Posts Categorized: Tax Update

Bank of America v. Commissioner of Revenue

Author: Kerry Reilly, Esq., K. Reilly Law LLC

Bank of America v. Commissioner of Revenue

SJC – 11995 (July 11, 2016)

On July 11, 2016, the Massachusetts Supreme Judicial Court (“SJC”) upheld the decision of the Appellate Tax Board (the “board”) that Bank of America N.A. (“B of A”), in its capacity as corporate trustee, qualified as an inhabitant of the Commonwealth of Massachusetts (“MA”) and was subject to the state’s fiduciary income tax for the trusts in question.

G.L. c.62 §10 (a) provides that income received by trustees is subject to MA taxes if “the persons to whom the same is payable, or for whose benefit it is accumulated, are inhabitants of the commonwealth…”  Under G.L. 62 §1(f), inhabitant” means – “(1) any natural person domiciled in the commonwealth, or (2) any natural person who…maintains a permanent place of abode in the commonwealth and spends in the aggregate more than 183 days of the taxable year in the commonwealth.” Section 14 subjects corporate trustees to the same tax regime as “natural” trustees.

The SJC affirmed that B of A was an inhabitant of the Commonwealth based on its extensive branch structure, its conducting of business related specifically to the trusts at issue – “maintaining relationships with the beneficiaries, making decisions about distributions to those beneficiaries, administering trust assets, and retaining certain records” – as well as conducting similar business for other trusts, and was thus subject to taxes pursuant to G.L. c.62 §10.

Estate of Sarah D. Holliday

By, Kevin M. Ellis, Esq. of Hemenway & Barnes LLP

Citation: TC Memo 2016-51

Overview:  The Tax Court held that the value of investment assets transferred to a family limited partnership (“FLP”) by decedent must be included in the decedent’s estate without discount.  The Tax Court determined that there were no legitimate and nontax reasons for transferring assets to the FLP, and that there was an implied agreement that the decedent retain the possession or enjoyment of, or the right to use the income from, the transferred property.

Summary of Facts:  Decedent (through her son, who held her power of attorney), created a limited partnership in which she was the 99.9% limited partner, and her wholly-owned LLC was the 0.1% general partner. Approximately a week after creating the entities, decedent contributed nearly $6 million of marketable securities to the partnership.  On that same day, she sold her entire membership interest in the LLC to her two sons, and gave 10% of her interests in the limited partnership to an irrevocable trust that she created.

Following all of the transfers, decedent owned 89.9% of the limited partnership, and also retained significant assets outside of the partnership.

The limited partnership agreement stated that one of its purposes was to provide “a means for members of the Holliday family to acquire interests in the Partnership business and property, and to ensure that the Partnership’s business and property was continued by and closely-held by members of the Holliday family.” Limited partners did not have a right to participate in the partnership’s business or operations, but the agreement did provide for distributions to limited partners to “the extent that the General Partner determine[d] that the Partnership ha[d] sufficient funds in excess of its current operating needs to make distributions.”

The partnership made one small ($35,000) pro rata distribution.

Decedent died two years after the creation of the FLP, and her estate claimed a 40% discount for her remaining 89.9% limited partnership interests.

Tax Court Analysis: The IRS argued that the transfer of assets to the partnership triggered §2036(a)(1), requiring that the partnership assets be included in decedent’s estate without a discount.

Inclusion under §2036(a)(1) requires that (i) the decedent made an inter vivos transfer of property, (ii) the decedent retained (either explicitly or by implied agreement) the possession or enjoyment of, or the right the income from the property, and (iii) the transfer was not a bona fide sale for adequate and full consideration.

Focusing on the second requirement of §2036(a)(1), the Tax Court found that decedent retained, by implied agreement, the enjoyment of the property. The Tax Court focused on language in the partnership agreement requiring the distribution of “distributable cash” (cash in excess of operating needs) on a periodic basis. The Tax Court also determined that that the decedent was entitled to distributions in certain circumstances, and that operationally, according to testimony of decedent’s son, if decedent needed a distribution, one would have been made to her.

Further, focusing on the third requirement of for inclusion under §2036(a)(1) – that the transfer was not a bona fide sale for adequate and full consideration – the Tax Court rejected the nontax arguments for the creation of the limited partnership. Specifically, the Tax Court rejected the following as legitimate and significant reasons for creating the partnership:

  1. Protection from litigators’ claims: The Tax Court noted that decedent had never been sued before, was not at high risk from “trial attorney extortion,” and in fact held other substantial assets that could be reached by any attempted extortion.
  2. Protection of assets from “undue influence of caregivers”: The Tax Court focused on the fact that decedent’s property was managed by her sons as evidence of her reduced susceptibility to this concern, and also cited a lack of evidence of any concern about this issue in forming the partnership.
  3. Preservation of assets for the decedent’s heirs: The Tax Court noted that the decedent was not involved in creating the entities, but that her sons did so as her power of attorney, and that other family assets were managed well without need for this structure.

The Tax Court made other determinations that undermined evidence of a bona fide transaction. The Tax Court found that this was not an arms-length transaction because no real negotiation or bargaining occurred. Further, the limited partnership did not maintain adequate books and records or follow other formalities that supported its operating as a meaningful stand-alone entity. Finally, the Tax Court noted that there was no active management of the assets, but rather only passive trading, which supported an argument that the transfers occurred only to obtain a valuation discount.

Estate of Purdue v. Commissioner

By, Caleb S. Sainsbury, Esq. of Morgan, Lewis & Bockius LLP

Citation: 145 T.C. Memo. 2015-249 (December 28, 2015)

Overview: This case addresses (1) whether the decedent retained an interest under §2036 of assets transferred to an FLP; (2) whether gifts of FLP interests qualify for the annual exclusion; and (3) whether interest on a loan to the estate to pay estate taxes may be deducted.

Summary of Facts: In 1995, the estate planning lawyer for Mr. and Mrs. Purdue advised them to establish an FLP and various trusts.  In 2000, the Purdues acted on this advice and contributed $22 million of marketable securities, an interest in a commercial building worth $900,000, a $375,000 promissory note from one of their children and an $865,523 certificate of deposit in exchange for all of the FLP membership interests.  The final agreement listed the following six reasons for establishing the FLP: to (1) consolidate the management and control of the property and improve efficiency in managing the property; (2) avoid fractured ownership; (3) keep ownership of the assets within the extended family; (4) protect assets from unknown creditors; (5) provide flexibility and management of assets not available through other business entities; and (6) promote the education and communication among extended family with respect to financial matters.

In addition, prior to the execution of the FLP, the estate planning attorney sent a memorandum to the Purdues summarizing five advantages of the structure. These advantages were (1) limited liability; (2) pass through income taxation; (3) minimum formalities; (4) appropriate entity for owning real estate; and (5) tax savings.

Prior to signing the documents, the Purdues had experienced some health issues. Mrs. Purdue had become semi-invalid due to a leg injury.  She had also experienced stroke-like symptoms in October 2000, but did not have residual neurological impairment.  Mr. Purdue was physically healthy at the time of the signing, but did experience symptoms of Alzheimer’s disease and was subsequently diagnosed with that disease.

Mr. Purdue died unexpectedly in August 2001 and his estate passed to a family trust and two QTIP trusts. From 2002 through 2007, Mrs. Purdue made gifts of the FLP membership interests to an irrevocable trust with beneficiary withdrawal rights.  The trust made approximately $1.95 million of distributions to the children from 2001 to 2007, with the majority of the cash coming from the FLP interests contributed to the trust.

Upon Mrs. Purdue’s death in 2007, a dispute arose among her children on whether the FLP should make a distribution to pay estate taxes. Because the FLP operating agreement required unanimous consent, this gridlock resulted in funds from the FLP not being available to pay the tax.  As such, some of the beneficiaries and the QTIP trusts loaned money to the estate to fund the estate tax payment.  The estate deducted the interest on the loan on the estate tax return.

Court Analysis:

  1. §2036 Issues

The IRS argued that Mrs. Purdue had a retained interest in all assets transferred to the FLP. However, the Court reasoned that §2036 did not apply with respect to the transfers to the FLP for the following reasons: (1) the record established legitimate and significant nontax reasons for creating the FLP, (2) the Purdues were not financially dependent on FLP distributions, (3) FLP funds and personal funds were not comingled, (4) the FLP maintained its own records and formalities were respected, (5) the assets were transferred to the FLP in a timely manner, and (6) the Purdues were in good enough health at the time of the transfers.

  1. Annual Exclusion

To qualify as a gift of a present interest in the context of FLP interests, the donees must have the use, possession or enjoyment of the FLP interests or the income from those interests. Although the donees could not transfer the FLP interests without the consent of all members, the Court reasoned that the donees did receive income from those interests and this satisfied the present interest requirement.  Therefore, the gifts did qualify for the annual exclusion.

  1. Deductibility of Interest

In order for the interest on a loan to the estate to be deductible on an estate tax return, the loan must be (i) bona fide, (ii) necessary and actually incurred in the estate administration and (iii) essential to the property settlement of the estate. See Treas. Reg. §20.2053-1(b)(2), §20.2053-3(a).  The Court reasoned that the loan was necessary because the FLP members could not agree on whether to make a distribution to pay the estate taxes.  Thus, the interest deduction was allowed.

Take Away Considerations:  This case provides a roadmap for highlighting factors resulting in a positive result for the client.  Particularly, advisors must take care to review the factors noted by the Court to avoid having the full value of assets transferred to an FLP included in the estate under §2036.

IRS Releases Proposed Regulations on Taxing Expatriates’ Gifts and Bequests to U.S. Citizens and Residents

By, Caitlin Glynn of Rackemann, Sawyer & Brewster

Recent guidance has been issued to implement Internal Revenue Code Section 2801 (“Section 2801”) which imposes a succession tax on U.S. citizens and residents who receive gifts or bequests from individuals who relinquished U.S. citizenship or ceased to be lawful permanent residents of the United States on or after June 17, 2008 and were “covered expatriates” as defined by the Statute.

IRC Section 2801 Explained

Section 2801 was added to the Internal Revenue Code by The Heroes Earnings Assistance and Relief Tax Act of 2008 (“HEART Act”).  In passing the HEART Act Congress determined that it was appropriate and in the interests of tax equity to impose a tax on U.S. citizens and lawful residents who receive from an expatriate a gift or bequest that would otherwise not be subject to U.S. estate and gift tax.  Under Section 2801 the receipt of covered gifts or covered bequests by U.S. citizens or residents from covered expatriates is subject to tax.  For purposes of calculation of the tax on the gift or bequest, the amount of the gift is its fair market value as of the date of receipt and the tax imposed is the highest applicable gift and estate tax rate (currently 40 percent).

Section 2801 is distinctive in that it imposes the tax on the recipient of the gift or bequest, rather than the donor or estate of the decedent.  The tax will be imposed whether the donor or decedent acquired the property transferred before or after expatriation.  The tax will not apply to those gifts that do not exceed the gift tax annual exclusion amount for the year.   The tax is also reduced by the amount of any gift or estate tax paid to a foreign country with respect to a covered gift or bequest.

Previous Guidance from the IRS

On July 20, 2009 the Treasury Department and the IRS issued Announcement 2009-57.  This Announcement states that the IRS intends to issue guidance under Section 2801.  The Announcement further provides that tax payments and filing requirements of the statute are deferred pending the issuance of final regulations.

The Proposed Regulations

The Proposed Regulations amend Title 26 by adding Part 28, “Imposition of Tax on Gifts and Bequests from Covered Expatriates.”  The proposed Regulations are divided into seven sections and include Sections 28.2801-1 to 28.2801-7.  See Internal Revenue Bulletin 2015-39.

Section 28.2801-1 sets forth the general rule of liability for the tax, that the tax is imposed on U.S. citizens or residents who receive covered gifts or covered bequests from a covered expatriate.  Domestic trusts and foreign trusts electing to be treated as domestic trusts are treated in the same manner as U.S. citizens.  Section 28.2801-2 provides definitions for Section 2801, including important terms such as “covered expatriate,” “covered bequest,” “domestic trust,” “foreign trust” and “power of appointment.”  “Covered expatriate” is defined by reference to Section 877A(g)(1).  Section 877A(g)(1) generally defines a “covered expatriate” as an individual who expatriates on or after June 17, 2008, and whose average annual net income for the period five taxable years before expatriation exceeds $124,000 (subject to a cost of living adjustment), or whose net worth as of expatriation is $2 million, or who cannot certify that they have complied with filing requirements for the five taxable years before expatriation, subject to certain exceptions.

Section 28.2801-3 addresses rules and exceptions applicable to the definitions of covered gift and covered bequest.  In general, the following transfers are excluded from such definitions: qualified disclaimers of property made by the covered expatriate; taxable gifts reported on a covered expatriate’s timely filed gift tax return and property included in the covered expatriate’s gross estate and reported on such expatriate’s timely filed estate tax return, provided that the gift and estate tax due is timely paid; donations to a charitable organization that would be deductible for gift or estate tax purposes; or transfers to a U.S. citizen spouse if such transfer would otherwise qualify for the gift or estate tax marital deduction.

Section 28.2801-4 provides specific rules regarding who is liable for the payment of the Section 2801 tax as well as how to compute the tax. As outlined above, a U.S. citizen or resident who receives a covered gift or a covered bequest is liable for the tax.  A domestic trust that receives a covered gift or covered bequest is treated as a U.S. citizen and is thus liable for the tax.  Of note, a non-electing foreign trust is not liable for the Section 2801 tax.  Thus, a U.S. citizen or resident who receives a distribution from a non-electing foreign trust is liable for the Section 2801 tax to the extent the distribution is attributable to covered gifts or covered bequests.  This Section also provides rules for contributions to charitable remainder trusts (CRTs) made by covered expatriates for the benefit of one or more charitable organizations and the benefit of a U.S. citizen or resident other than the charitable organization. The value of the charitable organization’s remainder interest in a CRT is excluded from the definition of a covered gift or covered bequest.  The value of the interest of the non-charitable U.S. citizen or resident in such contributions to the CRT is a covered gift or bequest and thus taxable, unless otherwise excluded.

Section 28.2801-5 provides guidance on the treatment of foreign trusts.  If a covered gift or covered bequest is made to a foreign trust, the tax applies to any distribution from that trust to a recipient who is a U.S. citizen or resident. The section also discusses how a foreign trust can elect to be a U.S. trust for purposes of Section 2801.

Section 28.2801-6 addresses how the basis rules under Sections 1014, 1015(a) and 1022 impact the determination of the U.S. recipient’s basis in the covered gift or the covered bequest.  This Section also clarifies the applicability of the GST tax to some Section 2801 transfers, among other special rules and cross-references.  Of note, unlike Section 1015(d), which generally allows gift tax paid on the gift to be added to the donee’s basis, Section 2801 does not provide for a similar basis adjustment.

Section 28.2801-7 provides guidance on the responsibility of a U.S. recipient to determine if a tax under Section 2801 is due.  The Treasury Department and IRS recognize that because the tax imposed by Section 2801 is on the recipient, rather than the donor or the estate of the decedent (that has access to the information related to whether the donor or decedent is a covered expatriate), U.S. taxpayers may have difficulty determining whether a tax is due. To aid the taxpayer, the IRS may disclose returns and return information upon request.

December 9, 2015 is the deadline for written or electronic comments to the above regulations.

IRS Announces Inflation Adjustments for 2016

By, Kerry Reilly, Esq.

Income Tax:

  • Highest Tax Bracket for Estates and Trusts. An estate or trust will be subject to the highest income tax bracket and Medicare surtax if taxable income exceeds $12,400 (increased from $12,300 in 2015).
  • Foreign Earned Income Exclusion. For taxable years beginning in 2016, the foreign earned income exclusion amount under §911(b)(2)(D)(i) is $101,300 (increased from $100,800 in 2015).
  • Expatriation to Avoid Tax. For calendar year 2016, under §877A(g)(1)(A), unless an exception under §877A(g)(1)(B) applies, an individual is a covered expatriate if the individual’s “average annual net income tax” under §877(a)(2)(A) for the five taxable years ending before the expatriation date is more than $161,000 (increased from $160,000 in 2015).
  • Tax Responsibilities of Expatriation. For taxable years beginning in 2016, the amount that would be includible in the gross income of a covered expatriate by reason of §877A(a)(1) is reduced (but not below zero) by $693,000 (increased from $690,000 in 2015).

Gift Tax:

  • Annual Exclusion for Gifts. The annual exclusion for gifts remains at $14,000 for 2016.
  • Annual Exclusion for Gifts to Non-Citizen Spouse. The first $148,000 of gifts to a spouse who is not a citizen of the United States shall not be considered a taxable gift by the donor (increased from $147,000 in 2015).
  • Large Gifts Received from Foreign Persons. Gifts from foreign persons in excess of $15,671 in aggregate must be reported to the IRS (increased from $15,601 in 2015).

Estate Tax

  • Unified Credit Against Estate Tax. The basic exclusion amount for an estate of any decedent dying during calendar year 2016 is $5,450,000 (increased from $5,430,000 in 2015).
  • Valuation of Qualified Real Property in Decedent’s Gross Estate. For an estate of a decedent dying in calendar year 2016, if the executor elects to use the special use valuation method under §2032A for qualified real property, the aggregate decrease in the value of qualified real property resulting from electing to use §2032A for purposes of the estate tax cannot exceed $1,110,000 (increased from $1,100,000 in 2015).
  • Interest on Certain Portions of Estate Tax Payable in Installments. For an estate of a decedent dying in calendar year 2016, the dollar amount used to determine the “2-percent portion” (for purposes of calculating interest under §6601(j)) of the estate tax extended as provided in §6166 is $1,480,000 (increased from $1,470,000 in 2015).

See Rev. Proc. 2015-53 for more details.

Proposed Changes to the Massachusetts Estate Tax

By, Kerry Reilly, Esq.

On January 15, 2015, Representative Shawn Dooley ((R), 9th Norfolk), et al., sponsored H.R. 2489 (replacing current Section 2A under Mass. Gen. Laws Chapter 65C). A hearing on the bill took place on October 20, 2015. This bill would, among other things:

  1. Repeal the current Massachusetts estate tax threshold of $1,000,000 and tie that threshold to “50 percent of the basic exclusion amount as defined in Section 2010 of the [Internal Revenue] Code” for those individuals dying on or after January 1, 2016.
  2. Allow for the exclusion of the principal residence from the Massachusetts gross estate provided the decedent was a resident of Massachusetts at the time of his/her death. The definition of “Massachusetts gross estate” has been changed to include this election.
  3. Allow the surviving spouse to apply the deceased spouse’s unused exclusion amount to his/her gross estate.   This would bring the Massachusetts estate tax exclusion in line with Federal tax laws allowing portability of estate tax exclusions between spouses.
  4. The”principal residence” and DSUEA elections would be made by the decedent’s Personal Representative on the decedent’s Massachusetts estate tax return.
  5. Lastly, the proposed bill would also simplify the tax table used to determine the Massachusetts estate tax liability, as follows:
If the Massachusetts taxable estate is: Over………… But Not OverThe Massachusetts estate tax
shall be:
$0 – $5,000,00010% of the taxable estate
$5,000,000 – $10,000,000$500,000 plus 11% of the excess over $5,000,000
$10,000,000 – $20,000,000$1,050,000 plus 12% of the excess over $10,000,000
$20,000,000+$2,250,000 plus 13% of the excess over $20,000,000

As of October 29th, no additional action has been taken with respect to this proposed bill.

The full text of the proposed bill can be found here:

Basis Consistency Requirements

By, Susan A. Robb of First Republic Trust Company

On July 31, 2015, the President signed the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (the “Highway and Transportation Funding Act of 2015, Part II”) into law. The new law, which extended the Highway Trust Fund expenditure authority, enacted Sections 1041(f) and 6035 of the Internal Revenue Code. These new rules address the basis of property received from a decedent and require personal representatives of taxable estates to provide a statement to both the IRS and to any person acquiring an interest in property included in the decedent’s gross estate for federal estate tax purposes.

Under the stepped up basis rules of § 1014, the basis of property acquired from a decedent is generally the property’s fair market value, either on the date of death or the alternate valuation date. In the past, beneficiaries receiving such property were not required to use the same value reported by the estate. Beneficiaries could claim the property’s fair market value (and therefore their basis) was higher than the estate tax value. § 1041(f) now provides that the basis of property received from a decedent shall not exceed the value of that property as finally determined for federal estate tax purposes or, if the value has not yet been determined for federal estate tax purposes, the value of that property as reported on a statement provided pursuant to § 6035.

The new law applies to property for which a federal estate tax return is filed after July 31, 2015. However, pursuant to Notice 2015-57, the § 6035 reporting requirements have been delayed until February 29, 2016. The delay should allow the IRS and Treasury Department to issue additional guidance regarding compliance with § 1041(f) and § 6035.

See Also: Internal Revenue Bulletin: 2015-36 (Notice 2015-57)

 

 

 

FRACTIONAL OWNERSHIP DISCOUNTS: TAXABLE VALUE OF JOINTLY HELD ARTWORK FOR ESTATE TAX PURPOSES

FRACTIONAL OWNERSHIP DISCOUNTS: TAXABLE VALUE OF JOINTLY HELD ARTWORK FOR ESTATE TAX PURPOSES

By:  Kerry Reilly, Esq.

Estate of James A. Elkins, Jr. v. Commissioner

13-60472 (5th Cir.)

Filed: September 15, 2014

Facts:

James A. Elkins, Jr. (“Decedent”), a Texas resident, owned a fractional share of 64 pieces of modern art at the time of his death.  Decedent owned 50% of the interest in two pieces of art and 73.055% interest in the other 62 pieces.  The Decedent’s children (“Petitioners”) held the remaining interests in the artworks and also served as the Executors of his estate.  Two of the art pieces were subject to a “lease agreement” whereby no interest in the works of art could be disposed of without the assent of all co-owners and no co-owner could transfer or assign his/her “rights, duties and obligations” without the prior agreement of all other co-owners.  With respect to the remaining pieces, a “Co-Tenants Agreement” governed each.  That agreement contained similar limitations.

In determining the estate taxes due upon the death of Mr. Elkins, the Petitioners retained Sotheby’s Inc. to determine value of the individual pieces and the Decedent’s pro-rata share of the artworks and Deloitte, LLP to determine the appropriate discount for lack of control and marketability.

Upon the timely filing for the Decedent’s Form 706, the Internal Revenue Service refused to allow any discount for the works of art and assessed a penalty against the Decedent’s estate of $9,068,266.    The Decedent’s estate challenged this penalty.

Tax Court Proceedings:

In the Tax Court proceedings, the Petitioners supplied evidence from three experts in addition to the Sotheby’s and Deloitte reports – a Texas lawyer, who was an expert on the time and cost associated with litigating restraints on alienation, an expert on valuation of fractional interests in property and an expert in the art market.

The Commissioner supplied one (admitted) rebuttal witness who claimed that “no recognized, [or established] market” existed for partial interests in works of art. In refusing to deviate from the “no discount” position the Commissioner supplied no evidence as to what an acceptable discount might be in the event the Tax Court disagreed.

The Tax Court rejected the Commissioner’s position that no discount was applicable under the “willing buyer/seller” test, however it also rejected the valuations provided by the Petitioners and applied its own discount of 10% for each work of art and assessed the related penalty.  The Decedent’s estate appealed.

Issue:

Is the Decedent’s estate taxable on the undiscounted value of the fair market value of the artworks or the discounted value; and if it is the discounted value which discounted value applies (1) the Tax Court’s 10% or (2) the percentages supplied by the Decedent’s estate?

Discussion and Decision:

The Fifth Circuit affirmed the Tax Court’s ruling with respect to the rejection of the Commissioner’s argument as to the “zero discount” because a “willing buyer and seller” would take into account the various restrictions on the artwork.    The Fifth Circuit strongly disagreed with the Tax Court’s application of its own unsupported discount amount.

In this concisely written opinion, the Court spent a fair amount of time discussing burdens of proof and evidentiary standards.  The Court noted that the “uncontradicted, unimpeached and eminently credible” nature of the Petitioner’s evidence and the complete lack of evidence from the Commissioner should have resulted in a decision for the Decedent’s estate with respect to the value of the discounts.

The Court noted that the “reversible error” was mainly found Tax Court’s analysis of the “willing buyer/seller” test.  The Court took issue with the Tax Court’s extensive focus on the Decedent’s children as the remaining owners, its insufficient attention to the “willing buyer” and the assumption that the “buyer” would immediately flip his/her interest back to the children at a market rate.  The Court noted that the Decedent’s children are “sophisticated, determined and financially independent,” and that they had rejected entirely the thought of ever selling their interests in the artwork, or the artwork itself.    The Court further notes that in the ‘absence of an established market,’ with the subjective characteristics of the other owners and the time and money it would cost a prospective “willing buyer” to overcome the legal restraints on the artwork the “willing buyer” would likely demand further discounting.

The Court (1) affirmed the Tax Court’s rejection of the “no fractional ownership discount” assertion, (2) affirmed the Tax Court’s holding that the Decedent’s estate may apply fractional-ownership discounts, (3) reversed the Tax Court’s holding that 10% was the appropriate discount, (4) held that the appropriate discounts were those supplied by the estate of the Decedent and (5) rendered judgment in favor of the Petitioners for $14,359,508.21 plus statutory interest.

Note:

The Court also noted, in a footnote, that the Commissioner’s rebuttal witness actually weakened the Commissioner’s argument in that by stating that “no recognized market” existed for fractional interests in artwork, the discounts applied to the various pieces should have been greater.

Favorable Tax Court ruling upholds trustees’ activities as qualifying trust for material participation exception under IRC Section 469 (and the net investment income tax under IRC Section 1411)

Author:  Alison E. Lothes, Esq., Gilmore, Rees & Carlson, P.C.

In Frank Aragona Trust et al. v. Commissioner, 142 T.C. No. 9, the Tax Court ruled in favor of the taxpayer, holding that a trust could and did materially participate in real estate rental activities, qualifying for the exception to the passive activity rules under IRC Section 469.  This case is helpful, as there are currently no regulations and very few rulings on how to apply the “material participation” rules to trusts.  The IRS has been interpreting the exception to be very limited but the Court agreed with the taxpayer that the activities of the trustees, including those in their capacity as employees of an entity owned by the trust, could be considered when determining whether the trust materially participated in the real estate rental business.

A majority of the trust’s business was operated through a wholly owned LLC but the trust also operated some of its real estate business directly and some through other entities.  The trustees were intertwined in the LLC, other entities and the business.  The LLC employed three of the trustees as full time employees (along with other employees, including a controller, maintenance workers, leasing agents and clerks).   Two of the trustees also held minority interests in several of the entities in which the trust was also a member.

The trust filed fiduciary income tax returns claiming losses relating to its rental real estate activities and characterized those activities as non-passive.  The IRS disagreed and determined that the rental real estate activities were passive, and as a result limited certain deductions and net operating loss carrybacks.

Under IRC Section 469, a passive activity is any activity which involves the conduct of a trade or business in which the taxpayer does not materially participate.  Generally, rental activities are considered passive activities unless (1) more than one-half of the personal services provided by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.  “Material participation” requires that the taxpayer be involved in the operation of an activity on a “regular, continuous and substantial” basis.

The IRS argued that a trust cannot qualify for the exception because it cannot perform “personal services.”  It claimed that the legislative history indicates that “personal services” can only be performed by an individual.  In the alternative, the IRS argued that even if the trust could perform personal services, when assessing whether the trust materially participates in an activity, only the activities of the trustees (and not the employees) can be considered.  In addition, the IRS sought to exclude the activities of the trustees that were not solely related to their fiduciary duties.  For example, the IRS argued that the activities of the trustees who were employees of the LLC could not be taken into account because those activities should be attributed to them as employees, not fiduciaries.  It also argued that a portion of the activities of the trustees who owned interests in the entities should be attributed to their personal ownership in the entities, rather than to their activities on behalf of the trust.

The Tax Court disagreed.  It noted that the trustees’ fiduciary duties to administer the trust in the interest of the beneficiaries are not put aside when they work for the LLC owning the real estate.  Therefore, their activities as employees of the LLC should be considered when determining whether the trust materially participated in its real estate operations.  It is interesting to note that the Tax Court did not determine whether the activities of the non-trustee employees should be considered because it was not necessary to the decision.  Lastly, the Tax Court held that the trustees’ individual minority interests in entities of which the trust was also a member did not impact the trust’s material participation because the combined minority interests in each entity held by the trustees were less than 50% and in all cases were less than the trust’s interest.

This case is very helpful for taxpayers in that the Tax Court adopted a relatively broad interpretation of whose activities (and in what capacity those activities are undertaken) may be attributed to the trust when determining if the trust materially participates in an activity.  This has recently become even more important because of the new 3.8% tax on net investment income under IRC Section 1411.  Non-passive trade or business income is not considered net investment income and so is not subject to the tax under IRC 1411.  This ruling may make it a little easier for trusts to prove that they are “materially participating” in a trade or business to avoid the 3.8% tax.

REV. PROC. 2014-18: PORTABILITY

Author: Alison I. Glover, Esq., Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

Purpose

The revenue procedure provides a simplified method for estates which were below the estate tax filing threshold and failed to file an estate tax return to elect portability.  This procedure provides relief to executors who may have been unaware of or misunderstood the filing requirement and also to executors of estates of same-sex couples who were recognized as spouses after the filing date.

Estates meeting the specified requirements will avoid having to file for relief under §301.9100-3.

Background

Sections 302(a)(1) and 303(a) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 allow the estate of a decedent who is survived by a spouse to make a “portability election” – which allows the surviving spouse to apply the decedent’s Deceased Spousal Unused Exclusion Amount (“DSUE”) to the surviving spouse’s own transfers during life and at death. The DSUE amount is defined as the lesser of “(A) the basic exclusion amount, or (B) the excess of the applicable exclusion amount of the last deceased spouse of the surviving spouse over the amount with respect to which the tentative tax is determined under Section 2001(b)(1) on the estate of the deceased spouse.” In order for the surviving spouse to apply the decedent’s DSUE amount to the surviving spouse’s transfers, the surviving spouse must elect portability of the DSUE amount on a timely filed Form 706, which must include a computation of the DSUE amount. The due date of an estate tax return required to elect portability is 9 months after the decedent’s date of death or the last day covered by extensions.

In 2013, United States v. Windsor struck down portions of the Defense of Marriage Act (“DOMA”). Previously, DOMA prevented the Service from recognizing same-sex marriages. According to Rev. Rul 2013-17, the Windsor decision allows, among other benefits, the surviving spouse of a same-sex married couple to make a portability election upon the death of his/her spouse.

The due date for estates required to file an estate tax return is prescribed by statute. However, if an executor is not required to file an estate tax return but may file an estate tax return to elect portability, the due date for electing portability is prescribed by regulation (20.2010-2T(a)).  Accordingly, an executor may seek relief under Section 301.9100-3 for a late filing.  In general, relief will be granted if the taxpayer acted reasonably and in good faith and the grant of relief will not prejudice the government. The Service has issued several letter rulings under Section 301.9100-3 granting an extension of time to elect portability under Section 2010(c)(5)(A) in situations in which the decedent’s estate was not required to file an estate tax return.

Applicability

This revenue procedure applies if:

  • The taxpayer is the executor of the estate of a decedent who:
    • Has a surviving spouse;
    • Died after December 31, 2010 and on or before December 31, 2013; and
    • Was a citizen or resident of the United States on the date of death.
  • The taxpayer was not required to file an estate tax return because decedent’s estate was under the applicable filing threshold;
  • The taxpayer did not file a timely estate tax return;
  • The taxpayer files a complete and properly prepared Form 706 on or before December 31, 2014; and
  • The taxpayer states on the top of the Form 706 that the return is “FILED PURSUANT TO REV. PROC. 2014-18 TO ELECT PORTABILITY UNDER SECTION 2010(c)(5)(A).”

Provided that all of these requirements are met, the taxpayer’s Form 706 will be considered to have been timely filed, unless it is subsequently determined that the taxpayer actually owed estate tax, in which case the relief will not be granted.

Limitations Period for Claim for Credit or Refund by the Surviving Spouse

To obtain a credit or refund of an overpayment of tax by reason of a portability election made under this revenue procedure, the surviving spouse (or the executor of the estate of a deceased surviving spouse) must file a claim for credit or refund of tax before the general limitations period. For example, a predeceasing spouse (“S1”) died on January 1, 2011. The assets included in the gross estate of S1 were under the exclusion. The surviving spouse (“S2”) did not file a Form 706. S2 died on January 14, 2011. S2’s taxable estate was over the exclusion. S2’s executor filed a Form 706 and paid estate tax on October 14, 2011. Under this revenue procedure, S2’s executor should file a claim for refund by October 14, 2014 – even if the estate of S1 has not yet filed a Form 706 under this procedure to make the portability election. Assume that in 2015, the Service determines that (i) S1’s estate has met the requirements for a grant of relief under this revenue procedure and is deemed to have made a valid portability election, (ii) accepts S1’s return with no changes, and (iii) issues an estate closing letter to S1’s estate. The refund claim filed by S2’s executor in anticipation of the filing of Form 706 by S1’s executor will be considered a protective claim for credit or refund of tax.

Effective Date; Pending Requests

This Revenue Procedure is effective on January 27, 2014. With respect to any ruling requests pending on January 27, 2014, the executor may rely on this revenue procedure, withdraw the letter ruling request and receive a refund of its user fee.