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The Will & The Way, May 2014 – a publication of the Estate Planning & Fiduciary Law Section of the North Carolina Bar Association (NCBA)

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Federal Case Law Developments

Tax Court Addresses Valuation of Family-Owned Investment Company with Built-In Gains.

In Estate of Richmond v. Comm’r, T.C.M. 2014-26 (Feb. 11, 2014), the tax court re-determined the estate tax value of decedent’s 23.44% interest in a $52 million family-owned investment holding company (C corporation) with a portfolio comprised mostly of publicly traded stock. The issues were valuation of the holding company interest and applicable discounts. Created in 1924, the company held assets with such low turnover that built-in capital gains made up roughly 87% of the portfolio’s total value. The company paid dividends regularly in recent decades. Factoring this into the lack of marketability and control discounts, the estate’s valuation reflected a 74% discount for estate tax purposes. Using a dividends-capitalization approach the estate valued decedent’s 23.44% interest in the company at $3.1 million on IRS Form 706. The Service disagreed and valued the interest at $9.2 million, issued a deficiency notice, and assessed a 20% ($1.2 million) accuracy-related penalty. Both parties adjusted their respective valuations. At trial the estate’s valuations were $5 million (dividends capitalization method) and $4.7 million (net asset value method), and the Service’s valuation was $7.3 million. The court found that the Service’s net asset value method was more appropriate than the estate’s dividends capitalization method because the former used easily-obtained market values that inherently reflected the company’s future income stream. Furthermore, finding that the 100% discount for built-in capital gains was unreasonable, the court applied a 15% discount based on the period that a typical investor would expect the company to turn over its stock. The court also applied 7.75% and 32.1% discounts for lack of control and marketability, respectively. After both parties’ expert testimony, the court determined the value to be $6.5 million leaving the estate with a reduced deficiency. The estate disputed the accuracy-related penalty on account of its engagement of and reliance on an experienced CPA. The court found the reasonable cause exception inapplicable and pointed out that the CPA was not a certified appraiser, the estate used only an unsigned draft valuation report (and never asked for a final report), and the estate failed to explain the difference between the 706 value and the value presented by the estate’s expert at trial. As a result, the court upheld the accuracy-related penalty.

Capitalized Interest on Whole Life Policy Loans Was Includible in Determining Gross Distribution and Taxable Amount Upon Policy Termination.

In Black v. Comm’r, T.C.M. 2014-27 (Feb. 12, 2014),petitioner was owner and insured under a whole life insurance policy. The policy allowed loans not in excess of cash value. An owner could surrender the policy and receive as a distribution the cash value less policy debt. Policy debt included outstanding loans and accrued interest, which, if unpaid, would be added to loan principal. Over time petitioner borrowed $103,548 against the policy but failed to repay the loans. The policy then terminated and policy proceeds satisfied the loans ($196,230). The insurance company issued Form 1099-R showing a gross distribution of $196,230 and a taxable income of $109,567 (i.e., gross distribution less $86,663 investment in the policy). Petitioner did not report the taxable income. The issue was whether capitalized interest was includible in determining the gross distribution and taxable amount on account of the termination. The court noted that under policy terms amounts borrowed plus interest were bona fide loans collateralized by the policy’s value. It further noted that upon policy termination when proceeds are used to satisfy loans the transaction is treated as if taxpayer had received the proceeds and applied them to the loans. The court concluded that capitalized interest was includible in determining the amount of the gross distribution upon policy termination. In addition, it rejected petitioner’s contention that the policy termination caused a discharge of indebtedness, as the debt was extinguished after application of the cash value to the debt. The court found the $30,571 understatement of income “substantial” and upheld the Service’s accuracy-related penalty under Code Section 6662(a) and (d).

Unrecognized Gain From QSub Election Did Not Create “Item of Income” Warranting Basis Increase.

In R Ball For R Ball III Appt. v. Comm’r, 113 A.F.T.R. 2d (3d Cir. Feb. 12, 2014), the Third Circuit Court of Appeals upheld the tax court’s determination that unrecognized gain after a QSub election and sale of the S Corp parent does not create an “item of income” under Code Section 1366(a)(1)(A) requiring parent’s shareholders to adjust their respective bases in stock under Code Section 1367(a)(1)(A). In 1997 ten trusts for the benefit of family members directly owned shares of American Insurance Service, Inc. (“AIS”) with an aggregate basis of $5.6 million. In 1999 the trusts formed Wind River Investment Corporation (“Wind River”), contributed all AIS shares to Wind River in exchange for Wind River shares, and made the S corporation election. In 2003 Wind River elected to treat AIS as a QSub. Before the QSub election the trusts’ aggregate adjusted basis in the Wind River shares was $15.2 million; thereafter the trusts increased their bases in the Wind River shares to a new basis of $242.4 million. Later in 2003 the trusts sold their Wind River shares to a third party for $230 million and claimed a loss of $12 million. The Service determined, however, that the trusts had realized a $214 million capital gain and issued deficiency notices totaling $33.7 million. Its position was that the QSub election and Code Section 332 deemed liquidation did not give rise to an item of income and therefore precluded the trusts from increasing their respective bases in the Wind River shares. The trusts argued that the deemed liquidation of AIS was a sale or exchange under Code Section 331 resulting in realized gain to Wind River. Moreover, even though Code Section 332 provides for non-recognition of gain, the trusts contended that the gain was an item of income under Code Section 1366(a)(1)(A), and accordingly increased their respective bases in the shares that were subsequently sold. The tax court sided with the IRS. It accepted the IRS’s position that when realized gain is not recognized, then it does not become an “item of income,” and it held that the trusts improperly increased their respective bases in the shares. The Third Circuit Court of Appeals affirmed the tax court and held that unrecognized gain is not income, cannot be an “item of income,” and, accordingly, the trusts cannot increase their bases in the shares on account of a QSub election.

Cash Contribution to LLC Followed By Allocation of Tax Credits to Contributing Member Was a Disguised Sale.

In Route 231, LLC, et al. v. Comm’r, T.C.M. 2014-30 (Feb. 24, 2014), the tax court held that a partnership’s transfer of 97% of its Virginia state tax credits to a 1% partner who had contributed $3.8 million to the partnership was a taxable disguised sale under Code Section 707. The partnership received the tax credits for contributions of conservation easements and land. The partner made the capital contribution and the partnership allocated the tax credits to that partner. The tax court held that this was a disguised sale consistent with Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, 639 F.3d 129 (4th Cir. 2011). It reasoned that Code Section 707 prevents use of partnership provisions to render nontaxable what in substance would have been a taxable exchange but for the use of the partnership.

Premature SEP-IRA Withdrawal Taxation and Additional Tax Upheld.

In Alexander v. Comm’r, T.C. Summary Opinion 2014-18 (Feb. 26, 2014), the tax court addressed a failure to report as income a SEP-IRA distribution and the liability for the 10% additional tax under Code Section 72(t). Petitioner (Thomas) was an electrical contractor whose general contractor (True Craft) owed him $130,000 on account of business difficulties in 2009. One of the True Craft principals proposed to give Thomas a promissory note for $130,000 and to assign real property to Thomas as security for the debt. But the real property, also security for a past due SunTrust mortgage, was on its way to foreclosure. True Craft proposed to Thomas that he pay SunTrust $36,000 to stop the foreclosure and preserve the security for Thomas’s promissory note. Thomas’s Schwab financial adviser (Peter) suggested that Thomas obtain a loan, but the loan could not be processed until after the foreclosure date. Peter then suggested that Thomas withdraw the funds from Thomas’s SEP-IRA. According to Peter if Thomas replenished the SEP-IRA with the loan proceeds within 60 days then there would be “no penalty with anybody.” Thomas, who had not reached age 59½ , wired $36,000 to his checking account on July 31, 2009, thereafter paid SunTrust, then received the $130,000 promissory note from True Craft. Thomas received the loan proceeds on September 30, 2009, then mailed a check to the SEP-IRA account. Schwab deposited the check on October 5, 2009, 66 days after the funds had been withdrawn. The 1099-R issued the following January reported a gross distribution of $36,000 and coded it as an early distribution. Taking the position that the amount was a rollover, Thomas did not report the amount on his 2009 income tax return. Concluding that Thomas did not meet the 60-day rollover contribution deadline in Code Section 408(d)(3)(A), the court noted that Thomas was free to obtain relief from the IRS under Rev. Proc. 2003-16, 2003-1 C.B. 359. Thomas also had tried to characterize the distribution as loan. According to the court the participant loan provisions of Code Section 72(p) are inapplicable to IRAs. Moreover, a loan would be a Code Section 4975 prohibited transaction, which would result in “even harsher” tax consequences. Not finding any applicable exceptions, the court upheld Code Section 72(t)(1) additional 10% tax on early withdrawals.  Finally, in light of Thomas’s efforts with Peter and the accountant to determine the tax liability, the court rejected the Service’s determination of an accuracy-related penalty under Code Section 6662(a).

Tax Court Does Not Reconsider Conservation Easement Accuracy-Related Penalty Based on Non-Valuation Grounds.

In Mountanos v. Comm’r, T.C.M. 2014-38 (Mar. 6, 2014), the tax court denied a taxpayer’s Rule 161 motion to reconsider Mountanos v. Comm’r, T.C. Memo 2013-138 (“Mountanos I”). In 2005 taxpayer conveyed a conservation easement on a California ranch. At the time of conveyance, the ranch’s use and development were limited according to the California Land Conservation Act of 1965. The tax court in Mountanos I held that the highest and best use of the property was the same both before and after the conveyance of the easement. As such, the easement itself had no value, and the tax court denied taxpayer’s charitable deductions derived from the reported value of the donated easement. The tax court did not address additional grounds raised by the IRS for denying the deductions, including taxpayer’s alleged failure to acquire contemporaneous written acknowledgement and taxpayer’s alleged failure to obtain a qualified appraisal. Taxpayer motioned the tax court to reconsider its decision primarily with respect to the accuracy-related penalty upheld in Mountanos I. Taxpayer argued based on Keller v. Commissioner, 556 F.3d. 1056, aff’g in part, rev’g in part T.C. Memo 2006-131 and Gainer v. Commissioner, 893 F. 2d 225 (9th Cir. 1990) aff’g T.C. Memo 1988-416, that where there are grounds for disallowing a deduction besides overvaluation, such other non-valuation grounds must be addressed permitting the taxpayer to avoid an accuracy-related penalty. The tax court denied taxpayer’s motion. The court distinguished Keller and Gainer from the current case. In both Keller and Gainer, the taxpayers stipulated that there were non-valuation flaws that would not permit the deductions they had taken. The tax court therefore disagreed with the taxpayer’s premise that the court was required to rule on the alternative grounds because such was not the case in Keller and Gainer since multiple grounds were not submitted to the court in those cases.

Conservation Easement Valuation Based on Highest and Best “Foreseeable” Use.

In Esgar Corp. v. Comm’r, 744 F.3d 648 (10th Cir. Mar. 7, 2014), the Tenth Circuit Court of Appeals considered the value of a conservation easement and the holding period for state tax credits that were generated by the easement donation and sold by the taxpayers. The taxpayers owned 2,200 acres of land, 1,470 of which was leased to operate as a gravel mine. The taxpayers granted a perpetual easement over 163 of the surrounding non-leased acres that specifically prohibited gravel or other mining on the property. The taxpayers claimed a charitable deduction for the property based on its highest and best use as a future gravel mining operation. The taxpayers also received state death tax credits that they later sold in the same month of receipt. Each taxpayer reported the proceeds from sale of state death tax credits as generating long-term capital gain, short-term capital gain, and ordinary income, respectively. On audit the Service determined that the conservation easements were valueless and that the tax credits were ordinary income. At trial the issue was the property’s value before the conservation easement, as the parties already had stipulated to the post-easement value. The tax court considered expert testimony and relied on the “highest and most profitable use” standard in eminent domain cases to conclude that although the property could be used for mining, there was no foreseeable demand for such use. It agreed with the Service that the property’s “highest and best use” was agricultural. In affirming the tax court’s valuation methodology that was based on the likelihood that the property would be developed as a gravel mine, the court held that there was no material difference between determining the property’s highest and best use in eminent domain cases and in conservation easement tax cases. In a separate decision the tax court held that while the state death tax credits were capital assets, the holding period was measured from the date of the conservation easement donation and credit issuance. Accordingly, the court affirmed the tax court’s holding that the sale proceeds generated by sale of the state tax credits within a month of their receipt should be reported as income from short-term capital gains.

Taxpayer’s Charitable Deduction for Conservation Easement Fails Perpetuity Requirement Because of State Law Limitation on Easement Duration.

In Wachter v. Comm’r, 142 T.C. 7 (Mar. 11, 2014),the tax court granted the Service’s summary judgment motion and disallowed a charitable contribution deduction for the donation of a conservation easement in North Dakota because North Dakota law limits easements to a maximum duration of 99 years, regardless of whether the parties agree otherwise. The Service determined, and the tax court agreed, that the 99-year limit on the duration of the easement kept the easement from being granted “in perpetuity” as required by Code Section 170(h)(2)(C) and from protecting the conservation purposes “in perpetuity” as required by Code Section 170(h)(5)(A). The taxpayers argued that the “so remote as to be negligible” protection of Treas. Reg. 1.170A-14(g)(3) should apply to save the easement from failing the perpetuity requirement because the 99-year running of the easement caused any remainder interest to be valueless. The tax court disagreed, finding that “remoteness” as interpreted by the courts is determined by looking to the likelihood of the future event, not the passage of time preceding the future event. As such, the tax court concluded that the event that caused the failure of the perpetuity requirement was not remote and that protection under Treas. Reg. 1.170A-14(g)(3) was not available. In addition to the conservation easements, the taxpayers donated cash to the donee organizations or related organizations. The Service argued on summary judgment that the taxpayers failed to comply with certain aspects of the contemporaneous written acknowledgement requirement, namely that the written acknowledgements were not contemporaneous and that the statements that the taxpayers received no benefits from the exchange were false because the taxpayers expected or received certain benefits. The tax court denied the Service’s motion with respect to the cash contributions, as there were material issues of fact as to whether the taxpayers complied with the contemporaneous written acknowledgement requirement.

Attorney’s Knowledge of Unpaid Tax Liability Imputed to Client.

In U.S. v. Shriner, Civ. Action No. 1:11-CV-2929 (D.C. Md. Mar. 12, 2014), upon motion for summary judgment, the District Court for the District of Maryland held that an attorney’s knowledge of unpaid income tax liability is imputed to the attorney’s clients. Decedent did not file income tax returns in 1997 and from 2000-2003. Upon decedent’s death, the appointed co-administrators of decedent’s estate hired a law firm to prepare decedent’s outstanding income tax returns. The estate filed the returns, and the Service assessed tax liabilities totaling $276,908. The law firm filed with the Service IRS Form 2848 requesting that all notices be sent to the law firm. The Service sent numerous notices to the law firm. The co-administrators distributed $470,963 to themselves as estate beneficiaries leaving the estate without enough assets to pay the outstanding tax liabilities. Under the federal priority statute, 31 U.S.C. § 3713, a fiduciary who pays estate debts before government claims is liable to the extent of the unpaid government claims. The government must show that (i) the fiduciary distributed estate assets, (ii) the distribution rendered the estate insolvent, and (iii) the distribution took place after the fiduciary had actual or constructive knowledge of the government’s claim. The co-administrators contended that they did not have actual or constructive knowledge of the tax liability. The court relied on Maryland law that imputes a law firm’s knowledge of unpaid taxes to the law firm’s clients. It granted the Service’s motion for summary judgment.

No Estate Tax Deduction for Disputed Value of Legal Malpractice Claim at Attorney’s Death, But Deduction of Post-Mortem Settlement Amount Allowed.

In Estate of Saunders v. Comm’r, 2014 U.S. App. LEXIS 4647 (9th Cir. Mar. 12, 2014), the Ninth Circuit Court of Appeals considered whether an estate properly claimed a $30 million estate tax deduction for a pending legal malpractice claim against decedent at his death. A client’s estate had brought a claim for $90 million in damages that allegedly resulted from decedent’s disclosure of damaging information about his client to the IRS. Decedent’s wife died one year after decedent’s death, and the wife’s estate tax return reported a $30 million liability. When the case was finally litigated and settled for $250,000 four years later, the IRS issued to her estate a deficiency notice for $14.4 million in unpaid estate taxes. The wife’s estate submitted experts’ reports and letters that stated (i) the claim was worth $30 million (later revised to $25 million); (ii) the claim was worth $19.3 million; and (iii) the claim was worth $22.5 million. The Service’s experts estimated the claim’s value to be $3.2 million, $6.3 million, or $7.5 million. The tax court held that the disallowance of the $30 million claim was proper and that the estate could deduct only the amount actually paid. The tax court found an estate tax deficiency of $12.4 million, which the estate appealed. The estate asserted that the claim was “certain and enforceable” and its value was ascertainable with reasonable certainty as of the date of decedent’s wife’s death. The court articulated elements in other opinions as requiring first that the claim must be classified as either (i) “certain and enforceable,” or (ii) “disputed or contingent”. If the claim were “disputed or contingent,” then post-mortem facts could be considered in determining the claim’s date of death value. The court disagreed with the estate’s position on the claim’s certainty and found that while it was not contingent, it was in fact disputed, as evidenced by the denial of liability in the post-mortem settlement agreement entered into after trial. The court held that because the claim was disputed, it was proper to take into consideration the post-mortem settlement agreement as evidence of the claim’s value. The court supported the lower court’s reliance on the diversity of expert opinions to find that the value of the claim lacked reasonable certainty as of the date of death. The court also upheld the tax court’s allowance of a deduction for the settlement amount actually paid because when a claim’s value is not ascertainable with reasonable certainty but later becomes certain then the taxpayer may seek refund under Treas. Reg. 20.2053-1(b)(3).

Decedent Constructively Received Proceeds from Acquisition of Company Stock Even Though Proceeds Not Actually Received Until Three Years Later.

In Santangelo v. U.S., 3:2012 C.V. 00071 (S. Dist. Miss. Mar. 19, 2014), the U.S. District Court for the Southern District of Mississippi, Northern Division, addressed whether proceeds from a corporate merger available to decedent through a stock redemption but not claimed until three years later should be recognized as income in the year available or three years later when actually received. After decedent’s death one stock certificate was redeemed and the other stock certificate was lost. The estate actually received payment for the lost stock certificate two years after decedent’s death (three years post-merger). The court held that the funds were constructively received in the year that they were made available (i.e., the year of the merger). Decedent’s lost stock certificate and the delay in redemption were self-imposed events that cannot operate to defer recognition of income to another year. Accordingly, the estate was in constructive receipt of the income when the funds were first available.

Additional 10% Tax Under Code Section 72(t)(1) Applied to Early Distribution From Qualified Retirement Plan.

In Fields v. Comm’r, T.C.M. 2014-48 (Mar. 19, 2014), the tax court addressed taxpayer’s liability for the additional tax on an early qualified retirement plan distribution. The petitioner withdrew $7,383 from her 401(k) plan before age 59½. Twenty percent of her distribution was withheld pursuant to her request that “all required taxes” be withheld. At trial she stipulated that the early distribution was not for medical expenses, health insurance premiums, disability expenses, or a first home purchase. Taxpayer thought that she should not be required to pay the additional 10% tax because she had asked that all taxes be withheld at the time of distribution. In sustaining the Service’s deficiency, the Court noted that while it was sympathetic to the plight of the taxpayer, she should have reported the additional 10% tax.

Court Finds Issue of Fact on Whether Reliance on Attorney’s Erroneous Advice on Estate Tax Return Filing Requirement Was Reasonable Cause Warranting Penalty Abatement.

In American Contractors Indemnity Co. v. U.S., 2014 U.S. Dist. LEXIS 37781 (N.D. Cal. Mar. 21, 2014),the U.S. District Court for the District of California considered the Service’s motion for summary judgment on the issue of whether there was reasonable cause for failure to timely file an estate tax return and pay estate taxes. The plaintiff, surety for the estate’s administrator, reimbursed the estate for over $1 million of late fees, interest, and penalties on estate taxes paid over three years after they were due. The estate’s administrator was twenty-one years old and lacked experience as a fiduciary, so she engaged an attorney to represent the estate. The attorney told her that the estate tax return was due within nine months of death, but that she could defer filing and payment of estate taxes until determination of the estate’s total value and identification of the estate’s actual beneficiaries. The young administrator was removed and replaced, and the surety reimbursed the estate for penalties and interest paid to the Service. The estate later filed a claim for refund and request for abatement, which first was assigned to the young administrator (as beneficiary) then re-assigned to the surety. The court stated that the failure to timely file an estate tax return and pay estate taxes results in penalties and interest absent reasonable cause. The issue was whether the administrator’s reliance on the attorney’s advice was reasonable. The court distinguished an attorney’s failure to tell “when” a return is due from an attorney’s advice on a tax law matter such as “whether” a tax liability exists. Reliance on advice regarding “when” a return is due is not “reasonable cause” because a taxpayer can easily ascertain a return’s due date. On the other hand, “whether” a return is due is a matter of substantive tax law where reliance on an expert’s opinion could be “reasonable cause” for penalty abatement. The court denied the Service’s summary judgment motion because there was an issue of material fact on whether the advice received by the administrator regarding whether an estate tax return was due was a matter of substantive tax law.

Interpleader Action for Use of Escrow Funds for Partial Satisfaction of Estate Tax Liability Does Not Preclude Under Res Judicata Subsequent Transferee Liability Claim for Remaining Unpaid Estate Tax Liability.

In U.S. v. Whisenhunt, 2014 U.S. Dist. LEXIS 38969 (N.D. Tex. Mar. 25, 2014),the U.S. District Court for the Northern District of Texas considered objections to the magistrate judge’s finding that defendant was liable for unpaid estate taxes as a recipient of an IRA distribution. Executor distributed estate assets before paying federal estate taxes, and the Service assessed tax, penalties, and interest of $178,000. Estate’s counsel filed an interpleader action to determine the proper beneficiary of $96,000 held in escrow. The federal government had priority on account of tax lien but that amount did not cover what the estate owed the IRS. The government sought judgment against the estate, the executor, and the beneficiaries for delinquent estate taxes. It moved for summary judgment against the estate’s largest beneficiary, who received $520,000 before payment of the estate tax liability. The judge found defendant personally liable as a transferee but barred the government’s claim based on res judicata. The earlier interpleader action relating to distribution of escrow funds in partial satisfaction of the estate tax liability involved the same “nucleus of operative facts.” The parties objected to the judge’s findings and sought review by the district court. The government argued that (i) res judicata cannot alter Congress’s statutory scheme for tax assessment and collection, and (ii) the operative facts in the interpleader action and summary judgment motion differed and therefore failed the test for res judicata. The court found res judicata inapplicable because the earlier action’s facts involved payment of escrow funds to satisfy a tax lien, while the latter action’s facts involved the beneficiary’s personal transferee liability for the unpaid portion of the estate tax liability. The court distinguished this case from others where res judicata barred liability for payment when such liability was raised after the amount of the liability had already been determined. In this case the estate’s liability was not an issue in the interpleader action, so defendant’s transferee liability could not have been raised. The court granted summary judgment for the government on defendant’s liability for unpaid estate taxes up to the amount of the distribution received by defendant from decedent’s IRA.

Ninth Circuit Upholds Inclusion of Marital Trust Assets and Rejection of Date-of-Death Value of Disputed Lawsuit Against Decedent.

In Estate of Foster v. Comm’r, 2014 U.S. App. LEXIS 5563 (9th Cir. Mar. 26, 2014), the Ninth Circuit Court of Appeals issued an unpublished opinion affirming the tax court’s finding of an estate tax deficiency of $3.2 million. At trial the estate had introduced evidence of the three marital trusts’ assets and an expert’s valuation of such assets. The estate had asserted that the assets and values thereof were impaired by the pending claim intended to unwind the transaction that had produced the assets. The estate had further contended that the hazards of litigating the claim and the freeze imposed on trust assets adversely affected the value of such trust assets. The tax court held (and the Ninth Circuit agreed) that the value of underlying trust assets was not subject to discounting because the lawsuit did not seek specific trust assets or cloud trust assets’ title, nor would any hypothetical buyer of trust assets ever become a defendant in the lawsuit. The court further held that the tax court did not err in valuing the marital trust assets as opposed to decedent’s beneficial interest (after application of discounts for hazards of litigation, lack of control, or lack of marketability) because the estate had acknowledged on the estate tax return that the value of the underlying marital trust assets were includible in the estate, and it had presented evidence of the assets’ values. Finally, the court upheld the tax court’s finding that the date of death value of a disputed lawsuit against decedent was not deductible as a claim against the estate because the value was not ascertainable with reasonable certainty, but that post-death events could be considered in determining the deduction.

Trustees Materially Participated in Rental Real Estate Business.

In Frank Aragona Trust v. Comm’r, 142 T.C. 9 (Mar. 27, 2014),the tax court addressed whether a trust can materially participate in rental real estate activities to qualify for the Code Section 469(c)(7) exception to the rule that all rental activity is a passive activity. If a trust were to qualify for the exception, then it could deduct losses from such activity against both passive and non-passive income sources. The Service took the position that the trust could not qualify for the exception because “personal services” can be performed only by an individual and not a trust. The trust owned rental real estate properties and interests in real estate businesses. The trustees were the late grantor’s five children and one independent trustee. Three of the trustees were actively involved in the trust’s businesses and also full-time employees of an LLC wholly-owned by the trust that managed most of the trust’s rental real estate properties. All trustees received trustees’ fees and the three trustees employed by the LLC also received wages from the LLC. The trust owned majority interests in entities through which it conducted real estate holding and development activities. Two trustees also owned minority interests in those entities. The three trustees who were uninvolved and not employed by the LLC were a dentist, a lawyer, and a disabled person.
On IRS Form 1041, Schedule E, “Supplemental Income and Loss,” the trust reported losses from its rental real estate properties. Some losses were attributed to the LLC, including trustee fees paid to all the trustees other than the independent trustee. In the deficiency notice the Service stated that the rental real estate activities were passive activities and reduced the net operating loss carrybacks to prior years. The Service also reclassified the trustees’ fees as fiduciary fees to be deducted on line 12 of IRS Form 1041 instead of as expenses deducted against rental income on line 5 of Schedule E. A passive activity loss is the amount by which the passive activity expense deduction exceeds passive income for the current year. Any passive activity loss may be carried forward to the following year, but net operating losses may be carried back to prior years. Generally speaking, under Code Section 469(c), a passive activity is any trade or business activity in which the taxpayer does not materially participate; however, rental activity remains a passive activity even if the taxpayer materially participates. There is an exception to this exception if (i) more than one-half of personal services performed by taxpayer are performed in real property trade or businesses in which the taxpayer materially participates, and (ii) taxpayer performs more than 750 hours of services during the year in any real property trade or businesses in which the taxpayer materially participates. A C corporation meets the exception’s requirements if more than half of its revenue is derived from real property trade or businesses in which the corporation materially participates.
The Service argued that the exception was inapplicable because a trust cannot perform personal services. Moreover, Congress did not intend the Code Section 469(c)(7) exception to apply to trusts because it expressly applied only to individuals and C corporations. The court rejected this argument and reasoned that individual trustees’ work can be considered personal services performed in a trade or business. The court also cited the Code Section 469(i) exception for up to $25,000 in losses from rental real estate, which applies to a “natural person,” and it concluded that by using the word “taxpayer” Congress did not intend to exclude trusts from the Code Section 469(c)(7) exception. The Service next stated that even if the Code Section 469(c)(7) exception applied to a trust, it would not apply in this case because the trust itself did not materially participate, as the trust-owned LLC employees’ (including “trustee”-employees’) activities should not be considered. The court noted the absence of regulatory guidance on this point and considered (i) the trust’s substantial real estate operations, and (ii) the activities of all six trustees in their respective roles as trustees and the trust-owned LLC “trustee”-employees to find that the trust materially participated in real estate operations. Accordingly, the losses from the real estate activities were not passive and therefore not subject to the passive activity loss limitations.
Finally, in light of the court’s holding that the activities were not passive, the court dismissed as unnecessary to resolve the issue of whether the trustees’ fees were expenses of the trusts’ rental real estate activities.

Tax Court Denies Charitable Deduction for Donation of Façade Easement Lacking Any Value.

In Kaufman v. Comm’r, T.C.M. 2014-52 (Mar. 31, 2014) (Kaufman IV), upon remand from the First Circuit Court of Appeals, the tax court denied a deduction for an architectural façade easement that was no more restrictive than pre-existing neighborhood restrictions. The court also upheld imposition of accuracy-related penalties notwithstanding taxpayer’s reliance on a qualified appraiser’s valuation to support such deduction.
In 2003 taxpayer entered into a preservation restriction agreement with the National Architectural Trust (NAT) whereby she agreed to restrictions on her ability to alter, construct, or remodel existing improvements on her historic row house in Boston. NAT suggested two appraisers. The appraiser taxpayer selected had performed eight appraisals for individuals granting similar façade easements. All appraisals had applied a discount percentage and included reasoning based on the appraiser’s initial conversation and ongoing communications with NAT representatives.
After the grant of the façade easement, taxpayer’s spouse, an MIT statistics professor, expressed concern that the decrease in the property’s resale value would exceed the value of the contribution’s tax savings. An NAT representative assured him that properties regulated by local historic preservation ordinances were not at a market value disadvantage compared to the same neighborhood’s unregulated properties. The representative also stated that one of NAT’s directors owned fifteen historic properties and never would have granted an easement that would have adversely affected director’s properties’ value. In addition, before granting the easement, taxpayer signed a mortgage subordination agreement with the mortgage lender that stated that the easement restrictions were “essentially” the same as existing ordinance restrictions.
The Service hired an expert to testify at trial that the methodology of the taxpayer’s appraisal report was flawed because it did not take into account the fair market value of the property before and after the easement, but rather applied a standard discount percentage to the initial value. Furthermore, the taxpayers’ appraiser conceded at trial that the easement did not affect the property’s highest and best use as a single family home. The court was not convinced by the taxpayer’s analysis that there was a reduction in value, and instead followed the Service’s expert analysis. The court held that façade easement restrictions were no more restrictive than those in place before the façade easement, and even if they had been, they did not reduce the value of the home. In addition, the court upheld the imposition of accuracy-related penalties because NAT represented to taxpayer’s spouse that the home’s value would not be reduced by the easement. Furthermore, notwithstanding the spouse’s sophistication, taxpayer reported a $220,800 charitable deduction for the façade easement.

Surviving Spouse’s Failure to Sever Deceased Spouse’s Revocable Trust Into Marital and Family Trusts Resulted in Partial Inclusion of Trust Assets in Surviving Spouse’s Gross Estate.

In Estate of Olsen, et al. v. Comm’r, T.C.M. 2014-58 (Apr. 2, 2014), the tax court determined whether revocable trust assets never severed into marital and family trusts after the first death are includible in the surviving spouse’s gross estate. Mr. and Mrs. Olsen each created a trust and appointed the other as trustee. Upon Mrs. Olsen’s death, the trust required Mr. Olsen as trustee to distribute trust assets to two marital trusts and a third family trust. Upon Mrs. Olsen’s death, Mr. Olsen completed IRS Form 706 and indicated that the assets were to be distributed as follows: $1,000,000 to marital trust A; $500,000 to marital trust B; and $600,000 to the family trust. But Mr. Olsen never severed the Mrs. Olsen’s revocable trust into family and marital trusts. After Mrs. Olsen’s death, Mr. Olsen withdrew from Mrs. Olsen’s trust $1,100,000 to fund charitable gifts and $400,000 for deposit into his personal accounts. Mr. Olsen kept no records nor did he account for trust funds so the trust(s) from which the distributions were intended to be made could not be determined. Upon Mr. Olsen’s death, none of the remaining value of Mrs. Olsen’s trust was included on his estate tax return, so the Service issued a deficiency notice to include the $1,000,000 date of death value allocable to the marital trusts in Mr. Olsen’s estate. At trial the Service took the position that the distributions had been from the family trust, so that the remaining assets were in the marital trusts and includible in Mr. Olsen’s estate. The estate took the position that the distributed assets were from the marital trusts, so the remaining assets were in the family trust and not includible in Mr. Olsen’s estate. The court looked to the trust instruments to resolve the dispute. The court noted that the family trust contained provisions prohibiting distributions to Mr. Olsen unless they were for his health, education, maintenance, or support. It found that Mrs. Olsen did not intend that family trust distributions be made to Mr. Olsen until exhaustion of the marital trust assets. The court concluded that the $400,000 distribution for Mr. Olsen’s personal use came from the marital trusts and accordingly reduced the value of the marital trusts includible in Mr. Olsen’s estate. On the other hand, the court ruled that the $1,100,000 withdrawn to fund charitable gifts came from the family trust as only the family trust allowed Mr. Olsen as trustee to make charitable gifts. The court ordered that the $1,000,000 stipulated value of the remaining assets in Mrs. Olsen’s revocable trust at Mr. Olsen’s death be reduced by the $400,000 distribution to Mr. Olsen. The remaining $600,000 was includible in Mr. Olsen’s estate.

Code Section 6166 Election Denied For Estate Tax Return Filed Over Two Years Late.

In Estate of Woodbury v. Comm’r, T.C.M. 2014-66 (Apr. 14, 2014), the tax court reviewed whether a taxpayer who filed an estate tax return 2½ years late substantially complied with the requirement that a Code Section 6166 election be made on a timely filed return. The estate’s extension request included a letter stating the estate’s intent to make the Code Section 6166 election with the return. The Service allowed the estate an extension but denied an additional extension. When the estate tax return was filed (2½ years late) it included a notice of election that met the Code Section 6166 requirements. The Service denied the election because it was not made on a timely filed estate tax return. The estate filed a petition for declaratory relief alleging that it made a valid 6166 election under the doctrine of substantial compliance. The Service filed a motion for summary judgment based on the requirement that the 6166 election be made on a timely filed return. The court first considered whether the estate had substantially complied with the 6166 requirements. The court noted that while the estate included with its initial extension request a letter stating its intent to make a 6166 election, the estate did not provide information on its closely-held business interests. Therefore, according to the court, the estate’s failure to provide such information was a failure to “substantially comply” with the Code Section 6166 statutory and administrative requirements. In addition, the court denied the request for an equivalent amount of time to pay the remaining estate tax and interest on the ground that the court lacked jurisdiction. Its jurisdiction was limited to the declaratory judgment on whether the election may be made.

Federal Administrative Developments

IRS Says It Doesn’t Have to Process Amended Form 1120S Without Change in Tax When Filed By S Corp Shareholder After Expiration of Limitations Period for Assessment or Refund Claim.

In CCA 201409005 (Feb. 28, 2014), taxpayer had filed an amended IRS Form 1120S after the Code Section 6501 ASED (assessment statute expiration date) and Code Section 6511 RSED (refund statute expiration date). The amended return reported no change in tax. Taxpayer apparently filed the return to adjust certain flow-through items that ultimately affected the individual shareholder’s return (and refund claim) by reducing flow-through income or increasing flow-through credits. The Service pointed out that the respective limitations periods for filing an individual return and S corporation return are separate. Specifically, the limitations period for the individual S corporation shareholder is not controlled by the S corporation’s filing of Form 1120S but rather by the shareholder’s filing of IRS Form 1040. The issue was whether the Service should allow or deny the shareholder’s claim for refund. A taxpayer must show entitlement to a credit or deduction, and the Service may examine whether the taxpayer correctly reported underlying flow-through items. If the entity return amounts do not match those reported by the shareholder, then the Service may disallow the claim for failure to substantiate. The Service found no authority requiring it to process or prohibiting it from processing after expiration of the limitations periods the amended Form 1120S reporting no change in tax liability. It concluded that although it should consider the late-filed return’s impact on the shareholder’s claim for refund, processing is not required and any decision to do so must be a business decision made on a case-by-case basis.

Treasury Releases Greenbook.

On March 4, 2014, the U.S. Department of the Treasury released General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals. Known as the Greenbook, the report includes numerous proposed changes to existing income and transfer tax laws. The Greenbook is available online at http://www.treasury.gov/resource-center/tax-policy/Pages/general explanation.aspx.

Tax Court Contradicts IRS Publication 590 in Holding 12-Month IRA Rollover Limitation Applies on Per-Taxpayer Basis to Aggregate All IRAs, not on a Per-IRA Basis.

IRS Announcement 2014-15 (Mar. 20, 2014) addressed the one-rollover-per year limitation of Code Section 408(d)(3) and provided transition relief for affected IRA owners. In general, Code Section 408(d)(3)(A)(i) provides that an IRA distribution will not be included in the distributee’s gross income to the extent the distribution is paid into an IRA for the benefit of the distributee no later than 60 days after distributee’s receipt of the distribution. Subparagraph (B) limits the individual to only one rollover in any one-year period. The Service issued guidance in the wake of Bobrow v. Comm’r, T.C.M. 2014-21 (Jan. 28, 2014). In Bobrow, the tax court had addressed whether the requirement of one nontaxable rollover contribution within 12 months applies on a separate basis for each IRA (IRS Publication 590, Prop. Treas. Reg. § 1.408-4(b)(4)(ii)) or in the aggregate for all taxpayer’s IRAs. The tax court agreed with the latter position on the Code Section 408(d)(3)(B) limitation. The subsequent administrative guidance provides that the “existing” rule (i.e., 12-month limitation on per IRA basis) will be allowed through the end of 2014. The Service intends to issue guidance allowing only one IRA rollover per taxpayer in a 12-month period, and such guidance will become effective January 1, 2015.

Foreclosure on Passive Activity Real Property Triggers Recognition of Passive Losses Regardless of Insolvency Exception to Cancellation of Indebtedness Income.

In CCA 201415002 (Apr. 11, 2014), the Service addressed the rules regarding (i) recognition of suspended passive activity losses upon disposition in a foreclosure of taxpayer’s entire interest in the activity, and (ii) exclusion of resulting cancellation of debt income due to taxpayer’s insolvency. The Service provided that a foreclosure on real property subject to recourse debt and comprising taxpayer’s entire interest in a passive activity triggers recognition of passive losses. It also is fully taxable transaction for purposes of Code Sections 1001 and 469(g)(1)(A), regardless of whether any resulting COD income is excluded under Code Section 108’s insolvency exception. Thus losses from the activity are not from a passive activity, nor will they be reduced by any excluded COD income under such exception.

North Carolina Case Law Developments

Challenge to CRT Funding Based on Decedent’s Incompetence is Not Estopped by Decedent’s Receipt of Equivalent Value When Elective Share Taken Into Account.

In Bland v. Harold L. & Audree S. Mill Charitable Remainder Unitrust, ___ N.C. App. ___, 754 S.E.2d 259, 2014 N.C. App. LEXIS 108 (N.C. App. January 21, 2014), the North Carolina Court of Appeals, in an unpublished decision, reversed summary judgment and held that a decedent’s acceptance of benefits did not constitute a ratification, affirmation, or approval of a trust’s validity when decedent’s “acceptance” was equivalent to that which she would be legally entitled when decedent’s elective share was taken into account. The Court of Appeals found that defendants had failed to show quasi-estoppel as a matter of law as it relates to decedent’s acceptance of distributions from a trust that was in dispute. Plaintiff sought invalidation of the trust based on decedent’s incompetence upon execution of a power of attorney. Defendants, acting under the power of attorney had created a trust for decedent. The trust paid certain distributions to decedent totaling approximately $487,618.63 as well as $25,538.74 to maintain the trust-owned residence in which decedent resided prior to her death. Defendants stated that when comparing the additional payments and direct contributions to the decedent, she received at least $554.87 more in distributions from the trust than her contributions into the trust. Defendants claimed that the difference resulted in decedent’s ratification of trust terms. The Court of Appeals disagreed and found that sufficient evidence had been presented to show at least a question of fact that decedent had not received more than she would have legally been entitled to had the trust never been funded. Decedent’s elective share must be taken into account in determining the total monetary amount to which decedent would be entitled, not simply the money decedent had contributed to the trust. Since decedent’s elective share could be more than the $554.87 difference, the trial court erred in granting summary judgment for defendants.

Absence From Marital Home Required To Preclude Spousal Inheritance by Intestacy Based on Abandonment.

In Estate of Joyner v. Joyner, ___ N.C. App. ___, 753 S.E.2d 192, 2014 N.C. App. LEXIS 20 (N.C. App. January 7, 2014), the North Carolina Court of Appeals, in an unpublished decision, affirmed summary judgment that a husband had not “abandoned” his wife for purposes of N.C. Gen. Stat.§31A-1(a)(3) and did not lose intestate succession rights. The wife died intestate approximately one month before her husband of 26 years died (also intestate). The wife’s siblings brought suit claiming that decedent’s husband had constructively abandoned her under N.C. Gen. Stat. §31A-1 because (i) he refused to take his wife to medical appointments without compensation for time and gas, (ii) the couple had ceased conjugal contact and the husband had engaged in extramarital relationships, (iii) the husband had moved into a separate bedroom in the home, and (iv) the husband refused to provide food or financial support for the last six years of their marriage. The Court found that intent to abandon and abandonment, even when combined, are insufficient to preclude an abandoning spouse from intestate succession. The Court found that, in order to preclude an abandoning spouse from intestate succession, the abandoning spouse “must also not [be] living with the other spouse at the time of such spouse’s death.” The Court found that absence from the marital home is a necessary element in order for an abandoning spouse to be precluded from intestate succession under N.C. Gen. Stat. §31A-1.

Court Addresses Dispute Over Disposition of Proceeds From Sale of Stock Acquired By Husband With Wife’s Funds.

In Clements v. Clements, NO. COA13-596 (Unpublished) (Feb. 4, 2014),the North Carolina Court of Appeals reviewed a grant of summary judgment in favor of incompetent wife for nearly $3,000,000 in proceeds from the sale of the stock husband had purchased with $400,000 of wife’s funds. Two days before their marriage in 1997, Mr. and Mrs. Clements executed a premarital agreement stating that each spouse’s separate property (and subsequent appreciation thereon) would remain separate property during the marriage. In 2000 Mrs. Clements wrote a check $400,000 to Mr. Clements from her separate property account. Mr. Clements used the funds to purchase shares of Pharmakon, LLC (Pharmakon). Later that year Mrs. Clements developed issues relating to alcohol and depression, then the parties separated briefly and later reconciled. Mr. Clements signed a letter documenting the $400,000 loan to him to invest in Pharmakon on her behalf and appointing Mr. Clements to serve as her representative to Pharmakon. Mr. Clements also signed a letter documenting a loan she had made to his construction business. In late 2001 Mrs. Clements notified Pharmakon that the shares had been purchased with money she lent to her husband and she signed a document purporting to quitclaim the shares to him. At trial two expert opinions were offered. Mrs. Clements’s expert opined that in mid-2001 she sustained frontal lobe damage that had permanently impaired her ability to manage her affairs and to communicate important decisions. Mr. Clements’s expert opined that Mrs. Clements’s medical record did not support the claim that she was incompetent when she executed the late-2001 documents, but the trial court refused to admit this opinion because the expert never evaluated or examined her nor interviewed those who knew her during that time period. The court held that because the opinion was inadmissible, there was no genuine issue of material fact that she lacked capacity. The attempts to make a gift or convey the shares to her husband in 2001 were void. The court ordered that the accounts and the trusts funded and property purchased with proceeds from the Pharmakon sale be disgorged or sold to satisfy her claim for the proceeds. The Court of Appeals reversed the lower court’s summary judgment finding that the evidence established as a matter of law that Mrs. Clements lacked capacity to make a gift to Mr. Clements when she wrote him a $400,000 check in 2000 or signed the Quitclaim Agreement in 2001. The evidence submitted at trial addressed only her mental capacity in 2001, not the previous year in which she wrote the check. Moreover, the Court of Appeals held that North Carolina law provides that “un-contradicted expert testimony is not binding on a trier of fact” who may determine the credibility and weight of the opinion. Other evidence to be considered by the jury included Mrs. Clements’s medical records from her 2001 alcohol rehabilitation treatment that described her as being cognitively capable and intact. There was evidence from which the jury could infer that Mrs. Clements made a gift of $400,000 to Mr. Clements or that she subsequently gifted the stock to him. The Court of Appeals cited 1946 Supreme Court ruling that when a purchaser of stock has it issued in the name of another, the transaction is a gift by constructive delivery. The Court of Appeals next chose to review the exclusion of expert testimony and found that that the trial court erred in excluding the expert opinion based on lack of personal interview citing North Carolina court decisions that have explicitly rejected the position that an expert must conduct a personal interview to give an opinion on mental state.

Charging Order Does Not Effectuate Assignment of Debtor’s Membership Interest in Limited Liability Company.

In First Bank v. S&R Grandview, LLC, No. COA13-838 (N.C. Ct. App. Mar. 4, 2014),defendant (Rhine) defaulted on various loans and guaranty agreements. A monetary judgment was entered against Rhine for over $3.5 million. Plaintiff attempted to collect on the judgment by filing a motion seeking a charging order against Rhine’s membership interest in S&R Grandview, LLC (LLC). The trial court granted plaintiff’s motion after finding that the charging order effectuated an assignment and ordered that (i) Rhine’s membership interest in the LLC be charged with payment of the unsatisfied amount of plaintiff’s judgment including accrued interest, (ii) plaintiff would have rights of an assignee of Rhine’s membership interest in the LLC, (iii) Rhine was enjoined from exercising any rights as a member of the LLC, (iv) Plaintiff shall receive all distributions and allocations from the LLC to which Rhine was entitled until the judgment was paid in full, (v) LLC members and manager shall not allow any distribution or allocation to Rhine unless or until the satisfaction of the judgment.
Rhine appealed and the Court of Appeals reversed the trial court’s order. In reversing, the Court of Appeals explained that it was proper to read (former) sections 57C-5-02 and 57C-5-03 together, and under the statutes’ plain language, a charging order gives a judgment creditor the right to receive only those distributions and allocations to which the debtor-member would have been entitled until the judgment is satisfied. Specifically, it charges the member’s membership interest with payment of the unsatisfied amount of the judgment with interest. The Court explained that a charging order does not effectuate an assignment of a debtor-member’s total LLC interest, enjoin a debtor-member from exercising membership rights, or cause the debtor-member to cease to be a member of the LLC.
Mr. and Mrs. Cella are shareholders of Manning, Fulton & Skinner, P.A., in Raleigh, North Carolina.
Views and opinions expressed in articles published herein are the authors’ only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.

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