New Tax-Related Blog

It looks like we have a new tax-related blog in town. The blog is published by Frederick Mischler, an Ohio attorney. It appears that Mischler’s blog will cover tax, estate planning, real estate and other business law topics. The wide array of legal topics should make Mischler’s blog a must read. Mischler’s blog can be found at http://fredmischler.blogs.com/.

December 20th, 2005 | No Comments »

Estate Plans in Uncertain Times

With 2006 fast approaching I can’t help but pause to think about our estate and gift tax regime. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 changed the rules of the game. Following the enactment of EGTRRA estate planners and tax attorneys went to work defining and clarifying how estate plans should be structured for maximum flexibility in light EGTRRA. Congress has yet to clarify the uncertainties associated with EGTRRA and, as a result, many taxpayers and tax advisers have yet to restructure their estate plans. The importance of restructuring estate plans is increasing as the sunset time EGTRRA draws near, so this post will review some of the basic uncertainties and solutions.

Perhaps the most obvious EGTRRA uncertainties involve the increasing applicable exclusion amount (AEA). The AEA has increased from $120,667 in 1977 to $3,500,000 in 2009. Much of this AEA increase has occurred over the past few years. For example, the AEA increased from $675,000 in 2000 to $2,000,000 in 2006. This large increase over such a short time will be particularly problematic for estate plans consisting of credit-shelter (or A/B) trusts with pecuniary formulas. The pecuniary formula is the mechanism in credit-shelter trusts which allocates the amount that is to go to the marital trust (for the benefit of the surviving spouse) and the family trust (for the benefit of others).

The pecuniary formula accomplishes this by: (1) allocating the surviving spouse the amount necessary to take full advantage of the unlimited marital deduction or (2) allocating the surviving family members an amount equal to the AEA. If there is no estate tax or AEA then in the former case the surviving spouse might not receive anything and in the later case the surviving family members might not receive anything. This situation will be most unfortunate for those individuals who are dependent on the decedent and who are otherwise unable to support themselves - such as surviving spouses and minor children.

This situation can be easily avoided with advance planning. For example, the estate could employ a non-formulary qualified terminal interest (QTIP) property allocation instead of a pecuniary formula. This could involve one-lung QTIP or Clayton QTIP trusts. Alternatively, the estate could cap the amount that passes to the family trust, employ a fractional marital deduction formula, or provide that the only property to pass to a credit-shelter trust would be the property disclaimed by the surviving spouse.

A second set of EGTRRA uncertainties involves the step-up basis changes. For those individuals who pass away after 2010 the tax basis of property from a decedent will be the lesser of the decedent’s adjusted basis in the property or the fair market value of the property on the decedent’s date of death. With numerous caveats, executors will be able to increase the basis of property by $1,300,000 and an additional $3,000,000 for property passing to a surviving spouse (either outright or in a QTIP arrangement). As discussed above, many estate plans employ a pecuniary formula which could result in the surviving spouse getting little or nothing from the decedent’s estate. In those cases the surviving family or other beneficiaries would not be entitled to the additional basis step-up. Using a non-formulary allocation would help ensure that this extra basis step-up is not wasted.

In addition, one of the caveats for the extra basis step-up is that the step-up is not available for property over which the descendant holds a power of appointment. Thus, property held in power of appointment trusts might not qualify for this limited basis increase; whereas, property held in QTIP trusts might qualify for the limited basis increase.

A third set of EGTRRA uncertainties involves the repeal of the state death tax credit. Many states have not decoupled from the federal estate tax system, so those states impose no state estate taxes. On the other hand, a number of states have decoupled and, thus, impose state estate taxes. This raises a number of planning opportunities for locating assets in different states and it also presents a number of obstacles for trusts which employ pecuniary formulas that are tied to the federal estate tax.

These uncertainties have made it more important to consider other estate planning structures, such as: transferring high income or appreciation property to grantor retained annuity trusts, installment sales to defective grantor trusts, transferring property to charitable lead annuity trusts where the remainder interest has only a nominal value, and making inter-family loans and gifts.

It is probably safe to say that most estate plans have not been updated in light of these uncertainties. These are a few of the considerations that taxpayers and estate planners will have to grapple with in the coming years — regardless of whether the estate tax is repealed or if the AEA is increased. It ought to be an interesting couple of years.

December 11th, 2005 | No Comments »

Entrepreneur Rollover Stock Purchase Plans

Financing a business start-up can be a challenge. Most traditional lenders require that a business be operational for at least a year before they will provide small business loans. Moreover, venture capitalists are quick to reject most start-up proposals and if the venture capitalist is willing to fund the start-up they typically demand a significant ownership stake in the business. This has caused many entrepreneurs to look for alternative means for financing business start-ups. The entrepreneur rollover stock purchase (ERSOP) plan is one such financing alternative.

The idea behind the ERSOP is to use the entrepreneur’s 401(k), IRA, or other qualified plans to fund the start-up. The ERSOP process looks something like this: establish a legal entity; get a taxpayer identification number and checking account for the entity; set up a trust and get a taxpayer identification number and a checking account for the trust; (hopefully) get a determination letter from the IRS specifying that the trust qualifies as an everyday employee stock option purchase plan (ESOP); roll the entrepreneur’s retirement accounts over to the trust checking account and then to the entity checking account; the entity transfers entity stock into the trust. At that point the money is in the business checking account and the business stock is in the ESOP.

Most transactions such as this are disseminated via financial planners or via the large accounting firms; however, it appears that very few of those advisors are actively recommending the ERSOP. Instead the ERSOP seems to be being pushed by the professionals who help facilitate the transfer of franchise businesses. There are a number of businesses on the internet that claim to specalize in handling these types of transactions (see, e.g., http://www.ERSOP.com).

The main problem with the ERSOP is that it involves pulling money out of retirement accounts to fund speculative business ventures. This is a particularly risky undertaking given today’s diminishing government safety net and increasing government regulation.

Other problems involve violating the self-dealing rules required for ESOPs, volunteering for additional accounting and compliance requirements and costs, limiting future business structuring by creating a near permanent stock ownership arrangement, possibly limiting the entrepreneurs’ rights if the business goes under or if the entrepreneur wants to sell the business in the future, and placing the business in a vulnerable position with respect to future changes in the law.

While these drawbacks will probably preclude the use of an ERSOP in most cases, this does not mean that the ERSOP would never be appropriate. A client who is going to start a business using other risky financing methods (such as taking on credit card debt), who is fully advised of the consequences and requirements, and who is fully willing to comply with the requirements and willing to take the risk might be a viable candidate for the ERSOP. The ERSOP may be particularly attractive for clients who have significant wealth that is held outside of their retirement accounts, but it is currently illiquid.

A tight money supply and tougher underwriting mandates from Congress will probably help fuel the popularity of ERSOPs and other alternative financing arrangements in the near future. However, long-term, ERSOPs will probably be legislated out of existence or will continue to be passed up for simpler financing alternatives.

November 26th, 2005 | No Comments »

Basic Estate Administration and Taxes: Elections & Timing

This post is written to remind non-tax attorneys who administer estates of a few basic tax issues that must be considered in administering estates. From a tax perspective, estate administration is all about making elections and timing distributions, income and expenses.

The first group of elections involves selecting tax years. IRC § 441 defines a taxpayers “taxable year” as the taxpayer’s annual accounting period that may be a calendar year or a fiscal year. IRC § 441(e) defines a “fiscal year” as any period of 12 months ending other than in the month of December. IRC § 441(d) defines a “calendar year” as a tax year as ending in December. The second election that the estate attorney must consider is whether to elect a “short period.” With some exceptions, IRC §§ 443 and 7701(a)(1),(14) provides that a “short period” is a period of less than 12 months. These elections essentially allow the estate attorney to terminate the tax year when it will result in the least amount of tax.

The second group of elections involves timing the receipt of income and flow through and allocation of tax attributes. Most states have adopted some version of the Uniform Principal and Income Act, which allows the fiduciary to elect to elect to allocate capital gains to principal. Similarly, Treas. Reg. § 1.643(a)-3(b)(1) permits the fiduciary to treat certain capital gain receipts as income for trust accounting purposes, IRC § 663(b)(2) permits the fiduciary to elect to treat certain distributions as having been made during the prior year, IRC § 645 permits the fiduciary to treat a revocable trust as part of the estate, IRC § 642(g) permits the fiduciary to elect to deduct administrative expenses, and IRC § 643(g) permits the fiduciary to treat estimated tax payers as made by beneficiaries.

There are a number of other decisions that fiduciaries must make that are not elections per say, but are in essence elections. For example, fiduciaries are often able to time distributions, to make distributions under residuary clauses versus specific distribution clauses in wills, to make in-kind distributions in lieu of specific distributions, and to allocate deductions and expenses to certain beneficiaries or property.

This combination of elections presents fiduciaries administering estates with a number of planning opportunities. For example, the fiduciary may elect a short fiscal year for the first tax year and then have the estate terminate and deductions or other tax attributes flow through to the heirs’ tax returns in the second tax year. This is possible because IRC § 642(h) specifically provides that certain carryovers and excess deductions pass through to the beneficiaries if they arise in the year that the estate is terminated. This can be particularly useful where the estate is entitled to significant depreciation or depletion deductions, which would otherwise be lost because the estate had deductions in excess of income. Similarly, in other cases these flexible election rules may permit the fiduciary to time distributions so that the heirs receive distributions and expenses in years where the heirs have other offsetting tax attributes or income.

Of course, tax minimization is often not the main consideration in administering an estate. However, the rules sufficiently flexible and present the fiduciary with a number of tax minimization opportunities. Fiduciaries administering estates should not inadvertently pass up these tax minimization opportunities.

November 19th, 2005 | No Comments »

Sometimes It is Best Not to NIMCRUT

The best laid tax plans often go awry as tax laws and life circumstances change. In other cases tax plans go awry because they were improperly conceived. I have been encountering a number of NIMCRUTs that should not have been undertaken.

The NIMCRUT, otherwise known as the net income with makeup charitable remainder unitrust, is a charitable trust that requires the less of a fixed percentage of the income (minimum 5%) or the actual earnings be distributed to the donor or other non-charitable beneficiary annually. Upon the demise of the donor or non-charitable beneficiary or the expiration of a set period (not to exceed 20 years), the trust assets are distributed outright to the named charity. Taxpayers typically establish NIMCRUTs in order to provide a current income tax deduction, to convert appreciated assets to income-producing assets, and to fulfill charitable inclinations.

NIMCRUTs often hold a variety of assets. The idea is typically to invest in growth assets during the donor’s accumulation years and then sell the assets and/or invest in income assets during the donor’s retirement years or when the donor wants to receive income. This allows the trust to have little or no income during the donor’s accumulation years, resulting in little or no trust distributions during those years. When the donor begins receiving income they are able to receive the amount stated in the trust plus an additional amount to make up for the under performing years. This can allow prolonged tax-free build up, current income tax deductions and a steady stream of income when the donor desires. This timing is most often achieved by investing in zero coupon bonds, partnerships or LLCs, or even variable annuity contracts. The partnership, LLC, and variable annuity contract options allow the trustee to turn the investment income on and off at will, which allows the trustee to most effectively make distributions when most appropriate for the donor.

Remember that most NIMCRUTs are established with appreciated property, which when sold by the trust does not result in capital gain for income tax purposes. Thus, the gain is typically appreciation that occurred before the trust was established. The Regulations prohibit such gain from being allocated to trust income, regardless of whether the state allows the trustee to allocate the gain from trust principal to trust income. Consequently, even though it is simplistic, I encounter NIMCRUTs where there is almost no trust income or items that can be allocated to income and the term of the trust is set sufficiently short so that it is impossible to time the distributions in a way that benefits the donor, as would otherwise be the case.

If that is not bad enough I have encountered NIMCRUTs that invest in variable annuities, which result in ordinary income when they are paid out. In these instances the donor is giving up the option to pay a lower capital gains tax currently in exchange for tax deferral and a higher ordinary tax at a later time. This can be particularly problematic for older clients or for trusts with shorter maturities. This is even more problematic in that all of the annuity income in such situations is fully taxable, rather than it being partially taxable and partially a return of basis as when individuals own and receive annuity income. Again, while simplistic, I have encountered a number of clients is this situation.

The combination of a NIMCRUT and a variable annuity or partnership can be a powerful planning tool; however, advisors must run the numbers before making such a recommendation.

November 13th, 2005 | No Comments »

Will the Gay and Lesbian Marital Rights Debate Come to the Tax Policy Arena?

It appears that the States have effectively shut down recent attempts by gays and lesbians to achieve full marital equality. However, this does not appear to be the end of this issue and it leaves me wondering if gay and lesbian rights advocates might try their case in the tax policy arena. This raises questions as to what this type of case would involve and what the implications would be if the case were successful.

Most likely the case would involve gay or lesbian partners filing a single tax return as married filing jointly or partners filing separate tax returns with the married filing separate status. Undoubtedly the IRS would reject the returns as filed, noting that gay and lesbian partners do not qualify as married under the state law. The gay or lesbian partners could then challenge the IRS position, likely by making an equal protection argument. The IRS would counter by arguing that Congresses has the Constitutional power to lay and collect taxes and that Congress has deferred to the state’s definition of marriage for tax purposes. So the ultimate question would be whether in this case the Congressional power to lay and collect taxes would trump an equal protection argument. Given Congressional deferral to state law to define marriage, it seems like an equal protection argument would triumph. So the question is then whether in this situation gay and lesbian partners could make a successful equal protection argument.

Essentially the gay or lesbian taxpayer would be arguing that Internal Revenue Code Section 6013 and other Code sections and administrative regulations and rulings and state laws treat gay and lesbian partners different than non-homosexual spouses even though the two groups are similarly situated. Moreover, the gay or lesbian partner would be arguing that state law definitions of marriage should not shape our federal tax law. There is some precedent for this type of argument in our tax law. For example, it has long been held that state law determines the nature of property rights, but federal law determines how that property is taxed. For a more specific example, state law grants individuals property rights for trusts that are created under state law, yet federal tax law (IRC Sections 671 through 677) determines which taxpayer actually owns the property for federal income, gift, and estate tax purposes. So state law may say that a specific person owns the property in the trust, but federal tax law may say that someone else may in fact own it for purposes of federal tax law. Applying this reasoning, the gay and lesbian partner would in essence be arguing that state law definitions of marriage can define marriage, but federal law should determine how married and unmarried taxpayers are taxed under our federal income, gift and estate tax laws.

Who knows if the Court would buy into this argument. However, it should be noted that the Court has struck down legislation where the Court found that the legislation was motivated by “animus” or “hostility” towards politically unpopular groups. For example, in Romer v. Evans, the Court struck down a Colorado constitutional amendment that would have prevented the state or any of its cities from giving certain protections to gays or lesbians. Essentially the Court held that the amendment had no legitimate government interest and the government interest being served and the means chosen by the government were not rationally related to the interest that the government asserted. This is the least restrictive analysis that the Court employs, so even if the Court applied this analysis to the case there would be a good chance that the gay or lesbian partner’s argument would be successful.

If this argument were successful then Congress would be in the position of having to simply allow gay and lesbian partners to enjoy married filing jointly status or amend the Internal Revenue Code. The big picture implication would be that gay and lesbian couples could combine their items of gain and loss and they would qualify for the more favorable tax rates and other tax benefits. Similarly such a change would have sweeping implications for all of the tax provisions that favor married couples, including health, retirement, insurance, and other provisions.

The administrative problem for the IRS would be the increased number of persons who the IRS would essentially have to treat as married under common law. Common law marriage, which is allowed in a number of states, affords taxpayers who can qualify as such with a number of tax planning opportunities (and a number of tax pitfalls). For example, a taxpayer who survives the demise of an unmarried partner that lives in one of these states is often able minimize or avoid the federal estate tax by arguing that he or she was in fact common law married (and therefore, qualifies for the unlimited marital deduction). Similarly, the IRS would have to address innocent spouse claims made by unmarried gay and lesbian partners and the IRS would have to deal with cases where unmarried gay and lesbian partners dispute who is entitled to the head of household exemption and other deductions and credits.

Such a challenge is not improbable and if successful it would force a number of tax code changes. This type of federal recognition of gay and lesbian rights would invariably further gay and lesbian rights and eventually it could even lead to full gay and lesbian marital equality.

October 23rd, 2005 | No Comments »

Can the IRS be Friendlier and More Efficient at the Same Time?

The Treasury has been working on stepping up its exam and collections efforts. As a result the IRS appears to be moving back its pre-Revenue Restructuring Act (RRA) of 1998 posture, which was enacted as a result of numerous IRS abuses. Yet, the IRS is still bound by the RRA. Are we asking too much of the IRS to be more efficient and friendlier at the same time? Is that possible? If so, how?

The short answers are that we are not asking too much and it is possible. Now, for the most part, IRS personnel are friendly. However, all that means is that they are a little more polite and they may even smile when they make false statements (citing notes of conversations that did not occur), make intentionally deceptive statements (purporting to state the law by reading a document aloud while intentionally skipping over the part that is helpful for clients, implying that the part that was read was all there was – even though the listener had copy of the exact same document in front of them), and flat out stating that they will not consider a taxpayers case (even though the internal revenue code, treasury regulations, and the internal revenue manual require that they do so).

I often encounter honest and fair IRS personnel that carry out their duties with the utmost integrity. But I have also encountered an increasing number of abusive IRS employees as of late. The increasing frequency of these encounters is probably a result of the Bush administration giving the IRS the go-ahead to ramp up its exam and collection efforts, an action which probably stirred up anti-taxpayer sentiment in the IRS that was previously dormant.

Regardless of the cause, I have been getting the impression that taxpayers’ are becoming more and more frustrated by the IRS. In fact, anti-IRS sentiment seems to have been increasing so much as of late that many taxpayers have begun talking about taking alternative actions against IRS personnel, such as bringing various types of civil suits against IRS personnel and even taking steps to harm IRS personnel financially. For example there seems to be an increasing number of taxpayers who are filing frivolous liens and financing statements against IRS personnel. We saw this recently in US v. Stouder II, which involved a taxpayer who filed financing statements against two IRS employees in the amount of $300 million, in an effort to harm the IRS employees’ personal credit rating. The federal court declared the financing statements void; however, the IRS employees credit rating was probably harmed. The taxpayer probably achieved his aim.

I feel caught in the middle. Of course I would never counsel a taxpayer to file a frivolous or fraudulent document or case, nor would any other tax attorney that I know. It is wrong. Taxpayers who file such cases should be subject to sanctions. However, taxpayers should have some more effective means of redressing grievances against abusive IRS personnel. We already have laws on the books that deal with these types of acts, yet this cat-and-mouse game continues. This game harms the IRS’s image, it hinders the collections of tax revenues, and it is a wasteful use of limited resources.

If there is to be some improvement it must start with the IRS. The IRS must admit that there is a problem. IRS personnel at the highest and lowest levels must begin to discover and weed out abusive employees. Moreover, the IRS must begin to recruit and retain fair and honest employees. Of course this would probably entail paying higher wages and seeking higher qualified employees. These steps should be taken before the IRS increases its collections activities; otherwise we will see more and more IRS abuses and taxpayers pursuing alternative remedies – a tit for tat scenario similar to the one that prompted Congress to enact the friendlier-IRS RRA. In the end, honest taxpayers are the ones that are harmed by this game. Why should honest taxpayers be subject to an increasing frequency of IRS abuses (which may very well be a response to previous abusive actions by other taxpayers)? At this point it is not likely that the IRS is going to change voluntarily, so Congress should preemptively act to halt this wasteful game.

October 16th, 2005 | No Comments »