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

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U.S. Supreme Court Unanimously Rules Inherited IRAs Not Protected Under Bankruptcy Code Section 522(d); North Carolina Opts Out of Federal Exemption System So N.C.G.S. Section 1C-1601(a)(9) Exemption for Inherited IRAs Remains Applicable.

In Clark v. Rameker, 573 U.S.­_(June 12, 2014), the U.S. Supreme Court held that inherited
IRAs are subject to creditors’ claims in bankruptcy and in so holding resolved the circuit split on the issue. The Court reasoned that an inherited IRA falls outside the meaning of “retirement funds” because funds cannot be held until the current owner’s retirement. Specifically, an inherited IRA (i) may never have additional funds invested for the owner’s retirement; (ii) must have funds withdrawn from the account regardless of how far the current owner is from retirement; and (iii) may be depleted at any time and for any purpose without penalty. The Court’s holding related to the federal bankruptcy code exemptions in 11 U.S.C. § 522(d), which under N.C.G.S. § 1C-1601(f) are not applicable to North Carolina residents. N.C.G.S. § 1C-1601(a)(9) specifically exempts inherited IRAs from enforcement of creditors’ claims.

Taxpayer Fails to Substantiate Material Participation Under Code Section 469.

In Billeci v. Comm’r, T.C. Summary Op. 2014-38 (Apr. 17, 2014), the tax court addressed a taxpayer’s claimed real estate losses. Unemployed in 2008 and 2009, taxpayer owned and managed four rental properties with a total of thirteen rental units. Taxpayer also owned vacant land that he was attempting to develop into an amusement park. Taxpayer did not record his time spent managing the properties in 2008 and 2009. He reported wages in 2008 from a severance package, and he claimed real estate loss deductions on his 2008 and 2009 individual income tax returns. In addition, he made a Code Section 469(c)(7)(A) election on his return claiming material participation in all his rental real estate activities. He sought deduction of all expenses and claimed losses, but he submitted no proof of his time spent on the activities. The Service denied the loss deductions and issued a deficiency notice. Taxpayer then attempted to re-create a log of his time spent managing his properties to meet the 750-hour material participation threshold. The court determined that taxpayer had not passed any of the tests for material participation. Taxpayer’s time log entries were ill-timed, incomplete, or inadequately detailed, so the court was unable to determine the time taxpayer spent on real estate activities. The court upheld the Service’s deficiency notice because the records were insufficient to prove taxpayer’s time on the activities. No accuracy-related penalty was assessed because the court believed that taxpayer claimed the losses in good faith and that he spent significant time to be considered actively engaged in the business, even though taxpayer did not have the records to substantiate hours of participation.

Taxpayer’s Attempt to Evade Self-Employment Tax Liability Failed.

In Seismic Support Services, LLC v. Comm’r, T.C. Memo. 2014-78 (May 5, 2014), taxpayer wished to avoid paying self-employment taxes. After his employer denied his request to treat him as an independent contractor, taxpayer formed a limited liability company (Seismic). Taxpayer owned 95% of Seismic; another LLC of which taxpayer was sole member owned 5%. In tax years 2007 through 2009, taxpayer performed all services on behalf of Seismic and Seismic received all the payments for such services. Seismic then made payments to the taxpayer, called such payments “distributions,” deducted them as management fees, and never filed employment tax returns. The Service claimed taxpayer was personally liable for self-employment taxes on the payments, which it considered guaranteed payments for services under Code Section 707(c). The taxpayer contended that the payments were for use of capital rather than for services. Agreeing with the Service, the court found that Seismic’s payments to taxpayer were determined without regard to Seismic’s income and that such payments lacked evidence of use for capital. It concluded that the payments were properly characterized as guaranteed payments for services. The court also upheld the Service’s imposition of a Code Section 6662 accuracy-related penalty, as nothing in the record showed any reasonable attempt by taxpayer or Seismic to determine the correctness of the tax positions taken.

Tax Court Rejects IRS’s Highest and Best Use Argument in Conservation Easement Case.

In Palmer Ranch Holdings Ltd. v. Comm’r, T.C. Memo. 2014-79 (May 6, 2014), the tax court largely upheld the value of the conservation easement contribution as claimed by the taxpayer. The property at issue was 82 acres of land in Sarasota, Florida. The Service conceded that the donation of the easement encumbering the land met all the Code Section 170 requirements, but it contested taxpayer’s claim that the easement’s value was $23,942,500. The dispute centered on the property’s “highest and best use” before the easement and whether the “highest and best use” as determined by the taxpayer was “reasonably probable.” Taxpayer argued that the property could be rezoned to permit denser development, thus making the property more valuable. The Service argued that the proposed rezoning plan was not “reasonably probable” due to the current low density zoning of the property and prior denials of rezoning applications containing part of the property. Under the Treasury Regulations applicable to conservation easements, a taxpayer may value an easement by determining the encumbered property’s value at its highest and best use prior to the easement, and then subtracting the value of the property’s highest and best use after the easement. This method is known as the “before-and-after” method of valuing an easement. The “highest and best” use of property must be a use that is reasonably probable, though it need not be the current use or an intended use of the property. The Service argued that a potential buyer had attempted (and failed) to rezone property approximately two years prior to the donation, that environmental mandates on the property would curtail development, that the property lacked sufficient road access for development, and that the adjoining neighborhood would oppose the development. The tax court disagreed with all the Service’s contentions, distinguishing other cases that relied on zoning history, and noting that the previous denial was a 3-2 vote subject to change over time. The tax court also noted that significant development had been permitted on other adjoining parcels that met the environmental and zoning constraints and that the concerns about road access and neighborhood opposition were too speculative to be considered by the court. After concluding that the taxpayer’s highest and best use of the property was the appropriate basis for valuing the property, the tax court applied a haircut to the taxpayer’s value, finding that that taxpayer’s appraiser’s calculations overstated the growth of the real estate market at the relevant time. The tax court did not impose accuracy-related penalties because taxpayer’s reliance on the appraisal was reasonable and in good faith.

Estate’s Reliance on Expert’s Advice May Be Reasonable Cause for Waiver of Penalty for Failure to Pay Timely.

In Estate of Thouron v. U.S., 2014 U.S. App. LEXIS 8890 (3d Cir. Pa. 2014) (May 13, 2014), the court held that a taxpayer’s reliance on a tax expert’s advice may be reasonable cause pursuant to Treasury Regulations Section 301.6651-1(c)(1) for failure to pay by the deadline if the taxpayer can also show (i) an inability to pay, or (ii) undue hardship from paying on time. Decedent died on February 7, 2007. The executor retained an experienced attorney to render tax advice to the estate. The estate tax return and payment were due on or before November 7, 2007. On that date the estate requested a 6-month extension and paid the IRS $6.5 million, which was much less than the estate owed. The estate did not request an extension of time to pay, nor did it pay the balance of its liability, as counsel raised the possibility of a Code Section 6166 deferral of payment. In May 2008 the estate timely filed its extended return, but having determined that it did not qualify for the 6166 election, it requested another extension of time to pay. The IRS denied the request as untimely and imposed a failure to pay penalty. The estate ultimately filed the proper form and paid all outstanding amounts, including a $999,072 penalty. The estate then requested a refund of the penalty claiming that failure to pay was not willful neglect, but rather resulted from reasonable cause. Taxpayer had the “heavy burden” of proving both elements. Reasonable cause for failure to pay applies if a taxpayer uses ordinary business care but still is unable to pay the tax or would suffer an undue hardship. The district court ruled that reliance on an agent was not reasonable cause for late payment. The Third Circuit viewed the failure to pay as arising out of reliance on a tax expert’s advice. According to the court, reasonable cause may apply if the estate can show inability to pay or undue hardship from paying on time. It remanded the case to the district court to determine whether such reliance actually occurred.

Tax Court Finds Zero Value Façade Easement and Applies Pension Protection Act (PPA) Penalties to Post-PPA Returns Filed With Pre-PPA Carryovers Relating to Pre-PPA Donations.

In Chandler v. Comm’r, 142 T.C. 16 (2014) (May 14, 2014), the owner of two historic single-family residences in Boston’s South End granted to National Architectural Trust (NAT) a façade easement on each property. Taxpayer claimed that the values of the easements were $191,400 and $371,250, respectively. The tax court agreed with the Service that the donated façade easements had no value. Boston’s South End is listed in the National Register of Historic Places and designated a National Historic Landmark District. In addition, Boston’s municipal government had established nine local historic district commissions to regulate construction in those districts. One such commission, the South End Landmark District Commission (SELDC), had jurisdiction over the two properties at issue. The Service primarily argued that the easement had no value because the restrictions placed on the properties per the easements did not meaningfully restrict the properties beyond the restrictions put in place by the SELDC. Both parties submitted expert reports as to valuation. The tax court did not find either expert report to be persuasive. The taxpayer’s report incorporated several comparable sales that were geographically irrelevant to the unique Boston market. The Service’s expert cited several properties that had increased in value following a façade easement, but it did not take into account extensive renovations on those properties. The tax court followed its previous ruling in Kaufman, which involved a façade easement in the same Boston neighborhood. The tax court agreed with the Service that the donated easements had no value. The tax court concluded that a buyer would not perceive the slight difference in the easement restrictions and the SELDC restrictions; therefore, the additional restrictions placed on the properties via the easements did not impact the properties’ fair market value.
The court also addressed taxpayer’s claimed basis increase upon the 2005 sale of one of the houses. Taxpayer claimed additional basis in the property of $245,150 for improvements but was unable to substantiate those expenditures during the examination. The Service disallowed the additional basis, but later taxpayer was able to substantiate $147,824 of the $245,150 improvement costs. The tax court allowed the additional $147,824 of basis despite its rejection of “before-and-after” photos of the renovations as substantiation of the additional expenses claimed.
Finally, the tax court addressed application of penalties given that the carryovers from the gift applied to multiple years, one of which was 2006, the year of the Pension Protection Act (PPA). PPA applied the 40% gross valuation misstatement penalty to 200% overvaluations and eliminated the previous “reasonable cause and good faith” exception. The tax court determined that filing the 2006 return reaffirmed the taxpayer’s claimed value and therefore the PPA penalty provisions applied.

IRS Did Not Use Overpayment of Non-6166 Portion of Estate Tax Due as Credit Against Gift Tax Due When 6166 Portion of Estate Tax Due Outstanding.

In Estate of Adell v. Comm’r, T.C. Memo. 2014-89 (May 15, 2014), the tax court addressed the collection of an estate’s unpaid gift tax liability for tax year 2006. Decedent died on August 13, 2006.  Before his death he paid a $6,667,018 legal judgment entered against his son. In November 2007 the estate reported on IRS Form 706 the amount of the judgment as a loan receivable by the estate.  It also made the installment payment election under Code Section 6166. $15,288,517 of estate tax was due, $8,094,558 was paid, and $7,193,960 was deferred. In November 2008 the estate filed an amended 706 that reclassified the judgment as a taxable gift and the attendant (late) gift tax return, which showed a gift tax due of $2,889,108. In August 2010 the estate filed a second amended estate tax return that reported a zero value for one of the companies and continued to show the judgment as a taxable gift. In October 2010 the Service assessed $2,889,108 of gift tax, a $650,049 late-filing penalty, and $742,847 of interest. In November 2010 the Service issued deficiency notices for $39,673,096 (estate tax with loan receivable as estate asset) and for $2,889,108 (gift tax with judgment payment as gift plus an unreported gift). The estate responded with a protest letter requesting a stay of collection, consolidation of the estate and gift matters, and penalty abatement given initial reporting of the judgment. It also requested application of the estate tax payment against the gift tax liability. Then the Service responded with $71,563 of additional gift tax due plus $137,821 of interest for tax year 2006. Then the Service issued to the estate an “intent to levy” notice and two weeks later a notice of federal tax lien. The Service sustained its proposed actions and the estate filed a petition with the tax court. The court noted that when the estate made the estate tax payment the gift tax return had not been filed nor had the Service assessed any gift tax liability. The Service applied the payment in its own interest because the estate’s directions were not made at that time. Furthermore, the estate overpaid the non-deferrable portion of the estate tax due but the deferrable 6166 portion was still due. Under Code Section 6403 the Service first must apply overpayments of the non-deferrable portion to the deferrable 6166 portion. Thus none of the overpayment was available to credit against the gift tax liability.

Tax Court Refused to Grant Summary Judgment in Favor of IRS in Ponzi Scheme Litigation Involving Decedent’s Pension Investment.

In Estate of Kessel v. Comm’r, T.C. Memo. 2014-96 (May 21, 2014), decedent’s estate paid the full amount of tax due on the value of decedent’s pension account with Bernard Madoff Investment Securities. The account’s value was supposedly $4.8 million upon decedent’s death in 2006, and the value was included in the determination of estate tax paid in 2007. Later the estate claimed that the value of the Madoff account was actually zero. It sought a $1,937,391 refund, which the Service denied. Thereafter it filed an action. The Service moved for summary judgment on the grounds that (i) the Madoff account, as opposed to the Madoff account’s purported holdings, was the property subject to the Federal estate tax, and (ii) that a hypothetical willing buyer and willing seller of the Madoff account would not reasonably know or foresee Madoff’s operation of a Ponzi scheme at the time of decedent’s death. The court denied summary judgment on the issue of whether the account – rather than the underlying assets – must be the property valued for estate tax purposes. The court could not determine whether the account (with an agreement restricting transferability) was a property interest exclusive of the assets held in the account. The Service argued that a Ponzi scheme is not reasonably foreseeable until it collapses. The court rejected the argument because there was evidence that as of the decedent’s death – two years before the collapse of the Madoff scheme – some suspected illegal actions. The court concluded that the access to this information and the degree it would affect the fair market value were disputed material facts, so it denied the Service’s motion for summary judgment.

Tax Court Denies Estate’s Summary Judgment Motion on Adequate Disclosure of Gifts.

In Estate of Saunders v. Comm’r, T.C. Memo. 2014-100 (May 27, 2014), the court denied estate’s summary judgment motion on issues of fact regarding expiration of the limitations period before the Service sent gift tax assessment notices. In 1953 decedent’s late husband founded a farm supply company that grew into a multistate operation. Decedent died on April 5, 2008, owning 41,073 shares of the company’s common stock. From 1999 to 2008 decedent had made annual gifts of shares to family members. She timely filed IRS Forms 709 (gift tax return) reporting the gifts for each year. The Service examined the gift tax returns and in 2012 sent the co-executors gift tax deficiency notices for 9 of 10 years. The estate had reported on IRS Form 706 (estate tax return) the shares’ fair market value as $3,696,570, but the Service increased the estate tax return’s value of the adjusted taxable gifts by $3,248,613 to conform to the determinations in the gift tax notices. The estate challenged the Service’s increase in the value of the adjusted taxable gifts reported on the estate tax return.
The estate moved for partial summary judgment on the issue of when the limitations periods applicable to Federal gift tax assessments begin to run. Under Code Section 6501(a) the Service generally must assess gift tax within 3 years after the gift tax return is filed. The limitations period begins upon the taxpayer’s disclosure of the gift in a manner that is adequate to apprise the Secretary [of the Treasury] of the gift’s nature. For estate tax reporting purposes, the prior taxable gift’s value is treated as finally determined if taxpayer reported the gift on a gift tax return and the Service does not challenge the gift’s value before expiration of the 3-year limitations period. “Adequate disclosure” of the gift triggers commencement of the limitations period. Generally speaking, a gift reported on a gift tax return will be considered adequately disclosed if the taxpayer provides, among other things, a detailed description of the method used to determine the fair market value of the property transferred, including any financial data used. This is a question of fact. The court concluded that the estate failed to show that there was no genuine dispute as to whether the statements decedent attached to the gift tax returns adequately disclosed the shares’ value so as to trigger the running of the limitations periods on assessment. Accordingly, the court denied the estate’s motion for partial summary judgment.

Family Business Shareholder’s Personal Goodwill is Not Corporate Goodwill and Therefore is Not Deemed Transferred from Corporation to Shareholder (Capital Gain) and from Shareholder to Sons (Taxable Gift).

In Bross Trucking, Inc. v. Comm’r, T.C. Memo. 2014-107 (June 5, 2014), the tax court held that a business owner (taxpayer) (i) did not receive a distribution of corporate goodwill and other intangible assets from his company, and (ii) did not give his sons such assets. Accordingly, taxpayer and his wife did not recognize capital gain, nor did they make a taxable gift of the assets (which would have been required to be reported on a timely-filed gift tax return).
In 1972 Chester Bross (“Mr. Bross”) organized Bross Construction. Ten years later he organized Bross Trucking of which he owned 100%. Most of Bross Trucking’s equipment was leased from CB Equipment, which Bross family members also owned. Bross Trucking’s principal customers were Bross Construction and other Bross family-owned entities. Bross Trucking continued to operate into the late 1990s when Missouri transportation regulators conducted a series of audits and investigations of Bross Trucking. After receiving an unsatisfactory rating and negative investigation results, Bross Trucking ceased operations but remained intact.
In 2004 Bross’s sons decided to organize a new company, LWK Trucking. LWK Trucking chose to independently satisfy all regulatory requirements (instead of transferring insurance and licenses from Bross Trucking). However, LWK Trucking hired as employees many of the independent contractors who had worked for Bross Trucking. It also used equipment leased from CB Equipment that had previously been leased to Bross Trucking (some of which still displayed Bross Trucking logos that were covered by LWK Trucking).
In 2006 Mr. and Mrs. Bross gave portions of a family holding company, Bross Holding Group, to their sons. Bross Holding Group owned several entities but not Bross Trucking. Mr. and Mrs. Bross used a valuation based on appraisal of the holding company’s underlying entities and assets, and each timely filed IRS Form 709 (gift tax return).
In 2011 the Service issued various notices of deficiency and accuracy-related penalties to Bross Trucking and to Mr. and Mrs. Bross. The Service contended that Bross Trucking distributed intangible assets to Mr. Bross and that Mr. Bross gifted the appreciated intangibles to his three sons when they organized LWK Trucking in 2004. The alleged value of the intangible assets would have required both filing a gift tax return and paying gift tax for tax year 2004. The Service contends that Mr. and Mrs. Bross should have included these prior period taxable gifts of appreciated intangibles in tax year 2004 on their 2006 gift tax returns.
The court addressed whether Bross Trucking distributed appreciated intangible assets to its sole shareholder, Mr. Bross; whether Mr. Bross then gave those assets to his sons; and whether such gifts should have been reported for tax year 2004.
The Service claimed that Bross Trucking distributed the intangible asset of goodwill to Mr. Bross, which he in turn gave to his sons. The Court found that that Mr. Bross did not transfer his goodwill to Bross Trucking. A business can distribute only corporate assets and cannot distribute assets that it does not own. Specifically, a corporation cannot distribute intangible assets that are individually-owned by its shareholders. Citing previous case law, the court recognized two regimes of goodwill: (i) personal goodwill developed and owned by shareholders; and (ii) corporate goodwill developed and owned by the company. Bross Trucking’s goodwill was owned primarily by Mr. Bross personally, and the company could not transfer any corporate goodwill to Mr. Bross in tax year 2004. Bross Trucking may have had corporate goodwill at some point but had lost most of it by the time of the alleged transfer. The loss of customers and potential inability of Bross Trucking to perform necessary functions as a result of the regulatory suspension was the primary reason why LWK Trucking had been formed. But trade names and trademarks are the embodiment of goodwill, and LWK Trucking took steps to disassociate itself with Bross Trucking, namely, hiding the Bross name that still appeared on some of the vehicles that LWK Trucking leased.
The court further held that Bross Trucking did not transfer an established workforce in place (another attribute of goodwill) to Mr. Bross. Rather, it appeared that LWK Trucking assembled a workforce independent of Bross Trucking which included new key employees and services offered by LWK Trucking. LWK Trucking may have hired former Bross Trucking employees, but there is no evidence that these employees were transferred to LWK Trucking rather than hired away on their own merit. Furthermore, many of the alleged transferred employees were likely independent contractors who were not obligated to work solely for Bross Trucking.
The court further concluded that nearly all the goodwill used by Bross Trucking was part of Mr. Bross’s personal assets. Bross Trucking’s established revenue stream, its developed customer base, and the transparency of the continuing operations were all spawned from Mr. Bross’s work in the road construction industry – all were a direct result of Mr. Bross’s personal efforts and relationships. Mr. Bross did not have an employment contract with Bross Trucking, and he never signed a non-compete agreement that would prohibit him from competing against Bross Trucking if he disassociated with the company. So while a key employee who develops relationships for his employer may transfer goodwill to the employer through employment contracts or non-compete agreements, the lack of an employment contract between Mr. Bross and Bross Trucking shows that Bross Trucking did not expect to—and did not—receive personal goodwill from Mr. Bross. Accordingly, Mr. Bross’s personal goodwill remained a personal asset separate from Bross Trucking’s assets.
The court finally concluded that there was no indication that LWK Trucking received goodwill from or benefitted from relationships with Mr. Bross just because Bross Trucking customers chose to use a different company. The similarity of customers between Bross Trucking and LWK Trucking did not mean that Bross Trucking transferred goodwill but rather that Bross’s sons cultivated and profited from independently created relationships.
Accordingly, the court held that because there was no gift of goodwill in 2004, there was no use of unified credit in 2004 that would have caused a deficiency and accuracy-related penalty imposed by reason of gifts made in 2006.

Taxpayer’s Premature IRA Withdrawal For Purchase of Real Property Resulted in Current Income Taxes and Additional 10% Penalty.

In Dabney v. Comm’r, T.C. Memo. 2014-108 (June 5, 2014), the tax court addressed a premature IRA withdrawal used to buy real property. In 2008 Guy Dabney had a self-directed IRA with Schwab. After “some Internet research” Dabney concluded that IRAs can hold real property, and he wanted his Schwab IRA to buy undeveloped land in Utah. Even though the Schwab customer service representative told Dabney that Dabney’s Schwab IRA could not hold alternative investments such as real property, Dabney nevertheless withdrew $114,000 from his IRA, checked the “early distribution” box on the form, wired the funds to Chicago Title, and instructed it to name the Schwab IRA as the real property owner. A bookkeeping error resulted in Dabney being named as the property’s owner, and in 2009 Schwab issued Dabney IRS Form 1099-R, which reported an early (i.e., before age 59½) withdrawal with none of the Code Section 72(t) exceptions applicable. Dabney and his wife did not report the withdrawal on their IRS Form 1040 (2009). The Service found a $42,431 deficiency and imposed an accuracy-related penalty. Dabney argued that the withdrawal was not a taxable distribution because it was either (i) a purchase made by the IRA, or (ii) a transfer between IRA trustees.
Finding against Dabney, the tax court determined that the IRA did not buy the property, as Schwab prohibited Dabney’s IRA from holding real property. IRAs custodians, like trustees, exercise considerable discretion to limit investments in their agreements. A trustee-to-trustee transfer could have worked had Dabney transferred his IRA funds to an IRA permitting alternative investments. Dabney’s transfer of funds to the seller, who was not an IRA trustee or custodian, did not qualify as a trustee-to-trustee transfer within 60 days contemplated by Code Section 408(d)(3). The tax court applied the additional 10% tax under Code Section 72(t), but it did not apply the accuracy-related penalty as Dabney was unsophisticated and diligently attempted to make the transaction legitimate.

Taxpayer’s Divorce Settlement Payments Didn’t Increase Property’s Basis and Taxpayer’s Use of Son as Qualified Intermediary Fails to Meet Code Section 1031 Like-Kind Exchange Safe Harbor.

In Blangiardo v. Comm’r, T.C. Memo. 2014-110 (June 9, 2014), the court reviewed the Service’s motion for partial summary judgment on (i) whether the Code Section 1031 deferred exchange requirements were met, (ii) whether a property’s basis can be increased on account of settlement payments made to two former spouses incident to divorce, and (iii) whether an accuracy-related penalty should apply. In 1995 taxpayer bought property A for $488,000. Taxpayer and his spouse later divorced, and in 2000 the spouse waived her interest in the property for $500,000. Taxpayer remarried, divorced again, and entered into an agreement where taxpayer’s second spouse waived her interest in the property for $80,000. After the second divorce, taxpayer sold property A for $2,250,000. Two weeks later he bought a vacant lot for $1,430,000 and claimed the purchase was a 1031 deferred or “like-kind” exchange. He also claimed that the two divorce settlements increased property A’s basis. The Service disagreed, disallowing the 1031 exchange on account of the son’s ineligibility as a qualified intermediary (i.e., son was a lineal descendant).  It also rejected the claimed basis increase because Code Section 1041(b) treats transfers incident to divorce as gifts to which the carryover basis rules apply. The court granted the Service’s motion for partial summary judgment.

Taxpayer’s Reliance on Counsel’s Advice Is Not Reasonable Cause if Advice Based on Unreasonable Factual or Legal Assumptions.

In Liftin v. U.S., 2014 U.S. App. LEXIS 10709 (Fed. Cir. June 10, 2014), the executor was required to file a federal estate tax return within nine months of the decedent’s death. The Service granted executor a six-month extension to file the return. Upon decedent’s death decedent’s wife was a citizen of Bolivia. The Code Section 2056 marital deduction provisions allow the marital deduction for property that passes to a surviving spouse if the spouse is either (i) a U.S. citizen, or (ii) a U.S. resident at all times after decedent’s date of death and before becoming a U.S. citizen. The executor engaged an attorney who suggested that to receive the marital deduction the widow first must become a U.S. citizen before the estate files the estate tax return. Despite paying an amount sufficient to cover the estate taxes due (even if deduction disallowed), the executor did not file the estate tax return by the extended due date. The executor relied on counsel’s (erroneous) advice that the estate tax return could be filed late. The decedent’s wife eventually became a U.S. citizen; however, the executor did not file the estate tax return until nine months later (i.e., twenty-three months after the original extended due date). The estate sought a refund in the amount of $198,727.75. The Service assessed late filing penalties in the amount of $169,643.06, which was later reduced to $135,714.45. The Court of Federal Claims granted summary judgment for the Service, finding that the nine-month delay in filing the return after the widow became a citizen was not due to reasonable cause. The Court of Appeals then affirmed this ruling. The Court of Appeals explained that for each month up to five months that a federal tax return is filed late, the IRS can impose a penalty of five percent of the tax due unless it is shown that the late filing is due to reasonable cause and not willful neglect. The estate attempted to argue that there was reasonable cause for the late filing based on the executor’s reliance on counsel’s advice that a late return could be filed after certain ancillary matters were resolved. But under Treasury Regulations Section 1.6664-4, a taxpayer’s reliance on counsel’s advice constitutes reasonable cause for failing to file a tax return only if the advice is not based on unreasonable factual or legal assumptions. The Court of Appeals noted that allowing taxpayers to rely on unreasonable legal assumptions by tax professionals would encourage taxpayers to seek out professionals who would give unreasonable advice to circumvent IRS penalties and fines. Such a consequence would ultimately harm the government’s ability to collect tax payments timely and properly. The Court of Appeals found that the assumption that the estate tax return could be filed nearly two years late was simply unreasonable. Thus, the estate’s reliance on the advice did not constitute reasonable cause and the ruling for the IRS was affirmed. The dissent argued that there should be no penalty whatsoever since the estate paid the taxes on time, and only the tax return was filed late.


Treasury Issues Final Regulations on Code Section 67 Deductions for Non-Grantor Trust and Estate Expenses.

The Department of the Treasury issued final regulations (79 Fed. Reg. 26616 (May 9, 2014)) that address the costs incurred by estates or non-grantor trusts that are subject to the 2% floor for miscellaneous itemized deductions. Generally, a cost is subject to the 2% floor if it is: (1) defined as a miscellaneous itemized deduction under Code Section 67(b); (2) incurred by an estate or (non-grantor) trust; and (3) would be commonly or customarily incurred by an individual. The final regulations retained the 2011 proposed regulations with minor modifications and clarifications.

Code Section 2056(a) Marital Deduction For Full Amount of Surviving Spouse’s State Law Elective Share Disallowed To Extent Elective Share Met With Foreign Country Trust Assets Benefitting Non-Spouse.

In CCA 201416007 (Apr. 18, 2014), decedent created an irrevocable trust to be administered in a foreign country (Country A). Country A’s laws governed the trust, the trust designated as trustee a corporate fiduciary in Country A, and decedent had designated himself and his adult child as beneficiaries. The trust contained shares of companies situated outside the United States. Upon decedent’s death in the United States, decedent’s spouse claimed her state law elective share and included the trust property in the calculation. The estate tax return claimed the marital deduction for the elective share amount including the trust property with foreign company shares. The Service found that under Country A’s laws U.S. forced heirship rules or any U.S. judgment would be ineffective. Furthermore, the adult child was the beneficial owner of trust assets. The Service determined that the Code Section 2056(a) marital deduction is allowable only for property interests that pass decedent to spouse as beneficial owner. It is not available for a property interest passing from decedent to a non-spouse as beneficial owner, as was the situation in this ruling.  Thus the Service disallowed the marital deduction for the portion of the elective share relating to the trust property.

Transfer of Private Foundation Trust Assets to Private Foundation Nonprofit Corporation Won’t Trigger Code Section 507(c) Termination Tax.

In PLR 201418060 (May 2, 2014), the same family maintained two philanthropic entities. One was a private foundation in the form of a nonprofit corporation, and the other was a private foundation in the form of a charitable trust. The family decided that combining the two entities would better serve the family’s charitable objectives. The entities entered into a transfer agreement that conditioned the transfer on amending the corporation’s articles, providing for two distribution committees, obtaining a letter ruling from the Service confirming treatment as continuation of the charitable trust, notifying the state’s attorney general, and promising to indemnify the trustees. The Service approved the transfer and found no self-dealing, no jeopardizing investments, and no change to the entities’ exempt status. The transfer would not result in a termination that would subject the trust to tax under Code Section 507(c).

IRS Offers Temporary Penalty Relief for Late IRS Annual Reporting Requirements Involving Owner-Only Retirement Plans.

Rev. Proc. 2014-32, 2014-23 I.R.B. 334 (May 9, 2014) announced a one-year pilot program that offers penalty relief for plan administrators or plan sponsors that are late filers of IRS Form 5500 series returns (employee benefit plan annual report) involving one-participant (i.e., owners and spouses) and certain foreign retirement plans. A “one-participant” plan is a retirement plan with at least one participant that: (i) covers only the owner of the entire business (or the owner and the owner’s spouse); (ii) covers only one or more partners (or partners and their spouses) in a business partnership; and (iii) does not provide benefits for anyone except the owner (or the owner and the owner’s spouse) or one or more partners (or partners and their spouses). An example is the “solo 401(k)” plan. The program is not available for retirement plans subject to Title I of ERISA (i.e., plans that benefit anyone in addition to owners and partners and their respective spouses), which should use the U.S. Department of Labor’s DFVC program. The penalties for failure to file timely are costly: $25 per day, up to $15,000 per return. Returns submitted after June 2, 2015, will not be entitled to relief.

Value of Land Leased by Private Foundation Excluded From Computation of Code Section 4942(e) Investment Return.

In PLR 201419017 (May 9, 2014), a private foundation’s wholly-owned LLC owned undeveloped real property. The foundation leased the property to a government instrumentality for nominal or no cost so that the instrumentality could harvest hay to feed livestock at the instrumentality’s historic working farm park. The foundation wanted the property’s value excluded from the aggregate fair market value of all the foundation’s assets used in computing the minimum investment return under Code Section 4942(e)(1). Concluding that the leasing activity carried out the foundation’s exempt purpose, the Service permitted the requested exclusion.

IRS Allows Midyear Windsor-Related Amendments to 401(k) and 401(m) Safe Harbor Plans.

In IRS Notice 2014-37, 2014-24 I.R.B. 1100 (May 15, 2014), the Service confirmed that a sponsor of a Code Section 401(k) or (m) “safe harbor” plan may adopt a mid-year amendment pursuant to earlier IRS guidance on the application of the Windsor decision to qualified retirement plans.

Service Explains Application of 9100 Relief to Failure to Make Statutory or Regulatory Portability Elections.

In PLR 201421002 (May 23, 2014), the executor of a non-taxable estate sought “9100 relief” (Treasury Regulations Section 301.9100-3) to extend the time for filing to elect portability of a deceased spouse’s unused exclusion (DSUE) amount pursuant to Code Section 2010(c)(5)(A). The Service stated that the Code prohibits a surviving spouse from using the DSUE amount unless the executor of the deceased spouse’s estate files a timely-filed (including extensions) estate tax return that includes the election. Code Section 2010(c)(6) required Treasury to issue regulations to implement the Code Section 2010(c) provisions on portability of unused exclusion between spouses. Code Section 6075 requires estate tax returns under Code Section 6018(a) to be filed within 9 months of the date of death. Code Section 6018(a) requires filing of the estate tax return for estates where a U.S. citizen or resident’s gross estate exceeds the basic exclusion amount for the calendar year of death. Significantly, Treasury Regulations Section 20.2010-2T(a)(1) treats an estate electing portability as an estate required to file the estate tax return under Code Section 6018(a). The 9100 relief provisions allow the Service to grant reasonable extensions of time to make a statutory election (election due date prescribed by statute) or a regulatory election (election due date prescribed by regulation or administrative guidance). Regulations Section 301.9100-3 provides an extension of time for making regulatory elections that don’t satisfy the automatic extension requirements of Treasury Regulations Section 301.9100-2. According to the Service, the portability election for executors already required to file an estate tax return with a specified due date under Code Section 6018 is a statutory election. On the other hand, the portability election for executors required to file an estate tax return only by way of 20.2010-2T(a)(1) (i.e., non-taxable estates) is a regulatory election. In the latter situation the Service has the discretionary authority to grant an extension if the request is reasonable, in good faith, and the relief sought will not prejudice the government’s interests. A 120-day extension was granted.

Trust Allowed to Distribute LLC Interests Instead of Marketable Securities.

In PLR 201421001 (May 23, 2014), a trust sought guidance before distribution of trust property to the remainder beneficiaries. The trust owned an entire interest in a trustee-managed limited liability company, marketable securities, and cash. The trust treated the LLC as a disregarded entity for tax purposes to hold certain trust assets with other assets held directly by the trust to address trust expenses and ongoing litigation. The trust provided that assets be held until the death of the last remaining member of a group of individual beneficiaries. Upon such death the trust sought an orderly distribution of trust assets to the remainder beneficiaries. The trustees proposed to establish two separate series limited liability companies, each wholly-owned by the trust, to facilitate the orderly distribution of the trust’s assets to the remainder beneficiaries. One would be funded with equity securities and the other would be funded with fixed income securities. The series LLCs would be treated as disregarded entities within the trust. The trustees proposed to make non-taxable pro rata distributions of the trust’s interest in the series LLCs to the remainder beneficiaries, requesting such distributions to be treated as if the assets of the trust were distributed outright to the remainder beneficiaries with the remainder beneficiaries immediately contributing the assets to the series LLCs in exchange for ownership interests in the partnership. Each of the remainder beneficiaries would be able to elect whether to receive additional trust distributions of assets held directly by the trust in the form of a direct contribution to the series LLCs on behalf of that beneficiary, treated as a deemed distribution followed by capital contribution of such assets, or to receive an outright cash or in kind distribution. The Service agreed with the non-taxable nature and deemed distribution characterization of the trust’s distribution of the series LLCs’ ownership interest to the remainder beneficiaries and direct contribution of the trust assets to the series LLCs on behalf of the remainder beneficiaries. In addition, the Service agreed that partial netting approach for reverse Code Section 704(c) allocations made upon the at least annual revaluations of the series LLCs was reasonable within the meaning of the Regulations. The Service also exercised its authority to permit the series LLCs to utilize the partial netting approach for forward Code Section 704(c) allocations subject to qualification as qualified financial assets, due to the burden on the series LLCs to use separate methods for forward and reverse Code Section 704(c) allocations and the implausibility of the method shifting the tax consequences of the built-in gain and loss among the partners.

Irrevocable Testamentary CLATs’ Annuity Payment Distributions Required By Charitable Pledge Agreements Weren’t Treated as Self-Dealing Under Code Section 4941(a)(1).

In PLR 201421024 and PLR 201421023 (May 23, 2014), upon deaths of both husband and wife, irrevocable testamentary charitable lead annuity trusts (CLATs) were created and funded to satisfy previously executed and outstanding charitable pledge agreements. The pledge agreements memorialized gifts from the trusts and the family’s foundation to a hospital and museum. As substantial contributors and spouses, husband and wife were disqualified persons with respect to both the private foundation and the CLATs. The Service determined, however, that payments by the foundation and the CLATs pursuant to the pledge agreements, which also included naming rights, would not be in satisfaction of a legal obligation of the couple and therefore would not constitute self-dealing under Code Section 4941.

Executor Granted 120-Day Extension to Amend Trust to Meet QDOT Requirements.

In PLR 201421006 (May 23, 2014), the Service granted executor a 120-day extension to amend a trust to meet the Code Section 2056A qualified domestic trust (QDOT) requirements and to file such amended trust with a supplemental IRS Form 706. Decedent, a U.S. citizen, was survived by a non-U.S. citizen spouse. Upon decedent’s death decedent created a trust for the spouse’s benefit during her life, and executor elected on the 706 to treat the trust as a QDOT, which would hold over $2 million in assets. The executor sought a ruling to allow amendment of the trust to provide that at all times it shall have at least one acting U.S. trustee that is a bank as defined in Code Section 581. The amended trust also would prohibit principal distributions without the U.S. corporate trustee’s approval. With respect to the bank trustee security alternative, Treasury Regulations Section 20.2056A-2(d)(1)(i)(A) requires the trust instrument to have a trustee that is U.S. citizen or a qualified domestic corporation. Concluding that the executor was acting reasonably and in good faith, the Service granted the extension of time.
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Mr. and Mrs. Cella are shareholders of Manning, Fulton & Skinner, P.A., in Raleigh, North Carolina. – See more at:


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