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- Written by: Martin M. Shenkman
2012 was one of the most significant years in estate planning history. While the outcome of the election, and perhaps even 2013 tax legislation, may be known by the time you read this checklist, the bottom line is that the fear of major unfavorable changes in the gift, estate and generation skipping transfer (GST) tax laws drove clients like never before in history to engage in gift planning in 2012. Now that the gift wave has subsided, practitioners have to deal with how those gifts affect 2012 Form 1040 compliance. The implications are legion and often surprising. Perhaps more than ever before in history, practitioners may have to (or would be advised to) meet with the client’s estate planning attorney before preparing the client’s personal 1040, trust 1041s and 1065s and 1120S returns for entities involved in 2012 gift planning. The points below summarize some of the myriad of issues that practitioners might confront for the first time.
√ Extend: Gift Tax Returns for 2012 will be the largest numerically in terms of number of returns, and largest in terms of wealth transferred in history. Extend will be the operative word. Practitioners should really consider extending any income tax return for any client that made 2012 gifts so that the automatic gift tax extension will also be received. If not, the gift tax return should be extended.
This will be necessary as the number, size and complexity of returns will warrant more attention than an April 15 filing date will realistically permit. Further, practitioners will have to consult with the clients other advisers (insurance, estate planning attorney and wealth manager) to identify gifts that they as CPAs may not have been informed of. All this will take time. If the new laws are not known, extending until they become known will be critical for many of the gift tax returns.
√ Late GST Allocations: Knowledge of the future of the gift, estate and GST tax may be essential if possible to determine the appropriate positions to take on 2012 gift tax returns, e.g. whether or not to allocate GST exemption to a particular transfer or not. For example, the client might contemplate making a late GST allocation on a 2012 gift tax return to protect a prior gift that was not initially intended to be GST exempt. This is not an esoteric issue only for the ultra-wealthy.
If in fact the GST exemption drops from $5.12 million to an inflation adjusted $1 million, as the law provided for 2013, it would be advantageous for many clients to make a late allocation of GST exemption to old insurance and children’s trusts that might otherwise not receive GST allocations. If the GST exemption does in fact drop in 2013, there may be no downside to making late allocations to old trusts if the GST exemption would be lost anyway.
√ Grantor Trust Returns: Most practitioners are familiar with revocable living trusts and reporting the income and deductions from such trusts on the client/grantor’s income tax return. However, the grantor trusts created in 2012 to take advantage of what many perceived to be disappearing tax planning opportunities are a different breed. Tax reporting for the common living trust is generally to simply have the trust use the grantor’s Social Security number and report all information on the grantor’s income tax return. This approach avoids the need to obtain a tax identification number or file a trust income tax return.
This simplified approach is permitted if the trust is a domestic trust, all income is reported by the grantor or the grantor’s spouse because the trust can be revoked by the grantor or a non-adverse party and the grantor or the grantor’s spouse are trustees. Treas. Reg. Sec. 1.671-4(b). But a trust that can be revoked would not achieve the transfer tax planning goals clients pursued in 2012 so that this reporting model is incorrect. The 2012 transfer tax planning trusts generally won’t be revocable and many won’t have the grantor as a trustee.
Practitioners have to modify their grantor trust reporting standards accordingly and be certain that separate Form 1041s are filed and appropriate grantor trust statements attached. This is important not only to properly report from a compliance perspective, but the filing of an independent return for these complex estate planning trusts could prove to be an important factor in demonstrating that the independence and formalities of the trust were respected. This could prove vital in the event of a later lawsuit or IRS challenge.
√ Who is the Grantor: Almost all trusts established that are grantor trusts, the person setting up the trust (“settlor” or “trustor”) is the grantor for income tax purposes. However, a planning technique known as the “beneficiary defective irrevocable trust” or “BDIT” has become more common and many were established in 2012 as wealthy clients endeavor to capture discounts and grantor trust status before possible changes in the law. In a BDIT typically a parent is the settlor, but as a result of a carefully drafted trust and the use of a Crummey power, the beneficiary of the trust, typically a child, is the grantor for income tax purposes. Care must be exercised to ascertain exactly who the intended grantor is before filing and potentially undermining the carefully sought tax result.
√ What Should be Reported: Many of the sophisticated estate tax planning trusts used in 2012 include a number of provisions or powers that can dramatically affect who owns which assets and who the beneficiaries are. Without understanding some of these unique nuances, not only might compliance be handled incorrectly, but the objectives of the entire plan may be undermined. For example, a “swap power” that provides the grantor, and sometimes another person, the right to swap or exchange assets outside the trust for assets inside the trust can instantly shift the ownership of valuable assets.
Many practitioners established 2012 trusts with cash or marketable securities intending in 2013 to have the client or another person designated in the trust exchange family business or closely held real estate interests for the cash in the trust. If such a ‘swap” was effected it would affect the 1120S or 1065 for the S corporation or LLC as well as the trust. While there would likely be documentation if a swap occurred, most estate planners do not document when nothing has occurred (i.e., no one has exercised the power). How can you know as a tax preparer that nothing has been done to affect trust assets without an affirmative statement from the person holding the power that it was not exercised? Failing to properly report such a transaction could have adverse effect on the entire estate plan, make the trust grantor 1041, the client’s 1040, and the entity’s return all incorrect. In addition to the swap power, some estate planners have commonly used the power to loan trust assets to the grantor without adequate security, or the power to add a charitable beneficiary.
Just like the swap power, if practitioners don’t confirm what, if anything, was done there may be no way to properly prepare multiple returns and the entire plan could be jeopardized. Given the dramatic surge in the number of these trusts that were completed in 2012 practitioners need to be alert and should corroborate in writing the status of these powers.
√ Schedule C and E Surprises: A common planning step in 2012 planning was to make gifts of interests in closely held LLCs. LLCs that may have been disregarded single member entities in prior years, or which could avoid their own filings as a result of a Qualified Joint Venture (“QJV”) election may now require their own returns rather than merely reporting on the client’s 1040 schedule C and E. Single member single purpose real estate LLCs will likely prove a common example.
Perhaps the biggest surprise for practitioners attempting to prepare 2012 1040s and entity returns is determining who owns what interests in the entity? Looking at last year’s K-1 and even the gift documentation won’t provide the answer. This is because many estate planners, especially near the end of 2012 used what are referred to as defined value clauses to effectuate gifts in 2012. These clauses fix in dollar terms the gift of interests in an entity or other asset made to a trust or other donee. So until the gift tax audit concludes it is impossible to know what percentage anyone owns. While there is scant if any law on how to report this, ignoring this reality on entity and client income tax returns might well be a factor the IRS uses in attacking the reality of these defined value clause mechanisms. Perhaps at minimum practitioners should consider reporting the estimated percentage transferred but attaching a statement to both the client’s and entity’s return disclosing the existence of the defined value clause and indicating that until its terms are resolved the percentage ownership interests are merely estimates that may have to retroactively be changed.
Conclusion
If this is all a bit unfamiliar, seek help from the estate planner who created the plan before filing any income tax returns for 2012. You don’t want to inadvertently undermine your client’s major 2012 estate planning.
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- Written by: Martin M. Shenkman
LLCs are ubiquitous in planning but there are a myriad of tax issues and complications in spite of their common use. Consider:
Not an LLC
LLCs can provide the individual members significant personal protection from liability claims even if they are active in the business. Practitioners should be alert to client investment and other endeavors that remain held in personal name rather than in LLC format. While the advantages of using LLCs over personal holding of many types of business endeavors or investment assets is obvious, many clients still have these held in their personal name. If, in preparing any Schedule C or E, practitioners identify rental real estate, even a small home based business that is not in LLC format, communicate the importance of addressing this to the client. Practitioners might even consider, to protect themselves, putting this recommendation and warning in writing. The fact that a client is a manager of the LLC should not taint this protection. This is quite different than the partnership context. If a limited partnership is formed, the general partner, unless an entity, will have full exposure to claims.
Importantly, and few clients understand this, if a limited partner becomes involved in active management of the partnership he or she will have personal liability.
Check the box
An LLC can opt to be classified under the check-the-box Regulations as either a partnership, an association taxable as a corporation or a disregarded entity. Practitioners should be mindful that these decisions have significant consequences apart from only the income tax issues. While there is a tendency to have LLCs structured as single member disregarded entities to avoid the cost to the client of filing an additional tax return, this will lessen significantly the protection the LLC will provide the client from lawsuits.
If the LLC instead is a multiple member entity, under many state laws that will provide valuable “charging order” protection in that a claimant will only be able to receive the limited economic rights to the members interest in satisfaction of a claim. If instead the client opts to be treated as an association taxable as a corporation in order to elect S corporation status, practitioners should warn the clients, perhaps even in writing, to make certain that their estate plans properly address the S corporation characterization. IRC Sec. 1361(a). Commonly used bypass trusts that are the cornerstone of many estate plans (even with the availability of portability) will not generally qualify to hold S corporation stock unless Electing Small Business Trust (ESBT) or Qualified Subchapter S Trust (QSST) provisions are added.
Certificate
LLCs are formed under state law by filing a certificate with the appropriate state agency. Practitioners should obtain a copy of the filed certificate that reflects the actual date of formation for their permanent files. This certificate will confirm the correct legal name for the entity, the exact date of formation, which is essential for tax compliance purposes. The certificate is usually a short and relatively simple to read document which every practitioner should read. Some certificates might limit the scope of the business the LLC can conduct. That might be significant if the LLC is engaged in an activity that is different than what was initially contemplated. The certificate may also establish whether or not the LLC is member managed or manager managed. If you have someone signing the return as a manager and the certificate says it is member managed (not manager managed) you have an issue to address.
Transferability
LLCs are governed by state law. Most state LLC laws are “default statutes.” If the owners (members) provide for a particular matter in the legal document governing the LLC, the operating agreement, then that operating agreement will govern. If the operating agreement doesn’t exist, or if it exists but is silent on a particular point, then the state law, by default, will govern as to that matter. LLCs should therefore have a governing operating agreement. A critical issue to address in the operating agreement is the transferability of membership interests. Most closely held or family business or investment LLCs are intended to stay within the small closely held group or family. State law should not be relied upon to restrict the transfer of ownership interests and an operating agreement expressly addressing this vital point should exist and be signed. The only way for practitioners to know for certain is to have a copy of the current operating agreement in their permanent file.
K-1s
LLC operating agreements will specify who owns what interests. However simplistic and obvious it sounds, it is not uncommon for practitioners to file Forms 1065 and issuing K-1s with percentages that differ from the operating agreement. Every practitioner filing a return for any LLC should have a copy of the operating agreement and as a routine part of each year’s tax preparation confirm that the ownership percentage is identical to that reported on the return. In addition, some attorneys issue membership interest certificates for LLCs. These are analogous to stock certificates. Practitioners should make certain every tax filing that the ownership percentages are identical for all three sources: certificates, operating agreement and K-1s.
State of Formation
LLCs are almost always formed in the state where the client resides and the practitioner practices, but this is not always the case nor always advisable. As estate planning has become sophisticated, more and more clients are setting up trusts in states like Alaska, Delaware, Nevada and South Dakota to achieve better tax and asset protection results. These trusts are no longer the purview of only the super-wealthy and are really appropriate for many clients. If a client has a trust in one of those states and that trust owns interests in an LLC for which you are arranging an income tax return, there may be significant advantages to the client of having that LLC authorized to do business in the state where the trust was formed, or preferably, organized from inception in that state and then authorized to do business in the state where the client resides (or where, for example, real estate or a business interest is located). Practitioners should be alert to filing requirements in these other states. If a practitioner notes that an LLC is owned in part or all by such a trust and is not authorized to do business in the state where the trust-member is located, bring it to the attention of the client or the client’s attorney.
Tax Rate Differentials
When planning for new entities practitioners should consider the possible impact of the new 3.8% Medicare tax on passive investment income that is to become law in 2013. IRC Sec. 1411.
Investment income includes gross income from interest, dividends, annuities, rents and royalties and net capital gains. This tax is imposed on net investment income or modified adjusted gross income (MAGI) over $250,000 ($125,000 for married filing separate, and $200,000 for single taxpayers). For LLCs, if the member in question is not a material participant as defined under the passive loss limitation rules under IRC Sec. 469), the LLC income would be deemed passive income to that member. There is also the possibility of higher marginal income tax rates on wealthy taxpayers. While LLCs as a pass through entity have enjoyed an income tax advantage over the corporate form, this may not continue to hold true in all cases. However, before considering a change in format, practitioners should carefully weigh the advantages of flexibility, simplicity and asset protection (see comments on charging order protection above) which LLCs afford clients. Also, the tax pendulum has swung back and forth several times and it may continue to do so in later years.
Conversion of Corporation to LLC
LLCs offer many advantages over corporate form and some clients that still hold assets or business operations in corporate format might wish to convert to an LLC. However, to do so would require the liquidation of the corporation. This could be achieved mechanically as follows: (1) The corporation forms an LLC; (2) The corporation contributes all of its assets, subject to any of its liabilities to the LLC in exchange for LLC membership interests; (3) The corporation liquidates distributing the only asset it holds, LLC membership interests to its shareholders. Many state laws will permit the filing of a certificate to accomplish this conversion process without the formal transfer of title to assets to the LLC from the corporation. The tax cost on liquidation and distribution may be prohibitive. An S corporation would face a similar tax. IRC Sec. 1371(a). But in an S corporation the gain recognized flows through to the individual shareholders who can increase their basis in their S corporation stock. IRC Sec. 1367. Because of these potential issues practitioners will sometimes use an approach known by various names like “the withering vine.” In this arrangement a new LLC is formed and new business is conducted in the new LLC. Meanwhile business in the old corporation is allowed to wither and eventually disappear. Practitioners should exercise caution in this type of plan. The IRS and even claimants may assert that the corporation actually transferred its goodwill to its shareholders who then in turn transferred the goodwill to the new LLC. This would effectively reconstruct the transaction to the approach described above with a commensurate tax result.
Conversion of Partnership to LLC
It can be advantageous to convert an existing partnership to an LLC to achieve the better liability protection an LLC offers. For example a general partner if not an entity has unlimited personal liability. Also if the partnership is a limited liability partnership it may expose members to unlimited contractual liability (e.g., on a lease). The partnership could liquidate distributing its assets into the new LLC. This could constitute a termination of the partnership. IRC Sec. 708(b). However, it appears that the IRS will treat the contribution of assets by the partnership to the LLC as tax free. IRC Sec. 721. See generally Rev. Rul. 84-52, 1984-1 C.B. 157, Rev. Rule 95-37, 1995-1 C.B. 130. If this approach is used then the partnership should not be treated as terminated, and no liquidation should be deemed to have occurred. Instead, the LLC could be treated as a continuation of the partnership.
Another approach can be achieved mechanically as follows: (1) The partnership forms an LLC; (2) The partnership contributes all of its assets, subject to any of its liabilities to the LLC in exchange for LLC membership interests; (3) The partnership liquidates distributing the only asset it holds, LLC membership interests to its partners. The costs involved in this conversion process probably will have to be capitalized and will not qualify for amortization under Code Section 709. INDOPCO v. Comr., 112 S. Ct. 1039 (1992).
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- Written by: Martin M. Shenkman
Introduction
How you plan and address the avalanche of 2012 gifts, the filing of 2012 gift tax returns in 2013 for those 2012 gifts, and the eventual audit many of these gifts will undoubtedly be subjected to, should all be influenced by how you will handle the Appeals of those audits. Starting with the potential end game scenario may prove valuable at each of the earlier stages of these gifts and related compliance and audit issues.
2012 will likely prove the most active year in the history of the gift tax. With the threat of a reduction in the annual gift tax exemption from $5.12 million to a much lower $1 million, and with discounts, grantor trusts, perpetual GST allocations all being proposed for legislative restriction or repeal, more wealthy taxpayers will make substantial transfers in 2012 than ever before. Large numbers of large dollar transfers will likely result in burgeoning IRS audit activity. But the large dollars being transferred will result in many of those audits going up to the Appeals Division as taxpayers and the IRS endeavor to settle what will undoubtedly be large assessments. The following checklists will highlight some of the steps practitioners will face, and some of the technical issues that 2012 gifts will likely raise.
2012 Issues to be Alert For
√ Inattention to Formalities: The Wandry case has resulted in some practitioners minimizing the importance of many gift planning details and instead relying on the backstop of a defined value clause to solve any gift tax problems. Wandry v. Comr., 2012-88. Simply put some practitioners may have thought that they did not need to be concerned about the quality of the appraisal, or whether other formalities were adhered to, as they may have done in prior years. Since many interpret the Wandry case as having given broad license to the use of defined value clauses, they may have reassessed the downside of a 2012 gift as more modest than perhaps should have been done. If the IRS revalued a gift at $4 million that the taxpayer had valued at $2 million the excess of 50% of the assets given would revert perhaps back to the donor or a non-taxable receptacle like a QTIP trust. Should returns and gift plans be audited that took this view, potentially every phase of the gift and underlying documentation may prove problematic.
√ Step Transaction Doctrine: The sheer time pressure to complete many 2012 gifts will result in missed steps, the lack of “aging” different phases of the plan, the completion of components that in the past may have been spread over several tax years into a single tax year, and more. These may all raise the specter of the IRS applying the step transaction doctrine to compress many transactions into a more costly tax result.
√ Reciprocal Trust Doctrine: This has been much talked about in the literature addressing 2012 planning, but that doesn’t assure problems won’t be common. If each spouse sets up an inter-vivos trust for the benefit of the other spouse and descendants, the IRS may view the trusts have not appreciably having changed each spouses’ economic position and attempt to uncross the trusts applying the “reciprocal trust doctrine.” While this is typically an estate tax challenge that will cause estate inclusion, it may also arise as an attack to unwind a donative transfer during a gift tax audit. Practitioners will have to evaluate the circumstances, and most importantly the terms of the trust agreements, and identify meaningful differences.
√ Gift Splitting Issues: If one spouse has title to the assets transferred by gift to a trust, the other non-donor spouse may join in splitting that gift. Gift splitting will be especially critical if absent the election to split gifts the transfer exceeds the transferor spouse’s remaining exemption. However, if the non-transferring spouse who would elect to gift split is also a beneficiary of the trust, gift splitting will not be permitted. As trusts become more complex, and more powers and fiduciary positions are added, it may not be obvious how or in what manner a spouse might be a beneficiary.
√ Economic Substance Challenges: In the 2012 frenzy to take advantage of the $5.12 million gift exemption some taxpayers will undoubtedly transfer more assets than might be appropriate. If insufficient assets are retained to fund the taxpayer’s living expenses for the future, the IRS may attack the transaction as not having economic validity, and inferring that there had to be an implied agreement between the donor and the trustees to make distributions or the transfer could not be made. Practitioners facing these challenges may have to develop budgets and financial forecasts for the donor/taxpayer to justify the transaction if this was not done at inception.
√ Competency: If the taxpayer did not have sufficient mental capacity to contract (which is a higher degree of capacity than that required to sign a will) the gift transaction will be ineffective. Given the potential impact of state estate tax in decoupled states, and the risk of a lower federal exemption amount, many older taxpayers will have undoubtedly been encouraged to make 2012 transfers. If the practitioners making those transfers did not take the steps to corroborate adequately the donor’s competency, on audit, an historical reconstruction of that evidence will be necessary. If by the time the audit occurs the taxpayer/donor is clearly incompetent, that won’t provide a basis to conclude incompetency at the earlier date when the gift was made, but it will make the demonstration of competency more difficult.
√ Post-Gift Operations: While practitioners handling audits and appeals generally view the documentation completed at the time of the gift as of paramount importance, they should not discount post-gift documentation that may be relevant to the gift tax audit. For example, if post-gift none of the formalities of a family limited partnership were adhered to, that might suggest that the gift of the FLP interest at a prior date was not valid.
Audit Process
√ Exam Letter: The first step in the audit process is for the taxpayer to receive a letter informing him that the IRS has determined to examine the gift tax return. In most cases the return is defended initially by the preparer. While for most returns that might be the CPA, in 2012 in particular it is likely that many estate planning attorneys will file Form 709. While many attorneys are expert in these filings, the scope of clients making 2012 gifts will undoubtedly result in some estate planning attorneys with little or no compliance experience filing returns. CPA practitioners should endeavor to be included in the team that represents the taxpayers from inception. The damage that can be done to a taxpayer’s position from an inexperienced practitioner handling the preparation may be compounded if the same inexperienced practitioner handles the gift tax audit.
√ Response to 30-Day Letter: At the end of the exam the IRS will issue a 30-day letter listing its proposed determination of the audit.
- If the results are not acceptable the taxpayer can file a protest of the results to the IRS Appeals Division. This is the most likely option pursued by most CPA practitioners, but it is not the only option. The Appeals route is chosen by most as it can be far less costly if the matter can be settled at Appeals than if the matter proceeded to trial. However, an error that is sometimes made is to prepare to a lesser degree for an Appeals conference than one would prepare for a trial. That can undermine the case. The protest to Appeals can also prove advantageous because the taxpayer must exhaust his or her administrative remedies in order to shift the burden of proof back to the IRS on the matter. IRC Sec. 7491.
- Instead of pursuing the Appeals route, the taxpayer can request that the IRS issue a 90-day letter. The tax assessment can be paid and the taxpayer can sue for refund of that payment in the Court of Claims or District Court.
- The taxpayer can choose not to pay the tax assessed and instead file a petition to the Tax Court challenging the determination. Some litigators choose from the latter option as a strategy to up the ante to the IRS on the case. However, in many cases the Tax Court will send the matter back to Appeals
Before an approach is selected, CPA practitioners who have not litigated with the IRS in court should consult with attorneys specializing in tax litigation to assess how the unique circumstances of 2012 may affect the decision. The dynamic may well prove different than that of prior years.
√ Gathering Information and Preparing the Case: Even if a Tax Court Petition is filed it will not address the taxpayer’s case in significant detail and many important pro-taxpayer arguments may not even be mentioned. Therefore, regardless of which of the above options is selected, practitioners should begin the preparation of the client’s case.
- This will include a detailed analysis of the case, positions, and arguments. Some practitioners prefer a more limited approach to the Appeals process, but that can be a significant strategic error. Many tax litigators recommend that the Appeals presentations be a precursor of what the taxpayer’s case would be at trial.
- Often it will be necessary to obtain testimony of expert witnesses, additional expert reports and other third party information. A likely issue in many audits will be the valuation of the assets given as gifts in 2012. Thus, practitioners may have to line up the expert who prepared an appraisal report (e.g., underlying real estate appraisal, discount entity appraisal, etc.). It may also prove advantageous to hire an appraiser who was independent of the first appraiser to corroborate the conclusions of the first appraiser’s report. In some instances the new appraiser may not concur with some of the assumptions and/or conclusions of the appraiser whose report was attached to the gift tax return. While costly, it may prove advantageous to have a new independent appraiser complete a new valuation report from scratch. If the new report addresses errors in the prior taxpayer appraisal report (and perhaps errors in any IRS obtained appraisal report) the new appraisal may move the entire case to a quicker resolution. The savings in professional fees might well outweigh the cost of the additional report. Some practitioners have strategically hired the appraiser that the IRS might use at this early stage for a corroborating analysis to preclude the IRS from later hiring its appraiser of choice.
- Take a comprehensive approach analyzing all issues to the appropriate degree of depth.
- Prepare a written analysis of the taxpayer’s entire case with a table of contents, timelines and other visual aids to demonstrate the strength of the taxpayer’s position.
- For complex gift transactions, e.g., involving multiple entities, layers of entities, underlying asset and discount appraisals, the rational organization of the files and other records may be essential to the outcome of the case.
- Even though the matter is a gift tax audit, review three years of income tax returns for the taxpayers and any entities involved in the gifts. Be certain you can explain any unusual items that may impact the valuation or completeness of any gift made.
√ Additional Information Requests: Be a Boy Scout – the motto “Be Prepared,” applies to every Appeals case. The critical ingredient to achieving the most favorable results at all levels of audit, including Appeals, is preparation. The client must understand that saving money on preparation could be a dangerous gambit. The professional team must be certain to obtain all the relevant information available. The necessary records and data may extend to much more than what was appended to the gift tax return, even if the return was meticulously prepared with an eye towards meeting the adequate disclosure rules. Obtain any relevant data from the IRS and third party sources, as well as the client.
This may include a number of procedures and steps. Consider a Freedom of Information Act ("FOIA") request. These might disclose useful information such as whether witnesses interviewed by the IRS have taken positions different than that by the IRS. Since the IRS has proposed a gift tax adjustment, consider IRC Sec. 7517 which permits the taxpayer to obtain copies of any documents that the IRS has on the particular case such as valuations, transcript of accounts, an indication of who has worked on each tax return and file. IRC 7602(c) permits a taxpayer to examine a list of witnesses the IRS has spoken to so that the taxpayer can interview them as well in preparing the taxpayer’s case.
√ Forms to File. Form 2848 authorizing the advisors to deal with the IRS should be addressed at the inception of the case. Form 4506 can be filed with the IRS Service Center to request tax returns for each entity and taxpayer involved. If the CPA practitioner has not been the one preparing all entity returns (e.g., a gift was made of an interest in a family LLC that in turn owns minority interests in other limited partnerships or LLCs).
√ Prepare the Case for Presentation: How the practitioner presents the case involved to the appeals office can be important to the ultimate resolution of the matter.
- Your presentation should direct the Appeals officer to the most relevant provisions of each key document and issue. Bear in mind that the Appeals officer will likely be inundated with matters, and making points clear, direct and succinct will make the Appeals officer’s evaluation easier and more efficient, and potentially more favorable for the taxpayer.
- Try to identify any errors in the examining IRS agent’s report. These might be procedural (e.g., determining the statute of limitations) and substantive (e.g., transposition of source data taken from public records, math errors in calculations, etc.). Identification of errors might help convince the Appeals officer of a lesser quality of work by the agent, or possibly even call into question some of the key conclusions of the audit.
- Build a list of taxpayer favorable conclusions to demonstrate to the Appeals officer that there are real risks (hazards) to the IRS if they pursue litigation after the Appeals level. These could be persuasive, especially if you identify significant new issues that the agent had not considered in the preparation of the examination report. This might all serve to encourage the Appeals officer to a settlement favorable to your client.
- Weigh the pros/cons of making strategic concessions when the facts are not favorable to the taxpayer. This can improve the taxpayer’s credibility with the Appeals officer and perhaps move the matter towards resolution. For example if a discount was clearly excessive, re-evaluate the discount and suggest a more reasonable compromise in your report. Conceding on some issues may be sufficient to move the matter to resolution.
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.
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- Written by: Martin M. Shenkman
Practitioners dealing with partnership tax returns face a myriad of complex tax issues. Additionally, consideration should be given to the broader planning context as changes in the law (e.g., resulting from the Budget Control Act mandates) and the economy (low interest rates and depressed asset values) will undoubtedly affect the status of many partnerships and client objectives. The following checklist highlights a list of some of the points practitioners should consider when reviewing Forms 1065:
√ Should you be filing a partnership return for a partnership or limited liability company of which spouses are the only two partners or members? If the couple meets the requirements to qualify as a qualified joint venture under IRC Sec. 761(f).2 they can avoid filing a Form 1065. The requirements are as follows:
- The joint venture must involve the conduct of a trade or business.
- The only members of such joint venture are a husband and wife.
- Both spouses materially participate (within the meaning of IRC Section 469(h) without regard to paragraph (5) thereof) in such trade or business.
- Both spouses elect the application of this subsection. #####
√ Proposals are pending to restrict many of the estate and gift tax advantages of using family limited partnerships (“FLPs”). If these proposals have not become effective when you are reviewing a FLP return encourage clients that may benefit from shifting wealth out of their estate, not only for tax reasons, but for asset protection or divorce protection, to act while the benefits may remain. Some of the changes include the expansion of Code Section 2704(b). Under current law restrictions on transfer which are more restrictive than state law are ignored for valuation purposes. In response to this, some states have made their statutes extremely restrictive, thereby negating the need for taxpayers to adopt restrictive partnership agreements, undermining the intent of this provision. Transfers before a change in the law becomes effective of entities organized in states with advantageous laws may provide considerable advantage.
√ Proposals have been made to tax higher income taxpayers at higher rates. In addition, starting in 2013 a 3.8% Medicare tax will apply to net investment income if your adjusted gross income ("AGI") is over $200,000 single ($250,000 joint) threshold amounts. IRC Sec. 1411. The greater of net investment income or the excess of modified adjusted gross income (MAGI) over the threshold will be subject to this new tax. The historic use of FLPs before discounts became the rage was to shift income to lower bracket family members. Before dismantling existing FLPs, practitioners should review the potential for income shifting, and the new requirements this entails. For example, to shift income by gifting FLP interests to a child, capital must be a material income-producing factor in the partnership. IRC §704(e)(1); Treas. Reg. §1.704-(e)(1)(ii).
√ Hedge fund interests have been the subject of considerable talk about restricting tax benefits managers can realize. Carried interests are a right that entitles the general partner of a private or public fund to a share of profits as compensation for managing the fund’s assets. These can be vested or unvested. Management fees are taxed at ordinary income tax rates while carried interests are taxed under present law as capital gains and are exempt from employment tax. Thus, the general partner receives income for services rendered at capital gain rates. 2007 HR 2834 introduced to tax carried interests as ordinary regardless of the charter of the item at the partnership level. This concept was reintroduced in 2009 when the House passed HR 4213 to tax carried interests less favorably. President Obama’s Greenbook, JCX-59-09 p.5, estimated the increment to the federal government from taxing carried interests at ordinary income tax rates at $24 billion. Evaluate the impact of such changes with any client holding these interests.
√ Proposals have been made to limit the maximum income tax rate at which higher-income individuals can realize a tax benefit of itemized deductions, personal exemptions, and certain preferences to 28 percent. It has been estimated that this change in the tax law will generate $410 billion in revenue. Practitioners should be alert to investment activities that may be suitable to shift into a partnership solution where the related deductions may potentially avoid these restrictions.
√ The transfer for value rules can result in the proceeds of a life insurance policy being subject to income tax. However, transfer of an insurance policy to a partner of the insured (or a partnership in which the insured is a partner) will not trigger the transfer for value rules. IRC Sec. 101(a)(2)(B). Practitioners should be alert for opportunities to help clients restructure the partners in a partnership to include those taxpayers who may be involved in insurance transfers. The partnership involved, however, must be a bona fide entity, and not merely an entity established to effectuate the insurance transfer. If the partnership owns significant other assets, and was not formed for the purpose of facilitating the transfer of the insurance policies, it may be respected as qualifying for an exception to the transfer for value rule. PLR 200120007.
√ Series LLCs are becoming more common. Delaware enacted the first law permitting series LLCs, but Texas, Oklahoma, Illinois and Tennessee have as well. In a series LLC the client can form one LLC and under its umbrella create a series of other LLCs each providing liability protection but without the cost and complexity of creating multiple entities. Practitioners should be alert for clients that may benefit from this technique, e.g. a client with many retail stores presently organized as a single partnership or LLC. Series LLCs may have their own business or investment purpose, classes of ownership interest, and liability limitations. The classification of a series that is recognized as a separate entity for federal tax purposes is determined under Reg. 301.7701-1(b). If an LLC with three members (A, B, and C) establishes two series LLCs (LLC-1 and LLC-2), with A and B the owners of LLC-1 Series, and C the owner of LLC-2 Series, the default classification of LLC-1 Series is a partnership and of LLC-2 Series is a disregarded entity. Under Reg. 301.7701-1(b).
√ Annual gifts of interests in partnerships will be obvious from the small changes in K-1 ownership percentages. If these gifts are apparent from the return practitioners should be certain that clients have had the partnership agreements (operating agreements in the case of an LLC) reviewed by counsel to be certain that the requirements for a present interest gift (a prerequisite to qualifying for a gift tax an annual exclusion) are met. IRC Sec. Sec. 2503(b). The Regulations provide that a future interest may be created by the limitations contained in an instrument of transfer used in effecting the gift. Regs. Sec. 25.2503-3(a). Thus, the partnership agreement, the assignment forms used to transfer the partnership interests or other documents may all undermine the clients sought after tax benefit. Price v. Commissioner, T.C. Memo. 2010-2.
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- Written by: Martin M. Shenkman
- Non-Acknowledged Gifts: Many clients make “informal” gifts to children and perhaps others that they do not view as gifts. Caution clients that the IRS appears to be ramping up gift tax audits. One program the IRS has instituted has involved its investigation of real property transfer records in more than a dozen states. The IRS has found that a substantial portion of deed transfers for no consideration were not reported on gift tax returns. 60-90% of gratuitous non-spousal real estate transfers were not reported on gift tax returns. If a client has simply transferred a vacation home or other property to his or her children but did not report it, a current IRS audit initiative may be quite a surprise. The client might feel that “only her hairdresser knows for sure” but they may be quite wrong. If clients have such unreported gifts it may behoove them to take the lead and file the missing gift tax returns. For most 2011-2012 transfers there is not likely to be a gift tax issue because of the $5 million exemption. However, for prior transfers when the gift exemption was $1 million (or less in earlier years) there may in fact be a tax issue.
- Unreported Gifts Have Rippling Effect of Consequences: Clients may assume that the only implication of the failure to report is the gift tax return, but this issue can extend further than the one return. If the client makes future taxable gifts and has to file a gift tax return to reports those gifts, those future returns must disclose prior gifts. This means all future gift tax returns would also be incorrect returns since the figure for prior taxable gifts would be incorrect. If the client’s executor becomes aware of an unreported gift and files an estate tax return, that too would be an incorrect return. This is a potentially substantial risk awaiting many unsuspecting taxpayers.
- Gift Splitting: To elect to gift split, both must be residents or citizens, married and alive at the time of the gifts, and neither can marry a new spouse during the year – Reg. Sec. 25.2513-1. Another 2011 and 2012 issue might arise when a client creates a trust for the benefit of his or her spouse and issue, give $10,240,000 to that trust, and elect gift-splitting so that the $5.12M gift exemption of each spouse can be applied to protect the transfer from current gift tax. Section 2513(a) allows a husband and wife to consent to treat gifts to third parties as if made one-half by each spouse. Stanley L. Wang, T.C. Memo 1972-143; Max Kass, T.C. Memo 1957-227; Rev. Rul. 56-439, 1956-2 Cum. Bull. 605. The problem that may arise in some of these types of transactions is that the non-transferor spouse may be made a beneficiary of the donee trust. It is not clear that gift-splitting is available for such a gift when the spouse to elect gift splitting is also a beneficiary of the donee trust. Gift-splitting requires that the gift be to a person other than the donor’s spouse. If gift-splitting is not allowed, only $5,120,000 of the gift will be covered by the donor’s exempt amount, resulting in $1,792,000 of gift tax at the 35% gift tax rate in effect in 2012. Carefully review prenuptial agreement provisions, or have client’s attorney do so and guide you, as to whether gift splitting is permissible.
- 2012 Gift Transfer Issues: Practitioners should be cautious in 2012 planning 2012 gifts, and cautious in 2013 reporting those gifts on gift tax returns. There are a host of unique issues that will affect 2012 gifts. A major issue that 2012 gifts is the significant incentive to consummate large gifts in 2012 to take advantage of the gift exemption, discounts, GRATs, dynast trusts and other tax benefits that may sunset or be changed.
- The compression of time to complete major gift transactions in 2012 will exacerbate proper planning – be alert in 2013 when filing 2012 gift tax returns.
- Reciprocal Trust Doctrine may be implicated when a husband and wife (or possibly other related or unrelated persons acting in concert) create identical (or perhaps even very similar) trusts for each other. Example: Husband gives $5.12 to a trust for the benefit of wife and issue, and wife gives $5.12 to a trust for the benefit of husband and issue. These trusts could appear quite similar to the typical bypass trust under a client’s will. This structure raises the specter of the reciprocal trust doctrine and the IRS or the Courts could “uncross” the two trusts and treat the wife as if she was the grantor of trust of which she is beneficiary, and ditto for husband. There is no clear safe harbor as to what constitutes sufficient differences between two trusts to avoid the application of the reciprocal trust doctrine. Therefore, the best approach is to make the trusts as different as is practicable under the circumstances. When reporting gifts to these trusts, all the relevant issues and data to corroborate the differences might be advisable to report on each spouse’s gift tax return. The fundamental concept of the reciprocal trust doctrine is that both the husband and wife are left in substantially the same economic position following the establishment of the two trusts as they were before the establishment of the two trusts. Avoiding the Reciprocal Trust Doctrine is not simple, but should be based on maximizing the number of meaningful legal differences between the trusts. This could include having one spouse as a beneficiary of the trust he or she creates, if the trust is formed in an asset protection jurisdiction such as Alaska, Delaware, Nevada or South Dakota (i.e., a domestic asset protection trust). However, the other spouse creates a trust for which he or she is not a beneficiary (i.e., not a DAPT). Use different distribution standards in each trust. Use different trustees or co-trustees. Give one spouse a noncumulative “5 and 5” power, but not the other spouse. Give one spouse a special power of appointment, but not the other. PLR 9643013. Consider these issues in planning, structuring and implementing these transactions, as well as when reporting them.
- Step-Transaction doctrine. The IRS can collapse a series of steps in a single integrated transaction and treat them as one. In 2012 one acute risk could arise in the following likely common scenario. The husband has title to most family wealth and makes a gift of $5 million to an irrevocable trust to use most of his exemption. The husband also gifts $5 million to wife which she almost immediately gifts to a trust she establishes to use most of her exemption. Was it a gift by virtue of the step transaction doctrine of husband to wife’s trust as well? This could trigger approximately a $5 million taxable gift.
- DSUEA - Portability and ordering rules Affect Gift Reporting: The $5 million 2011 and the $5.12 million 2012 “Deceased Spouse Unused Exclusion Amount” (DSUEA) is available for gifts and must be considered in planning and reporting all gifts post 2010. The issues are not simple. Are there ordering rules? So far there does not seem to be. Thus, it may be feasible to use the 2011 or 2012 DSUEA prior to using the surviving spouse’s own exemption. That would certainly be advantageous to avoid the risk remarriage and death of a new spouse would have to the prior deceased spouse’s unused exemption amount. Specifically, if the new spouse dies it will eliminate the old spouse’s DSUEA.
- Can new spouse gift split and circumvent privity rule: The privity rule prevents a new spouse from using the unused exemption from the deceased spouse. This can be illustrated more readily: If H-1 dies, W-1 can use his exclusion, but if W-1 remarries to H-2, H-2 can “inherit” W-1’s exclusion but not the exclusion H-1 “gave” to W-1. This is because of the privity rule that limits the use of unused exemptions. Some say there may be a means of circumventing this limitation through gift splitting. While it is not clear that this has been expressly prohibited it does appear to be contrary to the intent of the portability rules and practitioners should exercise considerable caution in taking this position on a gift tax return. Again, an example can illustrate: W-1 can use H-1s exclusion if she makes lifetime gifts. If W-2 remarries to H-2, can H-2 join W-1 in gift splitting? Gift splitting might arguably enable one spouse to make a large gift and have the other non-donor spouse treat the gift as if were one-half theirs. Can H-2 make a gift and have W-1 gift split thereby using some of H-1s exclusion to cover a gift by H-2? While the law is not clear, this may be a possibility. Consider carefully reporting and disclosing this position in detail on the return and in a comprehensive attached statement.
- Trust Administration Affects Gift Reporting: Practitioners report transactions that were gifts (or certain non-gift transactions like sales to grantor trusts). Reporting is based on the transaction as consummated. For example, if there was a sale, the sales contract, note from the trust to the client/seller, and other key documents will be relied upon to corroborate the transaction. However, as most practitioners are aware, many of the successful challenges by the IRS of various transactions occur as a result of the conduct of the taxpayer, trustee, and other often related parties and entities after the initial transaction is concluded. Practitioners should advise clients to meet after the gift tax return is over to discuss administration of the reported gift transactions so that the formalities of administration can be adhered to, and that if that is not done, the transactions as reported may not be respected. When a transaction is successfully challenged on audit many clients will blame the practitioners involved in the transaction, when, in perhaps a large majority of sophisticated gift transactions, it is the post-gift administrative errors and oversights that torpedo the plan. Too many practitioners view their role as one of compliance, but the follow up is essential if the manner in which a transaction is reported is not respected afterwards.
- What is a Gift: The term “Gift” under tax law definitions is broader then colloquial usage would imply. The gift tax is a tax charged on the right to give away, gratuitously, assets during your lifetime. Common usage of the term "gift" implies a donative intent; tax law does not require that you had any particular intent. All that the tax laws require to trigger the gift tax is a transfer of assets for less than full payment of value (consideration). Consider reciting that “no consideration was received in exchange for this transfer” in the transfer documents – use a gift letter to corroborate. The main issue with this broad definition is many clients will not realize the scope of what actually has to be reported as a gift. Practitioners should endeavor to explain to clients the scope of transfers that may be subject to gift tax and have the clients acknowledge that all relevant transactions were disclosed.
Is the Gift Complete: A transfer is not taxable (reportable) as a gift until complete. So practitioners should take some reasonable steps to assure that a transfer is in fact a completed gift before reporting it. To be complete, the donor must transfer beneficial interest in the assets to the recipient (donee). What does this require? What documents are used? The donor must give up “control” over the asset. An area of frequent issue with this is when the client gifts an FLP but borrows money back on a regular basis, or extracts most of the earnings as compensation without regards to the fair value of any work effort. In these cases has control been given up? To be complete the gift must be beyond donor’s recall. This might require an analysis as to whether each of the steps necessary to transfer the asset to the donee trust have been consummated, the terms of the trust and any governing documents, etc. Accountants preparing gift tax returns might need to consult with the client’s attorney to ascertain the legal status of the transactions involved. In some instances the transaction will be intentionally structured so that the gift transfer is intentionally “incomplete” in order to avoid a gift. For example, transfers to some trusts (e.g., asset protection trusts that don’t seek estate tax savings) might intentionally be incomplete. The determination as to whether a gift is incomplete can be more complex than the determination as to whether the gift is complete. A client can assure that the gift is incomplete by transferor retaining both a testamentary special power of appointment and also the right to veto any distribution proposed by the trustee. The IRS ruled in CCA 201208026 that a transfer to a trust was complete for Federal gift tax purposes where the donors retained a testamentary (exercisable at death) special power of appointment but named someone else as trustee who had the authority prior to the donors’ deaths to distribute all of the income and corpus of the trust to persons other than the donors or to distribute it to charity. These issues can be quite complex and clients may not understand the scope of the practitioner’s effort that may be necessary to ascertain the proper reporting position.
- Gifts Under Powers of Attorney: These represent another potential landmine for practitioners preparing gift tax returns. If the gifts were made by an agent, the IRS may raise issues of estate inclusion for gifts made under a power of attorney under IRC Section 2038 for federal estate tax purposes. The IRS may argue that the gifts made under a power of attorney which did not give explicit authority to the agent to make such gifts are invalid under state law and therefore revocable by the principal/decedent or a guardian ad litem appointed for such individual. Since these gifts are revocable until the individual dies, they are includible in the individual's estate. Practitioners should attach a complete copy of the power of attorney that was relied upon in making gifts. If the language is not expressly clear perhaps a memorandum of law or perhaps even an opinion as to the basis of the power of attorney document supporting gifts should be obtained. If the practitioner completing the gift tax return is an accountant, it may be advisable to involve the client’s estate planning attorney (perhaps the attorney that prepared the power of attorney under which gifts were made) to evaluate the situation.
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.
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