;
- Review if children education assistance is provided by the employer;
- Review the adequacy and costs of health care and disability income coverages while in the foreign location;
- Determine if your wills are effective based on your balance sheet and titling of assets, residency, and other factors;
- Make sure travel visas and work permits are current and appropriate;
- Review special family situations and needs.
Additionally, non-U.S. citizens and nationals who work or live in the United States should seek assistance to understand U.S. tax law as it applies to them. Becoming familiar with U.S. income tax rules should help foreign individuals to take advantage of the tax planning opportunities available; EisnerAmper professionals can assist employees and employers in this regard.
5. Applicable Federal Rates For February 2006
Sec. 7872 Rates
Short term rate
Mid term rate
Long term rate
The Sec. 7520 rate is 5.2%.
6. 2006 Tax Planning Observations: Specific Considerations
Employees should communicate to employers how much they would like to set aside in 2006 in a Code Sec. 401(k) plan or flexible spending arrangement, where the plan year coincides with the calendar year. An employee must elect in advance how much to set aside in the plan; similar rules apply to nonqualified deferred compensation plans.
Adjusting Federal Tax Withholdings
W-4 federal income tax withholdings should be reviewed in order to avoid 2006 tax underpayment penalty exposure.
Expensing Capital Investments
Considering forecasted capital needs in 2007, analyze 2006 acquisitions or defer to 2007 equipment purchases to maximize the benefit of the expensing deduction. Under Code Sec. 179(b)(2), the maximum expensing amount ($105,000 for 2005) is reduced dollarfor- dollar by the amount by which the cost of expensing-eligible property placed in service during the tax year exceeds $420,000.
Qualified disclaimers are an effective device in estate planning. In recent rulings, the IRS has potentially expanded the assets subject to disclaimers (Ltr. Rul 2005 03024; 2005 16004; 2005 19042; 2005 21033; Rev rul 2005-26 (2005-26 IRB 1368).
Review Trust Structures
Client considerations include Total Return Trusts, Asset Protection Trusts, Dynasty Trusts, and state-specific trusts. While the selection of trust situs is tax specific and fact based, considerations include: selecting a jurisdiction whereby the terms of the instrument will be carried out regardless of other states statues or laws; allowing perpetual trusts (when properly structured); avoiding income on certain income accumulated; application of attendant investor rules and provisions; division of responsibility is authorized; asset protection is available, and under attendant circumstances; if total return trusts are permitted; that court costs are minimized; confidentiality is preserved; and judicial relief is provided.
TD 9230 (12/5/05) adopts final rules regarding information reporting if the corporation is acquired or has a substantial change in capital structure; see also IRC Sec 6043 (c).
Family S Corporation Elections
S corporation family shareholder election Notice 2005-91 (2005-51) cites how to make the election to treat all members of a family as a single shareholder.
Prepaid Forward Contracts – Terms and Attributes
These financial contracts generally act as a hedge to protect against a decrease in stock value. However, where certain contract attributes are present, the contract could result in an unintended “constructive taxable sale” of the underlying stock by an investor. Contract attributes that could cause a constructive sale include: an excessive amount of forward proceeds measured by a percentage of the stock value; the investment bank being able to loan the stock to other (unrelated) investors; the investor agreeing to assign to the investment bank dividends on the nderlying stock; an excessive contract term; and other attributes.
Investors (typically high net worth individuals) have entered into so-called “variable forward” contracts with respect to stock. Under these arrangements, the client, with a substantially appreciated equity position, enters into a contract that economically resembles a combination of a sold call and purchased put. For example, assume the client’s basis in the stock is 10 and the stock has a current fair market value of 100. The client could buy a put at 90 (which limits her downside risk to 10) and sell a call at 110 (which limits her upside to 10). When the put (with a below-market strike price) and call (with an above-market strike price) are combined and permit share settlement, the resulting contract is referred to as a variable forward. Specifically, using our example, if the share price at maturity was below 90, the client would deliver one share, between 90 and 110, the client would deliver shares with a value of 100 and if the share price was greater than 100, the client would deliver a number of shares to the bank that allowed the client to recognize the value of 10% appreciation. Often, the bank writing these contracts will then make an upfront payment on the contract (usually no greater than 85 on the numbers used in the example). When there is an upfront payment, the transaction is known as a “variable prepaid forward contract.”
Additional Considerations To Be Aware Of
Proposed Treasury Circular 230 regulations focus on contingent fees, practitioner sanctions, who may practice before the IRS, prohibitions regarding representing conflicting interests, and standards for tax returns and documents. However, the regulations do not address the standards for written tax advice that were included in the final (2004) and amended (2005) regulations.
TAM 200541040: Contingent debt instruments were issued by a corporation, whereby the instrument referred to portfolio shares held by the corporation. The debt instrument was deemed to be (part of) a straddle.
Valuable collectibles and like kind exchanges under IRC Sec 1031. Be aware of the applicability (and non-applicability) of IRC Sec. IRC Sec 1031 (a). See Rev Ruls 54-268, (1954-2 CB88); 79-143 (1979-1 CB 264); 82-96 (1982-1 CB 113); see also Helvering, v. National Grocery Store (1938); Procter (19 TC 387 (1952); Notice 97-59 (1997-2, CB 209); and Tyler (P.H. Tem 47,058, March 6, 1947).
In TC Memo 2006-15, the taxpayer (Giles) was unable to demonstrate a profit intent with regard to horse breeding and selling activities. The IRS continues to win these cases when business-like and business purpose attributes are absent.
In Notice 2006-15 (2006-8 IRB) the IRS is re-examining a safe harbor released in Rev Proc 2005-24 (2005-16 IRB 909) for CRTs that are created during the grantor’s life and subject to a right of election by (on the part of) the grantor’s spouse to take against the grantor’s will. Pending further guidance, no spousal waiver of the right of election will be needed for any CRAT or CRUT – regardless of when created. Notice 2006-4 (2006-3 IRB) and the exclusion from IRC Sec. 409A of stock options and SARs granted before the effective date of the regulations.
Be aware of the IRS review of IRC Sec. 751 regulations and alternative treatments of partnership distributions of “hot assets” to provide greater simplicity; final regulations in connection with determining the tax basis of stock or securities received in IRC Sec. 368 or 355 transactions; final regulations defining statutory mergers (TD 9242, January 23, 2006), and separately foreign mergers (TD 9243, January 24, 2006); IRS Ltr Rul 200603002 and an allowable corrective reformation of an ILIT would not cause adverse estate or gift taxes (a policy exchange whereby the insureds inadvertently signed documents as owners of the policy when in fact the ILIT was the intended to be the owner); valuing annuities and determining income on IRA-to-Roth IRA conversions (Rev Proc 2006-13, 2006-13 IRB).
7. Gift Tax Deficiencies in Senda Case
The U.S. Court of Appeals for the Eighth Circuit released on January 6, 2006 a decision in which it affirmed the Tax Court's finding of gift tax deficiencies in relation to transfers of stock in a family limited partnership situation.
The taxpayers claimed that they made gifts of partnership interests to their children; the IRS asserted that they made indirect gifts of stock and valued the gifts at the full undisclosed value of the stock. The Tax Court agreed with the IRS and found gift tax deficiencies, and the Eighth Circuit affirmed.
The Eighth Circuit noted that the Tax Court had found that the taxpayers "presented no reliable evidence that they contributed the stock to the partnerships before they transferred the partnership interests to the children" and that this sequence is critical because a contribution of stock after the transfer of partnership interests is an indirect gift to the partners (to the extent of their proportionate interest in the partnership). Finding no clear error, the Eighth Circuit upheld the Tax Court's determination.
In 1998, the taxpayers created a family limited partnership, with the husband/father—as trustee of his revocable living trust—as the general partner with a 10% interest, as well as a limited partner with a 89.8397% interest. The wife owned a limited interest of 0.1303%, and each of their three children had a limited interest of 0.01%—held in (an oral) trust with their father as trustee. The children reported partnership income/losses on their individual tax returns.
At the end of 1998, in exchange for their interests, the taxpayers transferred 28,500 shares of MCI WorldCom stock (then worth about $2 million) to the partnership. The children's trusts then reportedly contributed oral accounts receivable (reported at $200) in exchange for their interests—which were unpaid at the time of trial. On their gift-tax return for 1998, the taxpayers reported that on December 28, 1998, they gave all their limited interests equally to their three minor children.
The next year, the taxpayers formed a second limited family partnership, with the husband/father's revocable trust as the general partner with a 1.0% interest, as well as a limited partner with a 97.97% interest. The wife owned a 1.0% limited interest. Irrevocable (written) trusts for each child held limited interests of 0.01% each. At the end of 1999, in exchange for their interests, the taxpayers transferred 18,477 shares of MCI WorldCom stock (then worth about $1.5 million) to this partnership.
The children's trusts reportedly gave oral accounts receivable (reported at $148) in exchange for their interests—which were unpaid at the time of trial. On their gift-tax return for 1999, the taxpayers reported that on December 20, they gave a total of 53.7% limited interest in this second partnership equally to the trusts for the three children, and claimed that they made gifts of partnership interests.
8. Estate of George C. Blount Buy-Sell Agreement Not Controlling of Value But Insurance Proceeds Not Added On
The Eleventh Circuit Court of Appeals in Estate of George C. Blount v. Commissioner, 2005 WL 2838478 (11th Cir. Oct. 31, 2005), affirmed in part and reversed in part the Tax Court’s holding in Estate of George C. Blount v. Commissioner, T.C. Memo 2004-116 (May 12, 2004). The Eleventh Circuit agreed with the Tax Court that the stock purchase agreement was substantially modified and was not binding during the decedent’s life, and, as a result, the value of the decedent’s shares must be their fair market value. The Eleventh Circuit did not agree with the Tax Court that the value of the company should be increased by the insurance proceeds that were to be used to purchase the decedent’s shares.
In 1981 when the decedent and his brother-in-law each owned 50% of the stock in their construction company, the two shareholders and the company entered into a buy-sell agreement (the 1981 Agreement) that restricted transfers of the stock during the shareholders’ lifetimes and at death. Transfers during life could be made only with the consent of the other shareholders. Upon the death of a shareholder, the estate was required to sell, and the company was required to purchase, the stock at an established price. The agreement provided that the shareholders and the company could redetermine the purchase price each year, but if the value was not redetermined, the price would be the company’s book value at the end of the fiscal year prior to the shareholder’s death. No redeterminations were ever made so the value was subject to the automatic adjustment.
Beginning in 1992, the company adopted an employee stock ownership plan (ESOP), which became a minority shareholder by purchasing stock from the decedent, his brotherin-law, and the company. The ESOP participants were employees of the company who were not related to the two shareholders, and the decedent did not have any personal relationship with any of these employees outside work. In January 1996 the decedent’s brother-in-law died, and, pursuant to the buy-sell agreement, his shares were redeemed by the company based on the company’s book value at the end of the preceding fiscal year. In October 1996 the decedent discovered that he was severely ill with cancer and sought to put his affairs in order. The company had always maintained a large reserve of cash in order to meet its bonding requirements without the need for personal guarantees. In assessing the impact on the company of purchasing the shares from his estate, the decedent determined that, taking into account the insurance proceeds on his life, the company would be able to purchase his shares for $4 million and still have sufficient cash to operate and meet its bonding requirements. Without consulting an attorney, the decedent individually and on behalf of the company as its president executed a shareholder agreement in November 1996 (the 1996 Agreement) that required the company to buy, and the decedent’s estate to sell, the decedent’s stock for $4 million. At the time he signed this agreement, the purchase price for his shares based on the 1981 Agreement would have been approximately $7.6 million.
The decedent died in September 1997 and shortly after his death the company redeemed his shares for $4 million as provided in the 1996 Agreement. Thereafter the ESOP owned all the company’s stock. The stock was valued at $4 million on the decedent’s estate tax return.
The Tax Court held that the 1981 agreement, as modified by the 1996 amendment, was to be disregarded for purposes of determining the value of the shares. The Tax Court also concluded that the amount of tax should be calculated by adding the insurance proceeds to the other assets in the corporation in order to arrive at the fair market value of the corporation.
Effectiveness of the Buy-Sell Agreement
In order for a buy-sell agreement to establish the value of property for federal estate tax purposes prior to the enactment of section 2703, the agreement had to meet the following three requirements:
- The offering price must be fixed and determinable under the agreement
- The agreement must be binding on the parties both during life and after death
- The restrictive agreement must have been entered into for a bona fide business reason and must not be a substitute for a testamentary disposition
Section 2703, applicable to agreements created or substantially modified after October 8, 1990, provides that any agreement to acquire property for less than its fair market value will be disregarded in valuing the property for federal estate tax purposes unless all of the following requirements in section 2703(b) are met:
- The agreement is a bona fide business arrangement
- The agreement is not a device to transfer the property to members of the decedent’s family for less than full and adequate consideration
- The terms of the agreement are comparable to those of similar arrangements negotiated at arm’s length
A buy-sell agreement must first meet the requirements of pre-section-2703 law and then, if applicable, the requirements of section 2703.
Agreement Requirements During Lifetime
In order to qualify for the exception to the general rule that stock be valued at its fair market value, the restrictive agreement must be binding during the life of the decedent. The Eleventh Circuit agreed with the Tax Court’s conclusion that the decedent was not bound by the agreement during his lifetime because he had the unilateral ability to amend it. The 1981 Agreement provided that is could be modified only with the consent of the parties thereto, and there was no mechanism for adding parties. After the brother-inlaw’s death, the 1981 Agreement could be modified with the consent of the decedent and the company, which was controlled by the decedent because he then owned 83.2% of the stock, was the only person on the board of directors, and was the president of the company. Because the decedent had the unilateral ability to amend the agreement, it was not binding on the decedent during his life and is disregarded in determining the value of his stock at his death.
Observation: The mere fact that the decedent owned the controlling interest in the company was not fatal to the requirement of binding during life. If the 1981 Agreement could have been modified only with the consent of all the current shareholders, the ESOP’s consent would have been required. Even though the ESOP owned only a inority interest in the company, its consent (if it had been required to modify the agreement) would have been sufficient to keep the decedent from having a unilateral ability to amend the agreement. See Estate of True v. Commissioner, T.C. Memo. 2001- 167.
IRC Sec 2703
While the Tax Court could have stopped its analysis of the buy-sell agreement at this point, it chose to continue on to see whether and how section 2703 would apply, if the Modified 1981 Agreement had satisfied the requirement that it was binding during the decedent’s life. The initial inquiry was whether the 1981 Agreement was substantially modified by the 1996 Agreement because section 2703 applies only to agreements created or substantially modified after October 8, 1990.
With regard to substantial modifications, Treas. Reg. section 25.2703-1(c)(1) provides:
“Any discretionary modification of a right or restriction, whether or not authorized by the terms of the agreement, that results in other than a de minimis change to the quality, value, or timing of the rights of any party with respect to property that is subject to the right or restriction is a substantial modification.”
The 1996 Agreement modified the portion of the 1981 Agreement dealing with purchase of stock upon a shareholder’s death by:
- Substituting $4 million instead of book value as the purchase price
- Eliminating the shareholders’ right to set the price each year
- Removing the automatic annual adjustment of the purchase price
- Eliminating the right of the company to pay for the stock in installments
As previously mentioned, the purchase price for the decedent’s shares upon the execution of the 1996 Agreement dropped from $7.6 million to $4 million, an amount that the Tax Court considered to be more than a de minimis change in value of the decedent’s and the company’s rights. The 1996 Agreement, to which the ESOP was not a party, changed the rights of the ESOP as the minority shareholder by eliminating its right to insist on book value as the basis of redemption by refusing to agree to reset the price and by eliminating the automatic annual adjustment to current book value. The 1996 Agreement also eliminated the company’s right to pay the redemption price in installments. The Tax Court concluded that these changes substantially altered the rights of the decedent, the company, and the ESOP, and, as a result, made the Modified 1981 Agreement subject to the provisions of section 2703.
On appeal, the Eleventh Circuit agreed with the Tax Court that the 1981 agreement was substantially modified in 1996, with the result that IRC Section 2703 applies. The substantial modification was evident in the valuation differences for the buy out; the change in the payment structure for the buy out; and the loss of any fluctuation in the price depending on future events.
Observation: Clients, who have buy-sell agreements that were executed on or before October 8, 1990 (the effective date of section 2703), should be reminded not to make any changes to those agreements without seeking professional advise. In Blount the decedent on his own modified the agreement and as a result the agreement not only became subject to the provisions of section 2703 but also no longer qualified to establish the estate tax value of the stock under the law as it existed prior to section 2703. The Tax Court applied the standard for “substantial
modification” contained in section 25.2703-1(c)(1), i.e., a change that is other than a de minimis change to the quality, value, or timing of the rights of any party with respect to the property.
The Eleventh Circuit found no error in the Tax Court’s determination that the agreement was not comparable to similar arrangements entered into by persons in an arm’s length transaction and therefore did not meet the section 2703(b)(3) prong of the exception to general rule of section 2703(a). As a result, the stock is includible in the decedent’s gross estate at its fair market value.
Fair Market Value of Corporation
The Tax Court had blended the analyses of the various experts to arrive at a value of $6.75 million for the corporation. The Tax Court then added the $3 million in insurance proceeds that the corporation would receive on the decedent’s death. As a result, the total value of the corporation was determined to be $9.85 million. The Eleventh Circuit held that the Tax Court erred in adding the insurance proceeds to the value of the corporation. Treas. Reg. section 20.2031-2(f)(2) provides that when valuing corporate stock consideration is given to nonoperating assets, including proceeds of life insurance policies payable to or for the corporation’s benefit “to the extent that such nonoperating assets have not been taken into account in the determination of net worth.” The Eleventh Circuit focused on whether the insurance proceeds have been otherwise taken into account.
The corporation in this case had acquired the insurance policy on the decedent’s life for the sole purpose of funding its obligation to purchase the decedent’s shares in accordance with the stock-purchase agreement. Even though the agreement could not be utilized for purposes of determining the value of that stock for federal estate tax purposes, the agreement remains binding between the corporation and the decedent’s estate. The Eleventh Circuit concluded that the insurance proceeds should not be included in the fair market value of the company because there is an enforceable contractual obligation that offsets those proceeds.
According to the court, “To suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construct of fair market value.”
9. IRC Sec. 2703 Applied to Restrictive Provision in Family Partnership Agreement
In Sidney Smith v. United States, 2004 WL 1879212 (W. D. Pa. June 30, 2004), a magistrate has filed with the district court a report concerning the government’s motion for summary judgment in a case involving the fair market value of minority limited partnership interests in a family limited partnership (FLP). His report concludes that the provisions of IRC section 2703 apply to the restrictive provision in FLP agreement.
Donor and his children created a FLP in 1997 that was funded with 100% of the common stock in an operating company. Initially, the donor owned a 2% general partnership (GP) interest and a 95.15% limited partnership (LP) interest, while his son owned a 1% GP interest and a .9% LP interest and his daughter owned a .95% LP interest. In the following year, the donor made gifts to both children of first a 6.865% LP interest and then a 13.37% LP interest. On his gift tax return, the donor reported the total value of those gifts at approximately $1 million. The IRS adjusted the value of the gifts to approximately $1.8 million. The donor paid the additional gift tax and filed a claim for refund. The sole issue before the court is the correct value of those gifts.
The donor’s appraised value for the transferred interests took into account a substantial discount for lack of marketability because of a provision in the FLP agreement that limits the price and the terms upon which the partnership would be required to pay a partner for his or her LP interest if that partner desired to dispose of his or her interest and the partnership exercised its right of first refusal to purchase the interest. According to the agreement, the partnership or the purchasing partners would give the selling partner a non-negotiable promissory note, payable over a term not to exceed 15 years (with the length selected by the purchaser), in equal annual installments of principal and interest, with interest equal to the applicable federal rate for long-term debt instruments. The IRS disregarded this provision in arriving at the value for the transferred interests under the authority of section 2703(a).
The government filed a partial motion for summary judgment requesting the court to determine that section 2703(a) applies to the case and requires that the value of the donor’s transferred LP interests be determined without regard to the restrictive provision in the FLP agreement. The representatives of the donor argued that section 2703(a) does not apply to restrictive provisions contained in “entity-creating partnership agreements” but only to independent buy-sell agreements and, in the alternative, that the FLP agreement falls within the safe harbor exception of section 2703(b).
Section 2703(a) generally provides that for purposes of calculating estate, gift, and generation-skipping transfer taxes, the fair market value of the property is to be determined without regard to:
- any option, agreement, or other right to acquire or use the property at a price less than its fair market value; or
- any restriction on the right to sell or use the property.
The Magistrate’s Recommendations
The magistrate’s report recommends that the district court grant the government’s motion for partial summary judgment on the application of section 2703(a) to the restrictive provision. It disagrees with the donor’s position that section 2703(a) does not apply to provisions contained in the partnership agreement. The report concludes that the restrictive provision falls within the plain language of section 2703(a)(i) and the regulations thereunder. Treas. Reg. section 25.2703-1(a)(3) provides that the right or restriction may be contained in a partnership agreement, articles of incorporation, corporate agreement, a shareholders’ agreement, or any other agreement.
The report states that because this provision of the regulations closely tracks the Congressional legislative history, deference must be given to this regulatory interpretation. The report also disagrees with the donor’s claim that this issue had been addressed in Church v. United States, 2000 WL 206374 (W.D. Tex. 2000), aff’d 268 F.3d 1063 (5th Cir. 2001). In that case, the court determined that a restriction in a partnership agreement prohibiting a buyer of a partnership interest from attaining the status of a partner (rather than being merely an assignee) is not the type of restrictions that Congress intended to reach under section 2703. The magistrate’s report distinguishes a restriction on the right a buyer of a partnership interest to become a partner from a provision that fixed the price of the partnership interest at less than fair market value.
The magistrate’s report next examined whether the safe harbor exception of section 2703(b) applies to allow the restrictive provision to be considered in determining the value of the gifts. The safe harbor exception of section 2703(b) applies if the restriction meets all three of the following requirements:
- It is a bona fide business arrangement;
- It is not a device to transfer the property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and
- Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.
With regard to the first prong of the safe harbor (bona fide business arrangement), the courts have recognized an arrangement as a bona fide business arrangement if it facilitates the maintenance of family ownership and control of a business. The report concludes that this requirement was satisfied because there is little doubt that the restrictive provision was designed to maintain family ownership in, and control of the FLP.
With regard to the second prong of the safe harbor (not a testamentary device), the issue of whether a restrictive agreement is a substitute for a testamentary device should be determined based on the facts in existence at the inception of the agreement after:
- an evaluation of the reasonableness of the stock purchase price;
- an examination of the intent of the parties; and
- an examination of all the other factors, such as the transferor’s health at the inception of the agreement; significant changes in the business; selective enforcement of the restrictive provisions; and the nature and extent of the negotiations that occurred among the parties regarding the terms of the restrictive provisions.
With regard to the third prong of the safe harbor (comparable arms’ length arrangements), the donor has the burden of showing that the agreement is one that could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arms’ length. This test is met if the right or restriction conforms to the general practice of unrelated parties under negotiated agreements in the same business.
The report concludes that factual inquiry would be needed to decide whether the second and the third prongs of the safe harbor exception are satisfied and thus summary judgment on these prongs is not appropriate.
Observations: While this is only a magistrate’s report to the district court, it is notable for being the first judicial pronouncement that addresses the applicability of section 2703 to a restrictive provision in a partnership agreement that fixes the price of a partnership interest at less than fair market value. This report serves as another reminder of the importance of not changing any buy-sell agreements and other restrictive agreements entered into prior to October 8, 1990, without carefully considering the ramifications of section 2703, which became effective on that date. For agreements executed, or materially modified, on or after October 8, 1990, it will be important to meet all three prongs of the safe harbor exception. Satisfying the third prong may be particularly
difficult because it requires evidence of comparable provisions for companies in the same business – information that may be difficult to obtain.
10. Share of Residential Co-Op Real Estate Tax Not Deductible For AMT
In Ostrow ((CA 2 11/22/2005) 96 AFTR 2d 2005-5584), by affirming the Tax Court the Court of Appeals for the Second Circuit has held that in computing an individual’s alternative minimum tax (AMT), a deduction allowed for regular tax purposes for her share of the real estate taxes paid by a cooperative housing corporation does not reduce alternative minimum taxable income (AMTI). This issue had not previously been decided by any Circuit Court of Appeals.
In 2001, Lauren Ostrow was a tenant-stockholder of a cooperative housing corporation. She filed jointly with her husband and, for regular tax purposes, they claimed a $10,489 itemized deduction for her proportionate share of real estate taxes paid by the corporation. In computing their AMT tax liability, the Ostrows treated the $10,489 as deductible in computing their AMTI. IRS disallowed the deduction for AMT purposes.
A deduction for real property taxes paid or accrued by the taxpayer during the tax year is allowed by Code Sec. 164(a)(1). In addition, a tenant-stockholder may deduct amounts paid by or accrued to a cooperative housing corporation within the tax year, to the extend that the amounts represent the tenant-stockholder’s proportionate share of the real estate taxes deductible by the corporation under Code Sec. 164. (Code Sec. 216(a)(1)). In computing AMTI, no deduction is allowed to an individual for miscellaneous itemized deductions (as defined in Code Sec. 67(b)) or “for any taxes described in paragraph (1), (2), or (3) of section 164(a)” unless the taxes are deductible in computing adjusted gross income; i.e., because they are incurred in a trade or business (Code Sec. 56(b)(1)(A).
11. Home Sale Relocation Expenses Could Result in Compensation To An Employee
In Rev Rul 2005-74 (2005-51 IRB), using an analysis of the benefits and burdens of ownership, the IRS analyzed the treatment for an employee of costs incurred by his employer in connection with three different home purchase programs offered to employees who are being relocated.
A sale occurs for federal tax purposes on the transfer of the benefits and burdens of ownership. Whether benefits and burdens have been transferred is a question of fact, in
which the following factors are considered:
(1) whether legal title passes;
(2) how the parties treat the transaction;
(3) whether equity was acquired in the property;
(4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the buyer to make payments;
(5) whether the right of possession is vested in the buyer;
(6) which party pays the property taxes;
(7) which party bears the risk of loss or damage to the property; and
(8) which party receives the profits from the operation and sale of the property.
The passage of legal title is a significant, but not determinative factor.
In Rev Rul 2005-74, the IRS, based on an analysis of the benefits and burdens of ownership, determined that in two situations there were two separate sales of the home: a fist sale from the employee to the employer and a second sale from the employer to a third party buyer. In the other situation there was only one sale from the employee to the third party buyer.
12. Mutual Funds Obtain No Tax Benefits by Investing in Commodity- Index Contracts
In Rev Rul 2006-1 (2006-2 IRB; IR 2005-142), the IRS issued guidance to clarify that income from commodity-index derivative contracts does not help a regulated investment company (mutual fund) qualify for the tax benefits usually enjoyed by mutual funds. However, to give funds enough time to adapt to the position and to communicate it to their shareholders, the IRS is applying the newly-announced position prospectively.
Some funds have entered into these derivatives to provide their shareholders with a totalreturn exposure to changes in the value of commodity indices. Many investment managers consider commodity exposure an important component of investors’ overall portfolio, in part as a hedge against inflation. Investments that create this exposure include exchange-traded commodity futures contracts and interest in commodity-trading partnerships. Historically, however, mutual funds did not offer this exposure directly, because under the tax law applicable to these funds direct investments in commodities do not generate qualifying income for a mutual fund.
Rev Rul 2006-1 holds that income and gains from indirect investments in commodities via certain derivative contracts are not qualifying income for mutual funds. However, the IRS will not apply the holding adversely to income that mutual fund recognizes on or before June 30, 2006.
13. Transitional Relief - Deadlines For Amending Qualified Plans
In Notice 2005-95 (2005-51 IRB), the IRS responded to concerns among the practitioner community as to when plan amendments must be adopted to reflect changes in various qualification requirements for Code Sec. 401(a) plans. The notice reaffirms the applicability of the timing rules under Rev Proc 2005-66 (2005-37 IRB 509) while giving transitional relief to plan sponsors and employers that will, in some cases, provide additional time to adopt plan amendments.
Rev Proc 2005-66, Sec. 5.05 provides a general rule for the deadline for the timely adoption of an interim or discretionary amendment. Where there are statutory or regulatory changes regarding plan qualification requirements that will impact provisions of a written plan document, resulting in a disqualifying provision, the adoption of an interim amendment generally will be required by the later of the:
- Due date (including extensions) for filing the income tax return for the employer’s tax year that includes the date on which the remedial amendment period begins, or 36
- Last day of the plan year that includes the date on which the remedial amendment period begins.
A plan maintained by more than one employer does not have to be amended for a disqualifying provision until the last day of the tenth month following the last day of the plan year in which the remedial amendment period begins.
14. Final Regulations Clarify Roth-IRA Option for 401(k) Plans
IRS has issued final regulations explaining the post-2005 rule that permits 401(k) plans to allow participants to choose to have all or part of their elective deferrals treated as Roth- IRA contributions (designated Roth contributions). The regulations generally apply for plan years beginning after 2005.
Observation: The final regulations carry a few surprises that will complicate designated Roth contributions and may make them less attractive to plan participants. For example, they say that Code Sec. 72 applies when determining the tax character of distributions of designated Roth contributions, instead of the established ordering rules that apply to regular Roth IRA payouts. More significantly, the designated Roth contributions are subject to the Code Sec. 401(a)(9) lifetime required minimum distribution (RMD) rules that apply to non-pension qualified plan payouts. By contrast, regular Roth IRAs are not subject to the lifetime RMD rules.
Observation: Generally, under Code Sec. 402A(d)(2), a qualified distribution from a designated Roth is one made after the five-tax year period beginning with the first tax year for which the taxpayer contributed to the plan’s designated Roth established for the taxpayer and is made: (1) on or after attaining age 59½, (2) at or after death (to a beneficiary or estate), or (3) on account of disability.
The final regulations generally follow the approach taken in the 2005 proposals, but include a number of modifications and clarifications.
Designated Roth contributions are defined as elective contributions under a qualified CODA that are:
(1) designated irrevocably by the employee when he makes the cash or deferred election as designated Roth contributions
(2) treated by the employer as includible in the employee’s income when he would have received the contribution in cash had he not made the CODA election (e.g., by treating the contributions as wages subject to applicable withholding requirements); and
(3) maintained by the plan in a separate account. (Reg § 1.401(k)-1 (f)(1))
See Reg Sec. 1.401(k)-1; Reg Sec. 1.401(k)-2; Reg Sec. 1.401(k)-6; Reg Sec. 1.401(m)- 2; and Reg Sec. 1.401(m)-5.
15. IRS Interim Guidance on Application of Section 409A to Outstanding Stock Rights
The IRS on December 23, 2005, released an advance copy of Notice 2006-04 providing interim guidance concerning the application of section 409A to outstanding stock rights.
Stock options and stock appreciation rights (i.e., stock rights) generally are excluded from coverage under section 409A if (1) issued with an exercise price that cannot fall below the fair market value of the stock at the date of grant, and (2) the stock right does not contain any additional deferral feature.
According to the IRS, Notice 2006-04 addresses the application of this exclusion to outstanding stock rights and specifically concerning the determination of whether the stock right has an exercise price no less than the stock's fair market value at the date of grant.
For stock rights issued before January 1, 2005 (which generally would have been nonvested as of January 1, 2005, to not otherwise be excluded under the section 409A grandfathering provisions), Notice 2006-04 provides that the fair market value determination will be made pursuant to the rules governing incentive stock options. The IRS reports that generally with this treatment, the exercise price is deemed to be the fair market value if the taxpayer can demonstrate that the issuer attempted in good faith to set the exercise price at fair market value.
Concerning stock rights issued on or after January 1, 2005, but before the effective date of the final regulations (proposed to be effective January 1, 2007), Notice 2006-04 reiterates the standard provided in Notice 2005-1—i.e., that the determination of fair market value may be made using any reasonable valuation method.
16. Regulations Propose To Treat Disregarded Entities as Separate Entities for Employment and Excise Tax Purposes
The Treasury Department and IRS in October 2005 released for publication in the Federal Register proposed regulations (REG-114371-05) which would treat qualified subchapter S subsidiaries (QSubs) and single-owner eligible entities—currently disregarded as entities separate from their owners for federal tax purposes—as separate entities for employment and related reporting requirement purposes and for reporting, paying, and taking other actions related to certain federal excise taxes.
Reason for Regulations
Because a disregarded entity is not recognized for federal tax purposes, the owner of the disregarded entity currently is treated as the employer for purposes of employment tax liabilities and all other employment tax obligations related to wages paid to employees performing services for the disregarded entity. According to the preamble of today's proposed regulations, administrative difficulties arising from the interaction of the disregarded entity rules and federal employment tax provisions affect both taxpayers and the IRS. Treasury and the IRS have stated that treating the disregarded entity as the employer for federal tax purposes would improve the administration of the tax laws and simplify compliance.
Similarly, difficulties arising from the interaction of the disregarded entity rules and certain federal excise tax provisions are intended to be remedied by the proposed regulations. As noted in the preamble, determinations of liability for excise tax—as well as allowances of a credit, refund, or payment—can rely on state (not federal) law.
To address these issues, the proposed regulations would treat QSubs and disregarded single-owner eligible entities as separate entities for certain employment tax provisions under subtitle C, certain excise taxes, and certain rules under subtitle F relating to items such as reporting, assessment, collection, and refunds of excise taxes. Under the proposed regulations, these entities generally would continue to be treated as disregarded entities for other federal tax purposes.
Proposed Effective Date
The employment tax provisions are proposed to apply to wages paid on or after January 1 after the date when the regulations are published as final regulations in the Federal Register. QSubs, disregarded single-owner eligible entities, and their owners can continue to use the procedures under Notice 99-6 to satisfy employment tax liabilities and obligations for periods before the regulations are effective (at which time, the notice would be obsolete). If, under Notice 99-6, the owner of the disregarded entity currently satisfies the employment tax liabilities and obligations with respect to wages paid to employees performing services for the disregarded entity, the owner must continue to satisfy such obligations until the effective date of these regulations.
The excise tax provisions are proposed to apply to liabilities imposed and actions first required or permitted in periods beginning on or after January 1 after the date the regulations are published is final regulations in the Federal Register. For periods before the regulations' effective date, the IRS will treat payments or actions made by a disregarded entity with respect to excise taxes as having been made or taken by the sole owner of that entity.
17. Taxpayers Can Claim General Sales Taxes Instead of Income Taxes As Itemized Deductions in 2005
Under the American Jobs Creation Act of 2004, taxpayers who itemize their deductions have the option of claiming either state and local income taxes or state and local general sales taxes. Taxpayers will indicate by a checkbox on line 5 of Schedule A which type of tax they are claiming.
Observation: :Tax Year 2005 is the last year that the law allows taxpayers the option to deduct state and local general sales taxes, although pending legislation may extend this option to future years.
Generally, taxpayers can deduct the actual state and local general sales taxes (including compensating use taxes) paid in 2005 if the tax rate was the same as the general sales tax rate. However, sales taxes on food, clothing, medical supplies and motor vehicles are deductible as a general sales tax even if the tax rate was less than the general sales tax rate. Sales taxes on motor vehicles are also deductible as a general sales tax if the tax rate was more than the general sales tax rate, but the tax is deductible only up to the amount of the tax that would have been imposed at the general sales tax rate.
Optional general sales tax tables included in the Schedule A instructions give taxpayers a sales tax deduction amount as an alternative to saving their receipts throughout the year and tabulating the amount actually paid. Taxpayers use their income level and number of exemptions to find the sales tax amount for their state. The line 5 instructions explain how to add an amount for local sales taxes if appropriate.
Generally, taxpayers may add to the table amount any sales taxes paid on:
A motor vehicle, but only up to the amount of tax paid at the general sales tax rate;
- and an aircraft, boat, home (including mobile or prefabricated), or substantial addition to or major renovation of a home, if the tax rate is the same as the general sales tax rate.
- Motor vehicles include cars, motorcycles, motor homes/recreational vehicles, sport utility vehicles, trucks, vans and off-road vehicles. Taxpayers may also include any state and local general sales taxes paid for leased motor vehicles.
While this deduction will mainly benefit taxpayers with a state or local sales tax but no income tax, (in Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming), it may give a larger deduction to any taxpayer who paid more in sales taxes than income taxes. For example, a person may have bought a new car, boosting the sales tax total, or claimed tax credits, lowering the state income tax paid.
Other items to keep in mind:
- Taxpayers who received refunds of state or local general sales taxes in 2005 for amounts paid in 2005 should reduce their 2005 state and local general sales taxes by this amount.
- Taxpayers who received a refund of state or local general sales taxes in 2005 for prior year purchases should not reduce their 2005 state and local general sales taxes by that amount.
- However, taxpayers who deducted state and local general sales taxes in the earlier year and the deduction reduced their tax may have to include the refund in income on Form 1040.
18. Charitable Giving Incentive and Charitable Organization Reform
Provisions in the 2005 Senate Bill (S. 2020)
Provisions in the 2005 tax reconciliation bill (referred to as the Tax Relief Act of 2005) was approved by the Senate earlier this month and includes charitable giving incentive proposals and charitable organization reforms. It is very likely the charitable provisions will be addressed in 2006 in Conference Committee action. Following are the highlights of the charitable provisions of S. 2020:
Following are the highlights of the charitable provisions of S. 2020:
- Charitable contribution deductions will be allowed for taxpayers who do not itemize;
- Tax-free distributions from IRAs for qualified charitable purposes will be excluded from income (a “direct distribution”). A qualified charitable distribution would be any distribution from an IRA made during the two year period after 2005 and before 2008, directly by the IRA trustee either to a qualifying organization to which deductible contributions can be made, or a “split interest entity” – that is a charitable remainder annuity trust or unitrust, a pooled income fund, or a charitable gift annuity;
- Direct distributions and split interest distributions are only qualified if made after the date the taxpayer attains age 70 and one half years of age;
- Contribution deduction for food inventory;
- Basis adjustment to stock of S corporation contributing property;
- Modify the tax treatment of certain payments to exempt organizations;
- Encourage contributions of real property made for conservation purposes;
- Charitable contribution deduction for book inventory;
- Penalty imposition for tax involvement by exempt organizations in tax shelter transactions;
- Excise tax on acquisition of interests in insurance contracts;
- Increase amount of excise tax imposed on certain exempt organizations;
- Improve accountability of donor advised funds;
- Improve accountability of supporting organizations;
- Reform rules for contributions of easements in registered historical districts;
- Various rules regarding (i) limiting deductions for clothing and modify recordkeeping requirements, (ii) overstatement of valuations of property, (iii) fractional interests in personal property,(iv) tax on private foundation net investment income, and (v) exemption standards for credit counseling organizations.
19. Special Care Must Be Exercised when Contributing Automobiles To Charity
The IRS will not recognize certain deductions that taxpayers may be claiming relating to donated vehicles sold at auction, as announced by the IRS on December 20, 2005. IRS said it was taking this action as the result of “questionable practices that have surfaced recently.” According to IRS, some donated vehicles have been sold at auction and the charities then claimed that the sales were to needy individuals at prices significantly below fair market value. The charities claimed that the sales triggered an exception to the general rule that the deduction allowed to the donor is limited to the proceeds from the charity’s sale.
20. The 40th Annual Heckerling Institute on Estate Planning: Summary Comments
Forecasts Regarding Federal Estate Tax Repeal
At the 2006 Conference, commentators suggested that the estate tax will not be repealed, primarily because of the decrease in revenues that would result. Further, because many states base their estate taxes on the federal estate tax law, a permanent repeal of the federal estate tax would result in loss of state revenues; however, in the event of a federal estate tax repeal or forms thereof, states could enact their own estate tax laws. The current environment appears to be embracing a reduction in the estate tax rate, rather than eliminating the estate tax altogether. Republicans are lobbying for a 15% or 20% estate tax rate, and an increase in the federal applicable exclusion amount.
Observation: As stated earlier in this Outline, Congressional proposals exist for estate exclusion amounts ranging from $2.5 million to $8 million.
There seems to be no intention to coordinate the gift tax exemption with the estate tax exclusion amount; the gift tax is viewed as a backstop to the income tax system. Without a gift tax, there is a Congressional concern there would be massive transfers to lower bracket taxpayers, with re-transfers back to higher bracket taxpayers after the income has been realized. The sentiments expressed by many commentators is that the gift tax exemption will remain at $1 million, and the gift tax rate will have a starting rate of 35% with a top rate at 45%.
Legislation regarding valuation discounts (in the context of reducing asset values subject to an estate tax) is not currently “on the table” although reforms regarding estate valuations broadly was cited by the Joint Committee on Taxation in January 2005.
2006 Treasury Focus Areas in 2006
As stated earlier in this Outline, the Treasury’s 2006 “Business Plan” is issued in July of each year and is usually a good barometer of what is on Treasury’s agenda regarding primary focus areas. 2006 Plan items include:
Private Trust Companies: This pertains to the “no ruling list” for the first time, with regard to private trust companies. The IRS has been inundated with the phenomenon of many requests from families with multiple trusts, who desire to consolidate these trusts into a single trust company of their own creation. In a typical ruling request, taxpayers first request the IRS to review a collection of lengthy and complex trust documents, and then request the IRS to rule that there would be no tax effect if those trusts were moved to a new private trust company. The IRS does not want to devote resources to such a review; instead, the IRS plans on issuing generalized guidance presumably through a Revenue Ruling or Procedure. Recent rulings issued regarding private trust companies include 20548035, 200546053-55, 200531004, and 200523003.
Valuing Section 2053 Debt Deductions: This item has been rolled forward from prior years’ Guidance Plans. The issue related to this item is the implications of changes in post mortem facts in valuing deductions under IRC Section 2053 The IRS would like to consider post mortem settlements of claims against estates in determining how much debt deduction is allowed under IRC Section 2053. The IRS may be hesitant about giving guidance, because if the deduction can be reduced based on post mortem facts, the estate can use post mortem facts to decrease values. Charitable Trusts: In 2003, the IRS issued sample forms for Charitable Remainder Annuity Trusts. In 2005, the IRS issued sample forms for Charitable Remainder Unitrusts. The IRS will now address the third leg of the split interest CRT stool: the IRS will issue sample forms for Charitable Lead Trusts.
Marital Deduction Qualification of IRAs: The IRS is planning on giving guidance on the “all income annually” issue that relates to a qualified plan and minimum required distributions (and related issues), and may be coordinating IRC Section 2056(b)(7)(c) “automatic QTIP qualification” as it relates to IRAs. This should be beneficial to taxpayers in the marital planning arena. Generation Skipping Transfer Tax Issue: This pertains to the one Treasury regulation project that was not made final last year: the IRC Section 2642 qualified severance rules. These regulations have encountered the most comment and controversy in their proposed form; therefore they are taking longer to finalize.
IRC Section 2704 Project: The IRS may plan on using an IRC Section 2704 regulation project in an effort to combat FLP and LLC discounts.
Lifetime Giving: Still a good idea?
Yes, making taxable gifts during one’s lifetime remains a good planning idea. Based on client facts, removing future appreciation from the estate is a good reason to make current gifts and in some states can generate state estate tax savings.
Planning Issues Considering Changes in State Death Taxes
The change in the federal estate tax laws in 2001 has led to complexities and confusion when dealing with the state death tax credit and the state estate tax systems. When addressing client planning opportunities, there are generally four types of state death tax regimes to consider:
Inheritance Tax, which uses varying tax rates depending on the relationship of the beneficiary to the decedent. Eight states have an inheritance tax: Indiana, Iowa, Kansas, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. Historically, inheritance tax rates were often less than the state death tax credit available on the surviving spouse’s death. All inheritance taxes have a zero rate on transfers to a spouse.
Stand-alone Estate Tax, is an estate tax that is not based on the state death tax credit as it existed before or after the enactment of EGTRRA, however it may mimic some of the federal estate tax laws under the Internal Revenue Code. Six states have this type of tax: Connecticut, Nebraska, Ohio, Oklahoma, Tennessee and Washington.
Decoupled Pickup Tax, which is a tax based on IRC Section 2011 in effect prior to the EGTRRA changes. The pickup tax is in effect for some or all of the years 2005-2009, even though no federal credit will actually be allowed for the tax. States following this system are the District of Columbia, Illinois (through 2009), Kansas, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Oregon, Rhode Island, Vermont, Virginia, and Wisconsin (through 2007).
Conformed Pickup Tax, is a tax that is imposed only if there is a state death tax credit against the federal estate tax under the IRC actually in effect at the decedent’s death. No tax will be imposed under such a statute from 2005- 2010, since there is no state death tax credit in those years. Some states with conformed pick up taxes also have an inheritance or stand-alone estate tax. These states are Indiana, Iowa, Kentucky, Nebraska, Ohio, Oklahoma, Pennsylvania, and Tennessee.
These varying state estate tax regimes have led to planning considerations regarding whether to use the full federal applicable exclusion in funding the bypass trust (e.g., credit shelter or family trust) at the first spouse’s death, with the residual sheltered by a marital trust. While there would be no federal estate tax in this instance, there would be a state death tax in most instances. This issue impacts the residents of eighteen jurisdictions (and, nonresidents of those states who own real property in those jurisdictions), which include, Connecticut, the District of Columbia, Indiana, Kansas, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee and Wisconsin (through 2007). There would be state death tax in these states since the applicable exclusion amount is lower than the federal exclusion, or there is a stand-alone estate tax. For example, if the federal applicable exclusion is at $2 million and the New York State exclusion is at $1 million, there would be no federal estate tax, but there would be a state estate tax of approximately $100,000.
In addressing client objectives, an advisor should consider whether to fund the bypass trust with the state’s applicable exclusion and increase the marital accordingly. If this scenario is undertaken, it would effectively waste a portion of the federal applicable exclusion amount. The Heckerling conference panel discussing this topic suggested that it may be better to pay the state death tax and not waste the federal applicable exclusion amount. States that have separate QTIP elections (i.e., Maine, Massachusetts, Oregon, Pennsylvania, and Rhode Island) afford a better planning opportunity. For those states, one can effectuate a “no tax scenario” for both federal and state purposes. While Connecticut has a separate state QTIP election, and New Jersey has a limited application, New York does not.
One commentator suggested that a client could consider the following in his/her estate plan: The wills could first establish a “family trust” based on the lower of the federal or state applicable exclusion amount. For state purposes, only consider the state of domicile. Second, fund a separate trust (qualifying for the QTIP election) with an amount representing the difference between the federal and state applicable exclusion amounts. This technique would allow an executor the ability to later decide whether a QTIP election would need to be made based on the particular situation at the time of the first spouse’s death. The residual can then be transferred into a marital deduction trust. Finally, a fourth trust can be created in the estate plan that would deal with the generation skipping tax exemption that remains unused at death. Application of the so called “Clayton trust” provisions would allow the executor the ability to elect to flip the marital trust into the Family Trust if a QTIP election is not made for the marital trust. Further flexibility should be written in the documents to allow splitting of trusts or using disclaimers.
Separately, it may be advantageous in a state that has no gift tax but a state estate tax the advantage of death bed gifting. Death bed gifts may reduce state death taxes even if limited to the federal gift tax applicable exclusion amount of $1 million. This approach should be considered in states where the state tax base is keyed to the federal taxable estate, which is reduced by the gift. This technique should be considered in those states that have a decoupled pick up tax and in a jurisdiction that has a stand-alone estate tax that does not have a three-year pull back rule. The unified Connecticut tax catches the death bed gifts, so planning in Connecticut is limited.
Other planning considerations could include accelerating income in respect of a decedent in cases where there is a state death tax since the IRC Section 691(c) deduction is not available for state death taxes.
Observation: Consider planning for those residents of conformed states owning real or tangible property in a decoupled state and how the decoupled state’s tax will apply to their estates. The creation of a partnership or limited liability company may avoid the payment of an estate tax to the state where the property is located. There are certain states, such as New Jersey, which does not impose an estate tax a nonresident’s property.
The Deductibility of Trust Investment Management Fees: The Rudkin Case
IRC Section 67(e), which pertains to the deductibility of investment fees, is a significant issue facing almost all estates and trusts. The issue is so controversial that it is possible that the Supreme Court will likely rule on the issue. There have been three cases decided in the previous years: , and the case(s). The Tax Court decision was reversed in and now the Case.
Statutory Language: IRC Section 67(e) says that the 2% haircut does not apply to deductions for costs which are paid or incurred in connection with the administration of the estate or trust, and which would not have been incurred if the property were not held in such trust or estate. The cases in this area have viewed this as a two-prong test: (1) incurred in connection with the administration of a trust or estate (which is usually easy to meet), and (2) the causation or “but for” test, which would not have been incurred if the property were not held in trust or estate.
IRS Position: The IRS’ position is that administrative costs necessitated by the trustee’s duties do not necessarily satisfy the second prong. The IRS argues that individuals often incur investment advisor fees, and such fees are not unique to trusts and estates; therefore, under this argument, the second prong test is not met.
The Courts Weigh In: The courts have provided a conflicted conclusion that if a corporate fiduciary were to hire an investment advisor on his payroll and charged a fiduciary fee, the fiduciary fee would not be unbundled and the entire deduction would be allowed. On the other hand, if the trustee hired an investment advisor and the trust or estate paid a separate investment advisory fee, then the investment advisory fee would be subject to the 2%. Rudkin is yet another victory for the IRS in which the Tax Court (in a unanimous decision) held that investment fees incurred by the trustee do not fall within the exception of IRC Section 67(e)(1) and are deductible only to the extent that they exceed 2% of the trust’s adjusted gross income. The long term impact of this case is that all Tax Court cases will follow Rudkin, unless this case is appealed. There is currently an appeal to the 2nd Circuit and there is a strong likelihood of reversal according to a panelist at the conference. According to the panelist, this is an “all or nothing” issue and the IRS is not settling.
Family Limited Partnerships (“FLP”): A good planning idea ?
Family limited partnerships continue to be utilized in family wealth planning, however precautions need to be taken:
- A carefully formed and operated FLP or limited liability company (“LLC”) with a significant business purposes continues to be successful and provides significant discounts;.
- The courts are reviewing the taxpayers’ motivation in creating these entities;
- Post-formation facts should support the carrying out of the business plan;
- The organizational documents are being reviewed to make sure there are no peculiarities;
- The funding of the FLP is reviewed to determine if personal use assets are being contributed, if all of the assets are being contributed, if there is a delay in the funding and if there is proper documentation;
- IRCode Section 2036(a)(1) “retained control” is a significant obstacle;
- Taxpayers are winning some cases that they should not win. So, planners should not necessarily rely on those cases to structure transactions for clients;
- If successful, the discounts can be substantial—up to 35%;
- The partnership or LLC ‘s formal structure should be respected. For instance, if there are liquidations restrictions, they should be followed. Distributing cash in a haphazard way is not helpful.
Separately and considering the above, we regularly advise clients that considering their objectives and facts, it is better for senior family members to give up holding any general partnership interest or managing the membership interest of the LLC. It is also recommended that if the senior family member holds a minority interest in the general partner interest, that this interest also be relinquished, as IRC section 2036(a)(2) may be argued by the IRS. We assist clients in determining if someone other than a senior family member should hold the general partnership interest, or be the LLC managing member.
If a client continues to own any limited partnership interests, one Heckerling panelist contended that there is some risk that IRC Section 2036(a)(2) could apply. It was recommended that the limited partnership interests held by senior family members be contributed to an irrevocable trust (with a third party trustee) that is an incomplete gift (i.e., the senior family member can retain a testamentary power of appointment over the trust).
Following is a summary of certain key planning considerations clients should consider for existing partnerships, and when planning for new partnerships.
- Senior family members should give up control of the entity especially if the entity is making non-pro-rata distributions. The client should not own any interest in the general partner (interest). The client could transfer the interest in the general partner to an irrevocable trust, with a retained testamentary power of appointment to make it an incomplete gift. A third party trustee can then vote the units. If the client wants to remain in control, there should be a significant business reason for this, but IRC Section 2036 risk remains;
- Senior family members may consider giving away their limited partnership interests if they are concerned about a IRC section 2036(a)(2) problem. Alternatively, the client could sell (in a bona fide transaction) the LP units to avoid a gift tax issue. However, the three year rule could apply to this transaction and the IRS may challenge the bon fide nature of the sale;
- Family limited partnerships should not be done unless there is a significant business reason;
- Review partnership operations (i.e., non-pro-rata distributions, books and records kept up annually, and family partnerships meeting);
- Don’t go to Tax Court if a partnership transfer has been challenged, and/or your client can pay the deficiency and go to district court.
There were a number of 2005 cases impacting FLPs: Strangi, Bongard, Senda, and Kelly. Coverage of these cases is cited in this Outline and will be covered in future issues.
Retirement Planning Considerations for 2006 and in the Future.
Beneficiary Designations: It is extremely important to periodically review all beneficiary designations on pension plans, other qualified and non-qualified plans, and life insurance companies. Life events may effectively render old beneficiary designations inappropriate. There are three wise beneficiary choices: (1) the surviving spouse, since the rollover provision is available; (2) the younger beneficiary, since future payouts can be made at a lower amount for a longer period of time; and (3) a tax-exempt organization, since all payouts are exempt from income and estate taxes. Bad choices for beneficiary designation include: (1) an older person; (2) a trust for the benefit of a spouse; and (3) the estate itself.
Year of Death and the Minimum Distribution Requirement (“MDR”): Assume the following: a taxpayer who is over age 70 ½ and had begun to take minimum distributions from his IRA dies before he has taken the distribution for that year. The beneficiary has to take the distribution in the year of death if the decedent did not take the distribution. The spouse wishes to disclaim the IRA so that it could go to the children, and make use of the applicable exclusion amount. Does taking the minimum distribution mean that she accepted the asset, thereby preventing a disclaimer ?
Revenue Ruling 2005-36 says that taking the minimum distribution does not constitute acceptance for purposes of the disclaimer rules. If the spouse had taken a distribution in excess of the minimum distribution, then she would not be within the safe harbor, and she would have the burden of proof that she did not accept the entire account by taking the distribution. If she exercises investment control and makes changes to the portfolio, then she is accepting the account, and no disclaimer can be made.
Self-directed IRA investing: Over the last several years, self-directed investing of one’s retirement plan seems to have become a trend. There are various pitfalls inherent in self-direct IRA investing.
Consider this example: a husband wishes to start a business and his spouse wants to invest in the business; can she have her IRA invest in the business? The answer to this business is a resounding “No.” This would effectively disqualify the IRA. What if she wanted her IRA to invest in real estate? The answer is a tentative “yes,” provided that certain precautions are met. For instance, a professional management company should be hired to take care of all operations of the real estate investment. The IRA cannot do business with the IRA owner personally or her family members, including renting out apartments to family members. If the IRA owner manages the real estate herself and commingles funds to cover expenses, a whole host of problems result. The commingling could be deemed to be a contribution to the IRA, which could be problematic if it was an excess contribution, thus causing penalties. If the IRA owner paid her back, this could be considered a distribution subject to income taxes and penalties. If she wanted to treat the transaction as a loan, then this could be a prohibited transaction which would disqualify the IRA. Proceed with caution.
Valuation of Life Insurance and annuity contracts: The IRS issued Revenue Procedure 2005-25 to deal with the issue of using invalid valuation rules to evade taxes. The procedure provides that the cash surrender value cannot be used as a valuation method. Instead, the fair market value must be used.
IRA owns a variable annuity contract: Retirements plans can invest in annuity contracts. When a retirement plan distributes an annuity contract, there is no immediate tax effect. The distributee will be taxed on the distributions from the annuity contract. What happens if the IRA is converted to a ROTH IRA? In the past, the distributee would only pay income tax on the cash value. The IRS issued a temporary regulation saying that if an annuity contract is inside an IRA, and that IRA is converted to a ROTH IRA, the distributee has to pay income tax on the annuity fair market value, and not the cash value. Revenue Procedure 2006-13 clarifies the treatment of these conversions.
We will discuss additional topics covered at the 2006 Heckerling Institute in upcoming issues of this Outline.
20. Articles and Publications and IRS PLRs and Revenue Rulings
Robert S. Keebler and Peter J. Melcher, Structuring IDGT Sales To Avoid Sections 2701, 2702, and 2036, 32 Estate Planning 10, 19-26 (October 2005); Jeremy T. Ware, Using QPRTs To Maximum Advantage For Wealthy Clients, 32 Estate Planning 11, 34-40 (November 2005); J. Joseph Korpics comments on the bona fide sale exception for family limited partnerships(October 18, 2005).
PLR 2006002002 (9/6/05) - The IRS ruled that prepayment by a grandparent of a grandchild's tuition will qualify for the gift and GST tax exemptions. In the facts of the ruling the grandchildren were already attending school, the prepayment was for a specific grandchild for a specific number of years of tuition, and the payments were nonrefundable and would be forfeited if the grandchild ceased attending the school.
Priv. Ltr. Rul. 2005-43-041 (July 25, 2005) - The IRS has ruled that the proposed amendment of a trust to change its governing law and the administration of the trust under the new law will not cause the trust to lose its generation-skipping transfer tax exempt status or result in any trust beneficiary being treated as having made a taxable gift for federal gift tax purposes. See also, Priv. Ltr. Rul. 2005-43-042, Priv. Ltr. Rul. 2005- 43-043, Priv. Ltr. Rul. 2005-43-044, Priv. Ltr. Rul. 2005-43-045 and Priv. Ltr. Rul. 2005- 43-046. Priv. Ltr. Rul. 2005-43-047 (July 13, 2005).
Priv. Ltr. Rul. 2005-43-063 (Aug. 02, 2005) - The IRS has waived the section 408(d)(3) 60-day rollover requirement for distributions from an individual retirement account. See also, Priv. Ltr. Rul. 2005-43-064 and Priv. Ltr. Rul. 2005-43-065.
- The IRS has waived the section 408(d)(3) 60-day rollover requirement for distributions from an individual retirement account. See also, and .
Priv. Ltr. Rul. 2005-43-061 (Aug. 01, 2005) - The IRS has ruled that the proposed early termination of a charitable remainder unitrust will not constitute self-dealing under section 4941(d); therefore, the disqualified persons with respect to the trust will not be subject to taxes under sections 4941(a) and (b).
Priv. Ltr. Rul. 2005-43-016 (June 30, 2005) - The IRS has granted an estate an extension to make a qualified family-owned business interest election under section 2057(b)(1)(B). 55
Priv. Ltr. Rul. 2005-43-001 (June 29, 2005) - The IRS has ruled that the proposed modification of a trust to close a class and divide the trust into four separate trusts will not cause either the original trust or the newly formed trusts to lose their generationskipping transfer tax exempt status, and that distributions from the four new trusts will be exempt from the tax.
Priv. Ltr. Rul. 2005-43-015 (July 05, 2005) - The IRS has ruled that the implementation of a settlement agreement will not cause a trust to lose its generation-skipping transfer tax exempt status or cause the trust to realize any capital gain.
Priv. Ltr. Rul. 2005-43-037 (July 12, 2005) - The IRS has ruled that the division of a generation-skipping transfer tax non-exempt marital trust into three trusts will result in a direct skip under section 2612(c), that the GST taxes due are payable by the trusts under section 2603(a)(2), and that the GST non- exempt trust will be liable for all federal estate taxes.
Priv. Ltr. Rul. 2005-43-039 (July 25, 2005) - The IRS has ruled that the amendment of a trust to change its governing law and the administration of the trust under the new law will not cause the trust to lose its generation-skipping transfer tax exempt status. See also, Priv. Ltr. Rul. 2005-43-040.
TC Memo 2005-269, 2005 – A Partner had to recognize gain on entire proceeds from partnership’s sale of partnership units to third parties on his behalf, which were then loaned to the corporate general partner. In the year at issue, taxpayer had zero basis in partnership taxpayer units he sold (Joseph D. Doll, et ux. v. Commissioner).
Timothy J. Coburn v. Commissioner (TC Memo 2005-283) - This matter addressed discharge of indebtedness income and gains from dealings in property, transfer or abandonment of property in satisfaction of liability, and recourse vs. non-recourse liabilities. The IRS determined that the taxpayer’s realization of income in the year he defaulted on a loan and abandoned the collateral/stock securing same was erroneous, even if loan was recourse vs. non-recourse. Code Sec. 1001 and the regulations thereunder dictated that if the loan was non-recourse, then abandonment of collateral in satisfaction thereof would be considered a sale, and any income realized thereon would be capital gain, not discharge of indebtedness income.
EisnerAmper provides services for family offices, and client advisors at financial services firms including investment banks, broker dealers, private equity and hedge funds, and trust companies. We provide periodic Outlines and presentations addressing current technical and training topics including updates on federal tax legislation, cases, and regulations. EisnerAmper professionals address family office and financial advisor questions involving estate, gift and trust matters; partnerships; taxation of investments; compensation planning; retirement and investment planning; insurance planning; U.S. and international tax matters; financial products; and other topics. We provide tax compliance services to family offices. EisnerAmper also provides international wealth advisory services for foreign individuals residing in the U.S., and U.S. citizens living abroad, including international income and estate tax planning and compliance services, treaty review, pre departure planning, tax credit analysis, compensation sourcing, and related services. In addition to assisting clients, EisnerAmper’s Personal Wealth Advisors Practice members are active in the professional and civic community, recently hosting students at a presentation by former British Prime Minister Sir John Major; attending presentations on corporate compensation and governance policies and a separate presentation on Middle East developments; hosting an event at the Pennsylvania Academy of the Fine Arts Museum and School; attending the 40th annual Heckerling Institute Tax Conference; being interviewed in the press regarding current trends in executive compensation and financial planning; and other activities including volunteering to assist various charitable organizations and educational institutions.