Traditional Estate Tax Planning Will Now Have to Include Sophisticated Income Tax Planning

Traditional estate planning focuses on minimizing the impact and addressing the limitations presented by our federal estate and gift regime. Very limited thought is put into the income tax consequences. This can prove to be a costly mistake – especially given the tax law changes that are looming on the horizon.

The estate and gift tax regime applies to property transfers. Estate and gift tax planning often consists of reducing the amount of estate and gift taxes payable so that the maximum amount of wealth and property can pass to lower generations. The issue that many estate planners do not address is whether the estate plan will deliver this wealth and property to the lower generations in a way that will put the lower generation in a position to take advantage of income tax planning opportunities.

The income tax is imposed on “gain” inherent in property. “Gain” is equal to the “amount realized” or sales price less the “tax basis.” “Tax basis” is generally equal to the cost that a person paid to acquire property. For example, one share of Berkshire Hathaway purchased in the early 1970’s would have a tax basis of about a hundred dollars. That same share is valued at approximately $1,000,000 today. Thus, if this stock were sold today it would produce approximately $999,900 in taxable “gain.” If the income tax rate applied to this gain is the current 15% capital gains tax rate, the sale would result in approximately $150,000 in federal income taxes (ignoring any state imposed income tax).

Our tax laws provide taxpayers with a way to avoid this tax. Specifically, our current tax laws provide that persons who inherit property will generally take a “tax basis” equal to the fair market value of the inherited property on the date that the person who bequeathed the property died (or six months thereafter). In the example above, the beneficiary selling the Berkshire Hathaway stock would produce no federal income tax because the taxable gain would be $0, which is the sum of a $1,000,000 sales price less a $1,000,000 stepped up tax basis.

As you can see, the strategy under our current (but soon to change) law is to hold on to low basis property until death, so that the lower generation obtains a stepped-up tax basis. This was most beneficial where the property to be transferred was producing tax benefits to the owner prior to his or her death.

For example, a person who owns rental real estate may have been offsetting the taxable income he or she was receiving from the property by claiming depreciation deductions. If the owner were to sell the real property during his or her lifetime, he or she will have to “recapture” or pay back the taxes on the depreciation amounts that he or she claimed. If the real property owner held on to the property until his or her death, and claimed the full depreciation for the property over time, they would not have to recapture or repay the taxes on the depreciation deduction and the inheritor would still get to step up their tax basis in the inherited property.

This “stepped up tax basis” rule will not apply for inheritances received from persons who die in or after the year 2010. Rather, after 2009 the inheritor will take a tax basis in the property equal to the lower of the tax basis that the dieing taxpayer had or the fair market value of the inherited property on the date that the person who bequeathed the property died.

The executor of the estate (or personal representative) will have the ability to allocate a basis increase up to $1,300,000 (and an additional $3,000,000 for property passing to surviving spouses). This $1,300,000 is an aggregate figure for the entire estate, meaning that the $1,300,000 basis increase is all that can be applied to all property of the estate. In other words, there is no $1,300,000 basis increase for each item of property in the estate.

There are a number of planning opportunities and pitfalls presented by these changes. Today’s estate plans should address these issues. Estate planners can address these issues (1) by taking a fresh look at how property can best titled (joint vs. individual, community property vs. separate property, entity vs. no entity, etc.) and (2) by monitoring (a) assets that are or are becoming low basis high appreciation assets (appreciating vs. depreciating assets, depreciable assets vs. non-depreciable assets) and (b) family changes that will present new planning opportunities over time (marriages, deaths, etc.).

This will require many traditional estate planners to substantially retool their estate forms and to keep up with current income tax planning opportunities. By way of example, estate planners will now have to consider how Section 1031 exchanges – an topic that is traditionally though to be outside of the estate tax planning arena — may impact their estate plans. This is particularly true given the coming elimination of the stepped up basis rules. Private Letter Ruling 123314-06 provides an excellent look at how Section 1031 issues may creep into traditional estate planning arena.

This ruling addresses whether a taxpayer is entitled to Section 1031 exchanged tax basis treatment for a transfer of one property that was received as a gift from a mother to the taxpayer for another property that is held in trust for the benefit of the mother (and with the taxpayer receiving a remainder interest in the trust).

Both of these properties were initially transferred to the taxpayer’s mother upon the taxpayer’s father’s death. Thus, the father opted to pass one parcel outright to his surviving spouse and he opted to place the other parcel in trust for the benefit of his spouse.

Today’s estate planner views this scenario in light of qualified disclaimer and qualified terminable interest property rules – with an eye primarily on transfer tax minimization. Thinking ahead a few years, this exact scenario will also raise significant income tax issues – such as the 1030 issue addressed in the letter ruling. If that will not be complicated enough, these issues will also bring with them the state income tax planning opportunities and pitfalls as well.

In the past estate planning attorneys often divided estate plans into those that are tax-motivated and those that are not-tax motivated (with non-tax motivated estate plans consisting primarily of a simple will and/or a revocable trust). The “tax” motivation was primarily based on transfer taxes — not income taxes. Given the new income tax planning opportunities, the old tax-motivated and non-tax motivated schema will have to be tossed aside.

The bottom line is that today’s estate planner will have to build flexibility into their estate plans so that their client’s beneficiaries can take advantage of these types of pure income tax planning opportunities.

February 10th, 2007 | No Comments »

IRS Data Gathering: I Couldn’t Have Said it Better Myself

Many taxpayers do not really understand that (1) IRS employees often ask for documentation that is not necessary, that is already in the IRS’ possession, or that the IRS could easily obtain; and (2) IRS employees are typically not clear (i.e., intentionally vague) when they request this information from taxpayers. I can tell you that this is the truth, but you don’t have to take my word for it.

The Treasury Inspector General for Tax Administration (TIGTA) is the agency tasked with auditing the IRS to help make the IRS more efficient. In one of its recent audit reports, TIGTA makes the following comment about how IRS employees often miss the mark [note: an “information document request” or IDR is one of the forms that the IRS examination employees use to “officially” ask taxpayers to turn over taxpayer records]:

In addition, in 35 of the 62 cases, the initial Information Document Requests (IDR) included unnecessary items or did not state clearly what was needed from the taxpayers. In all 35 cases, the revenue agents used the IDRs to request information that was already available in the case files or that could have been obtained through use of research tools readily available to the agents. In addition, in 10 of the 35 cases, the revenue agents did not state clearly what was needed on the IDR or did not specify the time period when requesting bank records. Taxpayer burden is increased when revenue agents request unnecessary information or are unclear about the information needed. We identified similar concerns in our review of the NRP study of individual taxpayers. The IRS agreed with our recommendation in that review and has completed the corrective action. We believe additional action is needed since this concern could exist on all examinations, not just NRP study examinations.

Having worked with many IRS employees, I have to say that these comments are right on the mark.

The worst IDR that I have read included a request for “All other personal and business financial records.” In that case the taxpayer was a small business owner who had a large storage shed full of financial records (the IRS examiner agreed to overlook the taxpayers inability to comply with the IDR after the taxpayer inquired as to whether the government could use its own forklift and heavy truck to help in the document copying process).

I would also that these exact same issues arise when IRS collections employees, not just IRS examination or audit employees, request taxpayer records. The IRS will generally start collecting information about taxpayers in the exam or audit function by means of the IDR. If the tax liability is not paid, the IRS collections employees will eventually start collecting the same information about taxpayers all over again (collections employees use the Form 9297, not the IDR, to collect this documentation).

One way to improve the efficiency of the IRS would be to provide the information collected by the examination or audit function to the collection function (at a minimum, the two functions should – but do not – share the same computer system!). This duplication no doubt slows down the tax collection process and imposes an additional burden on taxpayers. Perhaps TIGTA or the taxpayer advocate will add this to their agendas….

February 7th, 2007 | No Comments »

Reconsidering Murphy: Restorative Payments vs. Return of Human Capital

Last year’s Murphy v. United States decision was one of the most controversial tax cases in recent history. Unlike many other tax attorneys, I am not sure that I agree that the Murphy case was wrongly decided. One reason for this is that, in thinking about Murphy, I find it difficult to reconcile why “restorative payments” are tax free, yet payments that are a “return of human capital” are subject to tax.

In Revenue Ruling 2002-45 the IRS held that amounts paid by an employer to employees to compensate employees for losses associated with improper investments held in the employer-provided defined contribution plan, if the contributions are paid into the qualified plan, are not considered “contributions,” and, are not subject to the contribution limits. Instead, the amounts are considered “restorative payments.” According to the IRS, these “restorative payments,” up to the amount lost, are compensation for breach of a fiduciary duty and not for losses due to market fluctuations.

The IRS has now, in Private Letter Ruling 200705031, applied this logic to IRA payments where a taxpayer received a “restorative payment” from a financial institution to restore losses resulting from the financial institution breaching its fiduciary duty to invest prudently. The IRS made this ruling even though the taxpayer held the “restorative payment” in a separate taxable account and the taxpayer missed the sixty day deadline for contributing the “restorative payment” to another IRA.

These private letter rulings do not expressly address or state whether these “restorative payments” are taxable income to the recipients; however, the IRS, in Private Letter Ruling 200137065, under similar facts, did expressly state that “restorative payments” were not taxable income to the recipients (if “restorative payments” are taxable income to the recipients, it seems that the taxpayers should be allowed to contribute a “restorative payment” in an amount up to the amount of the loss plus the taxes imposed on the “restorative payment” — rather than just an amount up to the amount of the loss).

This “restorative” analysis sounds very similar to the controversial “return of capital” analysis employed by the D.C. Circuit Court in last year’s Murphy case.

In the Murphy case, the court held that amounts recovered for non-physical personal injuries (emotional distress and loss of reputation) unrelated to lost wages or earnings are not taxable income, because such payments were merely payments to return “human capital” – with “human capital” essentially being a non-taxed entity – because the loss results from the actions of a third party.

Compare that to “restorative payments,” which are non-taxable payments to restore funds to defined contribution plans and IRAs – which are non-taxed entities – because the loss results from the actions of a third party.

Is there really a difference between “restorative payments” and payments that are a “return of human capital?” If so then the rule is that payments to compensate a taxpayer for someone harming the taxpayer’s retirement account are tax free, yet payments to compensate a taxpayer for someone harming the taxpayer’s person are taxable?

The DC court has since vacated its Murphy decision and it has opted to rehear the case (apparently due to the negative reaction from the tax profession to the court’s analysis). I have not read the briefs for that rehearing, but perhaps the taxpayer raised this issue and/or the court will take the time to explain the difference between these two types of payments.

February 3rd, 2007 | No Comments »

IRS Clarifies Real Estate Broker Filing Requirement - Again

The IRS has released Revenue Procedure 2007-12, which clarifies what “assurances” real estate brokers must obtain from persons who sell their principal residence.

Real estate brokers are generally required to provide a Form 1099-S to a person selling or exchanging real estate. This form helps the IRS track the seller’s proceeds from the sale, to ensure that the seller reports that taxable income on their federal income tax return. Failure to file this form can subject the broker to tax penalties for failure to file a return or for failure to furnish a payee statement to the seller (Sections 6721 and 6722 penalties).

However, brokers are not required to file and are not subject to these penalties if the broker “receives written assurance in a form acceptable to the Secretary from the seller” that the sales proceeds are excluded from the seller’s taxable income pursuant to Section 121. Section 121 allows sellers to exclude up to $250,000 for single taxpayers and $500,000 for married taxpayers of gain from the sale of a principal residence if the taxpayer owned the property for five years and the taxpayer lived in the residence for two of the past five years.

In Revenue Procedure 2007-12 the IRS has spells out what constitutes “written assurance in a form acceptable to the Secretary.” Revenue Procedure 2007-12 sets out the following assurances that brokers must obtain:

(1) The seller owned and used the residence as the seller’s principal residence for periods aggregating 2 years or more during the 5-year period ending on the date of the sale or exchange of the residence.

(2) The seller has not sold or exchanged another principal residence during the 2-year period ending on the date of the sale or exchange of the residence.

(3) No portion of the residence has been used for business or rental purposes after May 6, 1997, by the seller (or by the seller’s spouse or former spouse, if the seller was married at any time after May 6, 1997).

(4) At least one of the following three statements applies:
The sale or exchange is of the entire residence for $250,000 or less.

OR

The seller is married, the sale or exchange is of the entire residence for $500,000 or less, and the gain on the sale or exchange of the entire residence is $250,000 or less.

OR

The seller is married, the sale or exchange is of the entire residence for $500,000 or less, and (a) the seller intends to file a joint return for the year of the sale or exchange, (b) the seller’s spouse also used the residence as his or her principal residence for periods aggregating 2 years or more during the 5-year period ending on the date of the sale or exchange of the residence, and (c) the seller’s spouse also has not sold or exchanged another principal residence during the 2-year period ending on the date of the sale or exchange of the residence.

(5) During the 5-year period ending on the date of the sale or exchange of the residence, the seller did not acquire the residence in an exchange to which section 1031 applied.

(6) In cases where the seller’s basis in the residence is determined by reference to the basis in the hands of a person who acquired the residence in an exchange to which section 1031 applied, the exchange to which section 1031 applied occurred more than 5 years prior to the date of the seller’s sale or exchange of the residence.

The main difference between this revenue procedure and the prior procedure is, as mentioned above, that it accounts for Section 1031 exchange transactions.

Revenue Procedure 2007-12 also provides a sample form that brokers may use to capture these assurances. Brokers must make sure to document these assurances for sales and exchanges of principal residences occurring after January 22, 2007.

February 2nd, 2007 | No Comments »

Tax Court Judge Can Rewrite Facts of Case That He/She Did Not Hear

The tax court released a 400+ page opinion related to the Supreme Court’s ruling in the Ballard v. Commissioner case today (available here). This case continues the saga of whether the tax court is truly an impartial judicial forum.

The readers of this blog will recall the Ballard case involved the Supreme Court holding that the tax court had failed to follow its own rules and it then tried to downplay the significance of its blatant rule violation.

Specifically, the issue in the Ballard case was whether a judge who did not actually hear the case could re-write a report (four years later!) that summarized the case that was written by the judge that presided over the case. The Supreme Court (citing the tax court’s own rules) issued a judicial opinion that clearly and unambiguously says that the answer is “no.” The idea is that the judge that heard the witnesses and saw the evidence presented is in a better position to judge the matter at hand, not a judge who is unfamiliar with the case.

Following the Ballard opinion, the tax court amended its rules of procedure. This amended rule essentially provides that the judge who did not hear the case can “adopt, modify, or reject the” recommendations of the judge who did hear the case and the judge who did not hear the case can correct “manifestly unreasonable findings of fact or [make] additional findings of fact, so long as any additional facts find direct support in the case record.”

In this first case applying this new rule, the tax court now exercises its authority to disregard and supplement the recommendations of the judge who actually heard the case. The court does this by analyzing the words used in the judge’s report and other documentary evidence – in the process disregarding testimony from IRS employees and from the taxpayer that the judge was not present to hear.

I don’t know that I agree with this opinion/rule. Personally, I think that the judge who hears the facts should be the final authority on what the facts are and are not. That is why you have the judge hear the facts in person, rather than just sending in video or audio tapes for the judge to review. The reality is that a lot of what goes on in the courtroom does not get included the record; therefore, a review of the record is inadequate to decide what the facts are in a case.

Also, I think this opinion/rule ignores the role of the courts, including the tax court, to give taxpayers a sense of justice, fairness, and, most importantly, finality. Having a second judge judge and rewrite the facts years after the case is heard will only result in taxpayer confusion and distrust.

After reading this 400+ page tax court opinion I can’t help but think back to something that one of my law professors used to say. The saying went something like this: “if you have to spend hundreds of pages to justify your position, your position is probably wrong.”

February 1st, 2007 | No Comments »

Another Example of Why Taxpayers Should Hire a Tax Attorney

A number of taxpayers attempt to represent themselves in tax court litigation. The recent case of Bhattacharyya v. Commissioner provides yet an example of why it is often best to hire a tax attorney to handle tax court litigation.

During the tax periods in question, the taxpayers received income of well over a million dollars. This income consisted of income resulting from the exercise of stock options, distributions from non-qualified deferred compensation plans and IRAs. The taxpayers did not fully report all of their taxable income and they claimed a significant amount of itemized deductions which, it turned out, they could not support.

The taxpayers filed their 1999 tax return in tax year 2003, requesting a tax refund for more than $100,000. The IRS examined that return and determined that the taxpayers were not entitled to a refund, they were liable for an alternative minimum tax in excess of $100,000. The taxpayers filed a suit for a tax refund in the US District Court, which was dismissed for lack of jurisdiction. The taxpayers appealed to the Ninth Circuit Court of Appeal, which affirmed the dismissal.

The taxpayers also filed their 2000 tax return in tax year 2003, again requesting a tax refund of more than $100,000. Upon inquiry from the IRS, the taxpayers submitted an amended return to reflect an alternative minimum tax liability. The taxpayers also reduced their taxable income on that amended return by a significant amount. The IRS issued the taxpayers a notice of deficiency for over $300,000 in tax and another $50,000 in tax penalties and the taxpayers filed a petition to have their case heard in tax court.

The IRS attorney filed an answer to the taxpayers’ petition, but he failed to request an increase in tax or an addition to tax for the increased penalties and interest. A month after the case was called, the IRS asked the court permission to increase the tax and addition to tax in the answer and the taxpayer asked permission to increase the tax refund claimed in the petition.

Not only did the taxpayers opt to prepare their own federal income tax returns (because their tax preparer had a brain tumor), they also opted not to hire a tax attorney. The arguments made by the taxpayers in the court proceeding were without merit (it appears that the taxpayers did not fully understand the tax consequences of their financial transactions) and the court ruled in favor of the IRS. The IRS also imposed a $100,000 Section 6651(a)(1) penalty due to the taxpayers filing their 2001 tax return twenty five months late, which the court upheld.

At the end of the day the taxpayers ended up paying several hundred thousand dollars in taxes that they may not have otherwise had to pay, they incurred a hundred thousand dollar tax penalty, and the taxpayers no doubt spent a considerable amount of time working with the IRS and attending court hearings.

Had the taxpayers opted to pay a tax preparer they would probably not have incurred any of these costs. Moreover, had the taxpayers hired a tax attorney they might have won their tax court case (possibly by responding appropriately to the IRS request to amend the pleadings after the court case had started) and they might have been able to have the IRS penalty waived.

January 31st, 2007 | No Comments »

Tax Free IRA Rollovers as Short-Term Loans: Two Examples of What Not to Do

Taxpayers often withdraw funds from their IRAs to cover short-term expenses with the hope that they can put the funds back in their IRA within the 60 day window for making a tax-free IRA rollover. When taxpayers miss this 60 day window, they are forced to ask the IRS to waive the 60 day time period based on “equity” and “good conscious.” The IRS just released two new private letter rulings based on “equity” and “good conscious.”

The IRS did waive the 60 day period in Private Letter Ruling 200704040. According to this letter ruling, the taxpayer withdrew monies from his or her IRA retirement account in order to purchase a home. The credit union that held the IRA told the taxpayer, incorrectly, that the funds must be deposited in another IRA on the date that was 62 days from the date of withdrawal. The credit union admitted that its employees miscalculated the 60 day period and the credit union, upon consultation with their tax attorneys, paid the fees associated with making the IRS private letter ruling request. The IRS held that the taxpayer’s reliance upon the date provided by the credit union was sufficient to waive the 60 day requirement.

Compare that to Private Letter Ruling 200704042. In this letter ruling the IRS refused to waive the 60 day period for rolling funds over to a new IRA. The facts for this ruling were that the taxpayer suffered a mental impairment. The taxpayer’s representative (probably a family member who was acting pursuant to a power of attorney document prepared by the taxpayer), withdrew the taxpayer’s IRA funds to pay for the taxpayer’s medical bills – not realizing the tax consequences of withdrawing money from the IRA. Upon consultation with a tax advisor, the representative submitted a ruling request to ask the IRS to waive the 60 day requirement. The IRS held that the taxpayer’s representative’s lack of knowledge about our tax laws was not sufficient to waive the 60 day requirement.

Reading these two rulings together provides an example of the difficult decisions that IRS employees often have to make and the level of discretion that IRS employees have in making these decisions. These two rulings also show taxpayers what not to do if they are considering withdrawing funds from their IRAs for temporary periods.

Obviously, taxpayers should try to meet the 60 day deadline for repatriating their IRA funds. If the taxpayer is worried that this deadline might be missed, then the taxpayer should have a practice of only working with less than competent, but 100% honest, tax and other financial advisors. Taxpayers should not rely on family members or friends, even if those persons are also tax advisors.

Is this the lesson that the IRS wants taxpayers to learn?

January 27th, 2007 | No Comments »