I am excited to share the news that I am joining PNC Wealth Management on December 28, 2010 as a Senior Wealth Planner in their Louisville office.

My colleagues at PNC will include Chris Staples, Jim Turner, and Melanie Warren, who are well known in Kentucky’s T&E Community. PNC’s Wealth Planning Group is led by Steve Pappaterra and Mark Buxton. You can learn more about the group (including its National Practice Groups focusing on various issues) here. I will be working with the Planning for Business Owners National Practice Group.

The core focus of this site - sharing and discussing recent developments in estate, tax, and financial planning – will be a very significant part of my role at PNC. In that role, I look forward to continuing the conversations and relationships with readers that have been the best part of publishing KYEstates in 2010, the incredible year when Estate Tax Repeal Actually Happened!

With colleagues at PNC, I plan to continue frequent speaking and publishing. To that end, if you are putting together a CLE program, have an article in mind, or just want to talk about an issue of interest to the T&E Community, you can always reach me at carter[dot]ruml[at]gmail[dot]com or 502.938.4184. When my contact information at PNC is available, I will also post it on KYEstates.com.

I want to mention, too, my appreciation for all of my friends and colleagues at Wyatt and in the firm’s estate planning department. My last day at Wyatt will be December 17.

In case you were wondering: no, we have not forgotten about the Estate Tax Forecasting Contest! As of today, there is still no definitive legislation (along those lines, see our March 12, 2010 prediction that has held up rather well here), so the contest is still open (and no, it’s not too late to enter). We will monitor developments closely, and as soon as we’re able to, we will eagerly award prizes (which will be great, we promise) and announce the winners.

Readers, thank you for your support for the site and for me during this first phase of KYEstates.com.

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Although the site’s material is posted as a resource for readers, KYEstates.com represents my own views. Please bear in mind that it does not represent the opinion, position, or views of The PNC Financial Services Group, Inc. or any of its affiliates (together, “PNC”) or Wyatt, Tarrant & Combs, LLP (“Wyatt”). Further, no material on this site is legal, tax, accounting, investment, or other professional advice. For more details, consult the site’s detailed disclaimer here.

You can tell your readers care about you when for four weeks you don’t post, and they begin to inquire after your health. Thank you, and your publisher is pleased to report that he is alive and very well! This has been a very busy month. No one seems to have gotten the memo that 2010 is the Year With No Estate Tax, because the phone keeps ringing. A lot. Clients keep acting like there is an estate tax. What’s more, the IRS is definitely still playing for keeps in their audits of transfer tax returns. Would the constant hum of activity suggest that (gasp) the estate tax is not going away for good?

One can’t dismiss that possibility.

Regular readers know we’ve covered “Forecasting the Fate of the Estate Tax” in some depth for a long time (for those posts, see here). Although KYEstates hasn’t hesitated to make qualitative predictions (see here for our March 12, 2010 post that continues to hold up rather well, if we do say so, all these months later), this late into the Year of Repeal, it’s time to get down to brass tacks and put some firmer numbers on the situation, don’t you think?

One obstacle immediately stands out: the estate tax is a political tax, not a revenue-raiser. (See here for an excellent brief by the Congressional Budget Office, explaining that during the last decade, the estate tax provided less than 1.5% of Federal government receipts.)  So, although it would be logical to expect that in an age of tragic(omical)ly sized deficits, the tax wouldn’t be reduced in scale and scope, politics isn’t logical. And because politics isn’t logical, it’s hard to forecast.

But that doesn’t mean markets don’t try. KYEstates thinks one of the most interesting political developments of recent years has been at the interface between politics and the capital markets, namely, political futures markets.  There are two leading political futures markets, Intrade.com and the Iowa Electronic Markets. These markets have some really fun applications, including figuring out what your estate tax exemption might be.

KYEstates has been busy at our “Skunk Works” and we are very excited to bring you our proprietary, exclusive, only-now-revealed-to-the-world POLITICAL RISK-ADJUSTED ESTATE TAX EXEMPTION FORECASTS!  We’ve prepared them for 2011-2012 and for 2013.

At KYEstates, we’re lawyers, so we definitely don’t believe all secrets should be open, but when it comes to estate tax forecasts, we do agree with Mr. Assanage that “information wants to be free”.  So, we encourage readers to dig into the actual Excel grids here. Play with them, apply your own intuition, and email us (carter {at} kyestates.com), please, with questions and comments. (Consider using your results to enter our Estate Tax Forecasting Contest.)

For readers who just want results, and only results, we’re happy to post the grids below.  In case PDF files are easier for any readers to print, they’re available here (2011-2012) and here (2013).

Readers, there is a lot of fun to be had in imminent posts in discussing the analysis in the grids, but for now, undertake your own review, and let us know what you think. Based on September 30, 2010 political futures markets, the KYEstates Political Risk-Adjusted Estate Tax Exemption Forecast is $1.71 million for 2011-2012 and $3.1 million for 2013.

Have fun with this! Happy Midterms, Happy Forecasting, and Happy Tax Planning Wishes to all of you….

It’s good to be back.

(** Just in case anyone out there doesn’t understand the intrinsic limits of political forecasting and prediction, and would mistakenly assume anything in this post is investment advice, please consult the detailed KYEstates disclaimer available here. **)

As we approach the Congressional midterm elections (still with no action on the estate tax), one often hears opinions in certain quarters that the government isn’t efficient. Studiously expressing no opinion about these claims generally, KYEstates is pleased to report that they’re untrue in at least one respect: the IRS has become very efficient at issuing Private Letter Rulings waiving the 60-day requirement for IRA rollovers in instances of “financial institution error”.  A quick scan of recent PLRs turns up at least three rulings on this issue. See PLR 201023073 (June 11, 2010), PLR 201023072 (June 11, 2010), and PLR 201022027 (June 4, 2010).

Generally, under section 408(d)(1), any amount paid out of an IRA is included in the gross income of the payee or distributee, but IRA rollovers that comply with section 408(d)(3) are an exception. That section provides that the income inclusion requirement doesn’t apply to any amount paid or distributed out of an IRA to an individual, if the entire amount received is paid into an IRA for the benefit of the individual, not later than 60 days after the individual receives the payment or distribution. (There is a similar 60–day rollover period for partial rollovers.)

This is the 60-day rollover requirement. It seems pretty straightforward, doesn’t it? Note, however, that more than 46 million Americans have IRAs. In a sample size that large, deadlines are bound to be missed. Sometimes the account holders who miss the deadlines are voters. And when the IRS claims that yes, the deadline did matter, and that yes, income tax is owed on the full amount of the distributed IRA funds not rolled over within 60 days, the voters get upset.  Some KYEstates readers may recall that when “Mr. Bigglesworth gets upset, people die!” The corollary to this near-universal truth is this: When voters get upset, legislators die. To avoid this unpleasant outcome, legislators sometimes take a break from fundraising and there-and-back photo op trips to Iraq and Afghanistan to put a leash on the IRS.

That’s what happened in 2001 with section 408(d)(3)(I), which provides that the IRS may waive the 60-day requirement under sections 408 where the “failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.”

Rev. Proc. 2003-16, 2003-4 I.R.B. 359 (January 27, 2003) provides guidance on when the IRS will grant a waiver of the 60-day rollover requirement. The IRS “will consider all relevant facts and circumstances, including: (1) errors committed by a financial institution; (2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error, (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and (4) the time elapsed since the distribution occurred.”  Rev. Proc. 2009-8 provides for a sliding fee scale: $3,000 for a rollover amount equal to or greater than $100,000, $1,500 for a rollover between $50,000 and $100,000, and $500 for a ruling on a rollover of less than $50,000.

The recent PLRs show a continuing IRS trend of leniency relating to financial institution errors.

In PLR 201023072, the institution incorrectly distributed more than the account holder’s required minimum distribution, without the account holder directing them to do so, and the account holder didn’t realize the excess distribution had been made until the 60-day period had expired.

In PLR 201023073, a taxpayer who had suffered investment losses removed funds from an IRA invested in equities, and brought the funds to another institution to invest in CDs.  That institution incorrectly deposited the funds into the wrong account, a non-IRA mutual fund.

In PLR 201022027, another taxpayer who had tired of investment losses withdrew IRA funds, intending to deposit them into a CD at a credit union. The taxpayer’s financial advisor at the first institution didn’t inform her of the 60-day rollover requirement. The taxpayer stored the check for withdrawn funds in a safe deposit box pending her return from a trip to take care of her sister. When she returned from the trip and tried to open the rollover IRA, the credit union staff said they couldn’t do so, because she’d missed the 60-day rollover period by one week.

In all three instances, the IRS granted waivers from the 60-day rollover requirement for the IRA distributions (cautioning, however, that required minimum distributions couldn’t be rolled over).

Bob Keebler of Baker Tilly provided useful commentary on exceptions to the 60-day IRA rollover requirement in this Forbes article. In contrast to the instances above, where the IRS granted waivers based on financial institution mistakes, Keebler cautioned that:

The IRS “isn’t too sympathetic when taxpayers make mistakes, unless there are extenuating circumstances, such as a taxpayers’ advanced age or incapacity. So for example, in PLR 200919071 the IRS denied a waiver to a taxpayer who admitted his failure to complete the rollover in 60 days was because he thought he had 90 days. In PLR 200738027, it turned down relief to a taxpayer whose failure to accomplish the timely rollover was due to mistakenly entering the wrong account number. And in PLR 200736036, it denied relief to a taxpayer who completed the wrong form over the Internet.

Keebler concluded that “this is a difficult area of the tax law with the IRS granting fewer and fewer favorable requests. Perhaps the moral of the story is to always use a ‘trustee-to-trustee’ transfer and to avoid the issue altogether.” KYEstates agrees with that advice.

At KYEstates, we’re happiest reporting on taxpayer victories, but if we have to report a loss, it mitigates our disappointment when the case is interesting. Anschutz v. Comm’r, 135 T.C. No. 5 (July 22, 2010), is that sort of case: an interesting taxpayer loss.  In this instance, a very expensive taxpayer loss (likely exceeding $21 million). (Out of professional courtesy, we hope the ruling is not also occasion for a correspondingly expensive claim under any legal opinions….).

Anschutz involved Anschutz Company and its sole shareholder Philip F. Anschutz, the well-known Los Angeles-based entrepreneur and natural resources investor. In the late ’90s, Mr. Anschutz needed to raise cash to fund his acquisitions of a number of professional sports venues and teams, including the Los Angeles Kings hockey team and the Staples Center in LA. Mr. Anschutz owned large equity positions in the Union Pacific railroad and Anadarko Petroleum. An investment bank, Donaldson Lufkin & Jenrette (DLJ) was only too happy to help Mr. Anschutz’s advisors consider a variable prepaid forward contract and stock lending agreement arrangement as a way to use these stock positions to raise the needed cash.

(A side note: DLJ is actually the “late DLJ”, having been absorbed into Credit Suisse First Boston in 2001.  For humorous investment banking nostalgia, see “Remember the Titans” at Leveraged Sellout.)

In 1999, Anschutz Company had made an election under Section 1362 to be taxed as an S corporation.  The Anschutz Corporation (TAC) was a qualified subchapter S subsidiary (“Q-sub”) of Anschutz Company.  TAC was the entity that entered into the transactions with DLJ in 2000 and 2001.  Because TAC was a Q-sub of Anschutz Company, the consequences of the income tax treatment of TAC’s transactions with DLJ directly affected Mr. Anschutz’s personal income tax return.

Before reviewing the structure of the transactions with DLJ, let’s consider the bigger picture, shall we?  Because the S-elections had been made in 1999, in 2000 and 2001 both TAC and its parent were within the 10-year built-in-gains period under Section 1374, an exception to the general pass-through rule for S corporation taxation. Section 1374(a) imposes a corporate-level tax on the net recognized built-in gain of an S corporation that has converted from C corporation to S corporation status. (The built-in gain is measured by the appreciation of any asset over its adjusted basis at the time the corporation converts from C corporation to S corporation status.)

TAC’s equity holdings had substantial built-in gains.  An outright sale of the equities would trigger these built-in gains.  A transaction promising to raise cash in relation to the equity positions without triggering a sale for income tax purposes (and thereby avoiding the undesirable double taxation of the built-in gains, once at the corporate level and then again at Mr. Anschutz’s level) would be very attractive.

That’s the sort of transaction DLJ was pitching.

Let’s consider how the transaction worked. It involved three classes of documents: a master stock purchase agreement (MPSA), prepaid variable forward contracts (PVFCs), and share lending agreements (SLAs) [Readers who enjoy playing Trivial Pursuit, if you thought of Patty Hearst when you saw "SLA" just now, you're not alone]. The Tax Court explained PVFCs as follows:

A forward contract is an executory contract calling for the delivery of property at a future date in exchange for a payment at that time. A PVFC is a variation of a standard forward contract. In a typical PVFC, a securities owner (the forward seller) holding an appreciated equity position enters into a forward contract to sell a variable number of shares of that equity position. The purchaser prepays its obligation under the PVFC to purchase a variable number of shares on a future date. At the maturity date of the contract, the forward seller will settle the contract by delivering either: (1) Shares of stock that had been pledged as collateral at inception of the contract; (2) identical shares of the stock; or (3) cash. Typically the number of shares or the amount of cash to be delivered at maturity is determined at or near the contract maturity date according to the market price of the stock at issue.

For readers who do best with examples rather than descriptions, the Tax Court was happy to provide this example of a PVFC:

Consider a taxpayer holding 100 shares of Corporation X stock, trading at $10 per share. The taxpayer enters into a PVFC to deliver a number of shares in 1 year and receives a $1,000 upfront cash payment. If the stock is trading at $10 or below, the taxpayer must deliver all 100 shares. If the stock is trading at $20, the taxpayer must deliver 50 shares or $1,000 cash.

The Tax Court described SLAs as follows:

Share-lending agreements are often entered into by equity holders who have taken a long position with respect to a stock and plan on holding it for an extended period. The equity owner can agree to lend the stock to a counterparty, who can then use the borrowed shares to increase market liquidity and facilitate stock sales….The borrower will normally pledge cash collateral, and the lender will derive a profit lending the shares by retaining a portion of the interest earned by this cash collateral. At the end of the lending period, the counterparty will return the borrowed shares to the equity owner/lender.

So much for the general approach, right?  In this particular transaction, the PVFCs required DLJ to make an upfront payment to TAC equal to 75 percent of the fair market value of the shares subject to the PVFCs, which had durations between 10 and 11 years.  In addition, TAC was allowed to retain the first 50% of the appreciation in the shares subject to each PVFC during the PVFC term. The MPSA required TAC to pledge collateral in exchange for the upfront cash payment under the PVFC. The pledge agreements by which TAC carried out this obligation further required Wilmington Trust Company (which was acting as TAC’s collateral agent) to enter into SLAs with DLJ. TAC received a prepaid lending fee equal to 5% of the fair market value of the shares lent under the SLAs.  The SLAs allowed TAC to recall shares it had loaned to DLJ, but if TAC did so, it would have to return a pro rata portion of the prepaid lending fee.

Before entering into its transactions with TAC, DLJ had entered into short sales corresponding to the equity positions TAC was going to put into the PVFCs.  The Tax Court cogently noted that these “short sales in effect hedged DLJ’s risk on the forward contract, because the short sales protected DLJ from a decrease in stock value during the term of the PVFC….If the fair market value of stock subject to the PVFCs dropped over the course of the contract, the short sales would earn a profit; if the fair market value increased, the PVFCs would earn a profit.”

In the transactions, TAC received upfront payments under the PVFCs exceeding $350 million, and prepaid lending fees under the SLAs exceeding $23 million.

So, readers, those are facts and the stakes.

The taxpayers treated the PVFC portions of the MPSA as open transactions and not as closed sales of stock, and therefore reported no gain or loss from the stock transactions on S corporation or personal income tax returns. In its notice of deficiency, the IRS claimed that TAC had entered into closed sales of stock, and was liable for Section 1374 built-in gains tax in 2000 and 2001 by the amount that the sale proceeds exceeded TAC’s basis in the stock (which was, predictably, pretty darn low). The IRS also claimed that the amount of built-in gain (less the tax on that gain) should have flowed through to Mr. Anschutz’s personal income tax return, causing deficiencies on that return. The taxpayers petitioned.

The Tax Court summarized the government’s argument as follows:

Respondent argues that TAC’s transfers of stock during 2000 and 2001 should be treated as closed transactions for Federal tax purposes. His argument comprises three parts: (1) TAC transferred legal title and the benefits and burdens of ownership; (2) the SLAs are not true lending arrangements, but a way for TAC to deliver the shares of stock to DLJ; and (3) TAC transferred the shares to DLJ in exchange for an ascertainable amount of consideration equal to 100 percent of the fair market value of the stock.

The IRS argued that the consideration was 100% (rather than the 75% upfront PVFC amount plus the 5% lending fee, for a total of 80%), because TAC was entitled to retain 50% of the appreciation in the stock subject to the PVFCs during the term of the PVFCs, as well as any dividends, and that these rights could be valued as equity options.  The IRS claimed that along with DLJ’s fees for structuring the transaction, these options were worth the 20% difference between the 80% upfront receipts to TAC and the full fair market value of the stock.

The taxpayers argued that TAC executed two separate transactions, one by the PVFCs, and the other by the SLAs, and that the transactions were open, not closed, with the result that no sale had occurred.

The Tax Court didn’t agree:

We agree with respondent that the shares subject to the VPFCs and lent pursuant to the SLAs were sold for Federal income tax purposes. TAC transferred the benefits and burdens of ownership to DLJ in exchange for valuable consideration. Petitioners must recognize gain in an amount equal to the upfront cash payments received upon entering into the transactions.

TAC entered into an integrated transaction comprising two legs, one of which called for share lending. The transaction comprised PVFCs and SLAs. The two legs were clearly related and interdependent, and both were governed by the MSPA.

It probably wasn’t helpful for the taxpayers that, as the Tax Court noted, presentations by DLJ provided an overview of the transaction as a whole, and stated that DLJ would borrow shares from TAC pursuant to the SLAs to cover its initial short sale obligation.

The Tax Court explained its holding as follows:

If we analyze the MSPA as a whole, it is clear that TAC transferred the benefits and burdens of ownership, including: (1) Legal title to the shares; (2) all risk of loss; (3) a major portion of the opportunity for gain; (4) the right to vote the stock; and (5) possession of the stock….TAC transferred all risk of loss and most of the opportunity for gain with regard to the stock subject to the PVFCs and lent to DLJ. TAC received 75 percent of the cash value of the stock up front. Even if the stock value fell over the term of the PVFCs, TAC would not have to pay any of this amount back. DLJ could do with the lent stock whatever it wanted and in fact disposed of the stock almost immediately to close out its original short sales….Petitioners’ argument might hold true if the SLAs were separate and distinct from the PVFCs. However, the two are linked, and we cannot turn a blind eye to one aspect of the transaction in evaluating another.

The overall outcome for the taxpayer was bad.  But the loss wasn’t total: the IRS lost its argument that TAC had realized 100% of the fair market value of shares subject to the PVFCs. Instead, the Tax Court found that although:

certain portions of TAC’s contracts can be valued as equity options representing TAC’s entitlement to some appreciation in price and future dividends, whether petitioners will ever receive that value will not be determined until the contracts are settled….Accordingly, petitioners must recognize gain to the extent TAC received cash upfront payments in 2000 and 2001, which would include the 75-percent payment based upon the fair market value of shares and the 5-percent prepaid lending fee.

The IRS also claimed, in the alternative, that TAC had caused constructive sales of the stock at issue under Section 1259.  The Tax Court disagreed with this argument, because TAC had eliminated its risk of loss through the PVFCs, but not its opportunity for income or gain.  Unfortunately, this conceptual win for the taxpayer didn’t change the practical result, because the IRS had won its first argument.

Anschutz is a significant decision because it may affect strategies high net worth individuals commonly use to hedge concentrated stock positions or avoid built-in gains tax from S corporations converted from C status within the previous ten years.  Further, Anschutz undercuts the positive treatment of prepaid variable forward contracts in Rev. Rul. 2003-7.  Advisors helping clients evaluate prepaid variable forward arrangements should note Anschutz carefully. Beyond the case’s particular facts, it also shows the broader risk of related transactions explained and “marketed” as a whole later being treated in like manner by the Tax Court.  If this unified treatment would be undesirable, one lesson of Anschutz is to be very careful in the creation and distribution of written materials that would suggest that separate transactions are part of a unified overall plan.

As noted by Prof. Paul Caron’s TaxProfBlog, David Cay Johnston argued in this blistering Tax Notes opinion piece that the Anschutz decision can be read for the proposition that the variable prepaid forwards arrangement would have passed muster if only DLJ hadn’t obtained the shares it needed to sell short to hedge its exposure under the VPFCs from Mr. Anschutz via the SLAs – and had rather obtained the shares it needed to sell short in the open market, from someone else.  Sourcing the short sale shares from a third party would have increased fees on the transaction by $1m to $1.8m, but this would have been a rounding error on the deal and only slightly offset the income tax savings. Johnston suggests that the IRS may have won the battle in Anschutz while losing the war against variable prepaid forwards more generally, at a cost of over $35 billion to the fisc.

By comparison, as Jeffrey Skatoff noted, the Congressional Budget Office has estimated that estate and gift taxes will raise only $15.4 billion in 2010. The revenue effects of variable prepaid forwards are over twice that of the entire transfer tax system, and yet variable prepaid forwards produce negligible political theatre, Senate votes, or think tank articles. It’s a Lewis Carroll kind of moment out there, readers, where things are getting “curiouser and curiouser” as we move through 2010, the year when estate tax repeal actually happened.

Anyone who has been following Elena Kagan’s confirmation hearings is up to speed on the judicial activism/strict construction debate. Strict construction of an exclusion from taxable income powered a notable win for the IRS in Gates v. Comm’r, 135 T.C. 1 (July 1, 2010), a very interesting income tax case that will have implications for private clients at all wealth levels.  Gates involved Section 121, which allows exclusion of gain from the sale of property owned and used by the taxpayer as the taxpayer’s principal residence for two of the five years preceding the sale. (The excludible amount of gain is $250,000 for single filers and $500,000 for a husband and wife who file a joint return.)

Gates held that taxpayers who tore down their house (after living in it for at least two of the five years before it was torn down), and then built a replacement house on the same land, but sold the new house without living in it, could not exclude their capital gain on the sale from their taxable income.

In this case, Mr. Gates had purchased a modest 880 square foot residence in 1984 in California for $150,000.  In 1989, Mr. Gates married Mrs. Gates, and the couple lived in the house for at least two years from August 1996 to August 1998.  In 1996 the petitioners decided to enlarge and remodel their house, and hired an architect.  After reviewing building and permit restrictions enacted since the original house was built, they demolished their original house and built a new three-bedroom house on the property.

The Tax Court’s opinion noted that:

The footprint of the new house has a very different shape from that of the original house, and it appears to be two to three times larger than the footprint of the original house. Only about one-half of the land area of the original house overlaps with the land area covered by the new house, and no part of the original foundation perimeter corresponds to the foundation perimeter of the new house.

In April, 2000 Petitioners sold the new house for $1.1 million. At the time of the sale, petitioners had never resided in the new house. The record shows that the sale resulted in a $591,406 gain to petitioners. On a 2000 return that was not timely filed, the petitioners excluded all of this capital gain from their income. They later agreed that at least $91,406 of the capital gain should have been taken into 2000 gross income, but argued that the remaining $500,000 gain was excludible from their income under Section 121. The IRS sent a notice of deficiency in 2005, increasing petitioners’ 2000 income by $500,000 and claiming that petitioners had failed to establish that any gain on the sale of the property was excludible under Section 121.

The Tax Court explained its statutory construction task for Section 121 as follows:

The issue presented arises from the fact that section 121(a) does not define two critical terms–“property” and “principal residence”.  Section 121(a) simply provides that gross income does not include gain from the sale or exchange of property if “such property” has been owned and used by the taxpayer “as the taxpayer’s principal residence” for the required statutory period.

The IRS argued that “petitioners did not sell property they had owned and used as their principal residence for the required statutory period because they never occupied the new house as their principal residence before they sold it,” because the term “property” meant a “dwelling that was owned and occupied by the taxpayer as his “principal residence” for at least 2 of the 5 years immediately preceding the sale.”

The taxpayers argued that the Section 121(a) exclusion applies to gain on the sale of property that was used as the taxpayers’ principal residence, and focused on two facts. First, they had used the original house as their principal residence for the required period.  Second, they had sold the land on which the original house had been situated. The taxpayers argued that the “term ’property’ includes not only the dwelling but also the land on which the dwelling is situated,” and that they could satisfy Section 121′s requirements by living “in any dwelling on the property for the required 2-year period even if that dwelling is not the dwelling that is sold.”

Because Section 121 does not define the terms “property” and “principal residence”, the Tax Court undertook a statutory construction exercise, reviewing the plain meaning of the terms and legislative history dating as far back as 1951. Based on this review, the Tax Court concluded that:

The legislative history demonstrates that Congress intended the term “principal residence” to mean the primary dwelling or house that a taxpayer occupied as his principal residence.  Nothing in the legislative history indicates that Congress intended section 121 to exclude gain on the sale of property that does not include a house or other structure used by the taxpayer as his principal place of abode.  Although a principal residence may include land surrounding the dwelling, the legislative history supports a conclusion that Congress intended the section 121 exclusion to apply only if the dwelling the taxpayer sells was actually used as his principal residence for the period required by section 121(a).

Of course, once the Tax Court reached this conclusion, it became pretty clear that this opinion would be bad news for Mr. and Mrs. Gates, and for other taxpayers not excited about historic preservation.  The Tax Court might even have felt sorry for Mr. and Mrs. Gates, but it had a job to do:

Although we recognize that petitioners would have satisfied the requirements under section 121 had they sold or exchanged the original house instead of tearing it down, we must apply the statute as written by Congress.  Rules of statutory construction require that we narrowly construe exclusions from income. Comm’r v. Schleier, 515 U.S. at 328.  Under section 121(a) and its legislative history, we cannot conclude on the facts of this case that petitioners sold their principal residence. Accordingly, we hold that petitioners may not exclude from income under section 121(a) the gain realized on the sale of the … property.

Readers may immediately spot some problems with the Tax Court’s decision.  If Gates is taken for the proposition that there is no “tacking” on the 2-of-5-year Section 121 requirement for a teardown, but that there is for renovations, what about the predictable line-drawing problems in defining where renovation ends and teardown begins? These sorts of problems were highlighted in a dissent from Judge Halpern: “The majority’s report will undoubtedly raise … remodeling versus rebuilding questions….  I think that the better course would be to avoid provoking those questions.”

The dissent (in which Judge Mark Holmes, previously featured in KYEstates, joined) advanced its argument with a sympathetic hypothetical (e.g., hurricanes in Florida — tornadoes in Kentucky?):

…consider a taxpayer whose longtime home is demolished by a natural disaster (a hurricane).  The taxpayer lacks insurance.  Nevertheless, she rebuilds on the same land (perhaps a bit further from the ocean) and lives in the rebuilt house for 18 months, and then she sells the house and land at a gain.  Although the taxpayer satisfies the property use condition, I assume that, nevertheless, under the majority’s analysis, she gets no exclusion because she fails the temporal condition; i.e., she has not lived in the rebuilt house for 2 or more of the last 5 years.  I assume further that, if her house had been only damaged (and not demolished), and she repaired it, she would get an exclusion.  That seems like an untenable distinction to me.

Judge Cohen wrote a concurrence to the majority opinion, and rebutted the dissent’s “future consequences” line of argument:

The dissent objects to the result and argues that the majority’s analysis in this case will distort the result in other cases in which the taxpayer should qualify for the section 121 exclusion. The response to this argument is straightforward–it is not this Court’s job to anticipate and decide cases that are not yet before it. We may reach a different conclusion in cases involving different facts if and when the opportunity arises, but we should not distort the result in this case by anticipating those cases.

The dissent, however, didn’t believe this much judicial restraint was advisable:

It is no answer to that criticism to say, as Judge Cohen does, that it is not the Court’s job to anticipate and decide cases that are not yet before it.  We are a national court that treats its own cases as precedent until we overrule ourselves by action of the Court Conference.  This case (and my arguments) have been before the Court Conference.  We should recognize, as no doubt the Commissioner and taxpayers will, the weight that the analysis in this case will carry in similar situations under principles of stare decisis.

Because the dissent didn’t carry the day, Gates has immediate consequences for private clients throughout the United States who tear down their houses, and build new homes on their property. After Gates, if a job change, family illness, or other unpredictable event requires the homeowner to move within two years of building the new house, the Section 121 capital gain exclusion is jeopardized. This means that any demolition decision should incorporate an assessment of capital gains tax risk. Attorneys, trust officers, wealth managers, and accountants who work with any clients tearing down a home – please warn them about Gates.

Thanks to KYEstates reader Chris Staples of PNC Wealth Management in Louisville for alerting us to this significant and interesting case.

]]> http://kyestates.com/2010/07/25/tax-man-likes-home-additions-tear-downs/feed/ 1 http://kyestates.com/2010/07/25/tax-man-likes-home-additions-tear-downs/ http://feedproxy.google.com/~r/KYEstates/~3/L3KaAPsrygA/ http://kyestates.com/2010/07/24/happen-income-taxes-2011/#comments Sat, 24 Jul 2010 19:06:10 +0000 Carter Ruml http://kyestates.com/?p=1198

On the estate tax front, it’s been a Macbeth/Faulkner fortnight in Congress – full of sound and fury, signifying nothing. Meanwhile, however, the clock is also ticking on expiration of the 2001 and 2003 Bush tax cuts, potentially affecting many private clients and business owners. To that end, readers may be quite interested in the link Paul Caron at TaxProfBlog posted to a useful online calculator from the Tax Foundation (a self-described nonpartisan research group in Washington, DC… that actually does seem to be reasonably nonpartisan).

The calculator, available directly at MyTaxBurden.org, allows the user to compare tax results under any given level of income, dependents, and deductions for three scenarios: 1) full expiration of the Bush tax cuts at the end of 2010; 2) the Bush tax cuts are made permanent; and 3) the Bush tax cuts expire, and the Obama administration proposals are adopted.  For a great chart that compares various income tax parameters under the three scenarios, visit here. To get a quick sense of what is at stake, review the tax bracket chart here.  The “married filing jointly” bracket schedule is below:

A quick glance at the table above shows that compared to extension of the Bush tax cuts, the Obama Administration’s proposals disadvantage married joint filers with taxable income above $235,550.  The only substantial fear for taxpayers with taxable incomes below $235,550 is Congressional gridlock that leads to full expiration of the Bush tax cuts (the complete list of the tax provisions that will expire if no action is taken is here).

In a separate report by William Ahern, however, the Tax Foundation forecasts that full expiration of the 2001/2003 Bush tax cuts is unlikely:

The probability that Congress will just let all those tax cuts expire at the end of 2010 is small. The result would be a massive tax hike on middle-income people because the Bush tax cuts have been worth about $2,200 in tax savings each year for the median family of four.

The most likely scenario is what President Obama has outlined in his budget: that the majority of the Bush tax cuts will be kept, but the ones that benefit couples who earn over $250,000 and singles making over $200,000 will either be allowed to revert to their higher, 2001 levels, or they will be raised in some other fashion.

Readers, although our primary focus for now is transfer taxes and this dramatic year when estate tax repeal actually happened, we’ll continue to monitor the income tax situation, too, and keep you posted.

Although normal activity in much of Louisville seems to be temporarily suspended this weekend due to one of the most impressive logistical enterprises since the Berlin Airlift, the children’s swimming City Meet, the T&E Community still needs tax updates, and KYEstates is happy to share this report on Matthies v. Comm’r, 134 T.C. No. 6 (Feb. 22, 2010). In Matthies, the Tax Court ruled against taxpayers who had used a IRA funds to buy life insurance through a “Pension Asset Transfer” plan marketed by a life insurance underwriter.

New Jersey tax attorney Maureen P. Dougherty explained what the taxpayers had hoped to achieve in the transaction quite nicely:

Taxpayer had accumulated substantial funds in an IRA account. If taxpayer did nothing, the funds in the IRA would be subject to income tax if withdrawn during taxpayer’s lifetime, would be includable in taxpayer’s estate to the extent remaining at his death and would retain that taxable character in the hands of his beneficiaries after his death. When offered an opportunity to avoid these tax outcomes, taxpayer undertook the … PAT strategy to move funds out of his IRA … into a second to die life insurance policy held in an existing Irrevocable Life Insurance Trust. If the strategy worked all income, gift and estate taxes would be avoided.

Florida tax attorney Charles Rubin provides a nice description of the PAT strategy to avoid income and transfer taxes on IRA funds:

While there are variations, the typical arrangement involved the creation of a pension plan in a closely-held entity, which received a roll-over distribution from the taxpayer’s IRA. The plan would then purchase a substantial life insurance policy. A feature of the policy would be that the insurance company would receive a substantial surrender charge if the policy was surrendered. The policy would then be sold to an insurance trust established by the taxpayer, removing the policy from the pension plan. The insurance trust would be buying the policy at a substantial discount in price – getting the insurance out of the pension plan at a reduced cost, and thus moving assets out of the plan without incurring an income tax. The insurance trust would often then convert the policy to one that did not have the surrender charge feature.

As Rubin explains: “The planning makes sense in theory. However, as one would expect, the IRS was not pleased with the technique.”

And so the hammer dropped on the taxpayers in Matthies, who closely followed the general transaction format described by Rubin. First, the taxpayers established a wholly-owned S corporation, “Bellagio Partners, Inc.”  Five days after forming the S corporation, the taxpayers a profit-sharing plan for it, based on the insurance company’s prototype plan. The taxpayers were the sole trustees and committee members for the profit-sharing plan, which received a favorable determination letter from the IRS in October, 1999 (about one year after it was formed).

Meanwhile, in January 1999 the profit-sharing plan had purchased a second-to-die insurance policy in the face amount of $80 million. In 1999 and 2000, the taxpayer made two separate transfers of $1.25 million each from his IRA to the profit-sharing plan.  In turn, the profit-sharing plan made two separate insurance policy premium payments of $1.25 million. In late December 2000, the profit-sharing plan transferred the insurance policy to the taxpayer. In exchange, on the same day, the taxpayer transferred approximately $315,000 to the profit-sharing plan. In January 2001, the taxpayer transferred ownership of the policy to an ILIT. One day after the transfer, the ILIT exchanged the policy for a different survivorship policy issued by the same insurance underwriter with a face value of almost $19.5 million.  Perhaps not surprisingly, the insurance company waived surrender charges on the exchange of the policy, and the replacement policy had no surrender charges. The insurance company accepted the full account value of the old policy (without surrender charge) as payment in full of the single premium due on the replacement policy. Thereafter, no premiums were paid on the replacement policy.

At the time the profit-sharing plan transferred the policy to the taxpayer, the policy’s account value was approximately $1.37 million. The policy, however, was subject to a surrender charge of approximately $1.06 million, with the result that the policy’s cash value net of surrender charges was approximately $315,000.

When the taxpayers filed their income tax returns for the year of the policy transfer, they reported no income from the transfer of the policy from the profit-sharing plan to the taxpayer. In its notice of deficiency, the IRS argued that the taxpayers had approximately $1.05 million in gross income from the transfer of the insurance policy and were liable for $59,000 in accuracy-related penalties under § 662(a).

The Tax Court succinctly identified the issue in dispute between the taxpayers and the IRS: “The nub of their disagreement is the proper valuation of the insurance policy as of the date it was transferred to petitioner…the parties disagree as to whether in valuing the insurance policy, reduction should be made for the surrender charge.”

The Tax Court discussed life insurance valuation regulations (see, e.g., T.D. 9223, 2005-2 C.B. 591) under § 402(a) in effect before and after 2005.  (Rubin provides a useful summary of those regulations here.)  It then reviewed general principles under § 61(a) and the bargain-sale rule of Comm’r v. LoBue, 351 U.S. 243 (1956).

The Tax Court then began to apply its analysis to the facts of the case, and it wasn’t hard to tell where the Court was going.  Observing that the “transfer from the profit-sharing plan to petitioner was pursuant to a prearranged plan for him to use IRA funds to buy life insurance through the profit-sharing plan, which was established for this purpose and with the expectation that it would shortly thereafter distribute the policy to petitioner,” it concluded that the “transaction was in no sense arm’s length,” and had been undertaken with the “objective of minimizing petitioners’ taxes on the transfer of the insurance policy to petitioner”.

Accordingly, the Tax Court concluded that “insofar as petitioner purchased the life insurance policy from the profit-sharing plan at a bargain price, the bargain element is includable in his gross income pursuant to section 61.”

To find the amount of the bargain sale, the Tax Court then evaluated whether the insurance policy’s value at the time of the transfer included the surrender charge.  The Court found that it did, citing § 7702(f)(2)(A), which defines the “cash surrender value” of a life insurance contract as the “cash value determined without regard to any surrender charge.”

Although it did not expressly cite the economic substance doctrine, the Tax Court was clearly influenced by the substance of the transaction because it noted the fact that the insurance company had credited the ILIT for the amount of a single premium payment on the replacement policy that included the surrender charge, only two weeks after the profit-sharing plan had transferred the policy to the taxpayer.

Therefore, the Tax Court found that the taxpayer had paid the profit-sharing plan $1.05 million less for the life insurance policy than its value of $1.37 million at the date of the transfer, and that this bargain element of the sale was includible in the taxpayer’s gross income pursuant to section 61.

The outcome for the taxpayer could have been worse. Because the Tax Court had not previously addressed the tax treatment of a bargain sale of a life insurance policy under § 61 or § 402(a) or the definition of “entire cash value” under the applicable regulations, it found that the taxpayers had a reasonable basis for their return and declined to impose accuracy-related penalties.

Matthies calls to mind the old adage that “there’s no such thing as a free lunch.”  (Non-Roth) IRA balances are ordinary income, and the IRS wants to be sure it ultimately has the opportunity to tax that income. Shifting IRA balances into life insurance and then temporarily depressing the value of that life insurance based on surrender charges that then aren’t actually applied by the insurance company….if you were an IRS agent, wouldn’t that seem somewhat abusive to you?  (At the very least, it invites an economic substance attack.) At KYEstates we support creative tax planning, but we’re not surprised at the outcome in Matthies. Occasionally, the IRS does have to win at least a case or two, and it doesn’t seem unreasonable that they won this case under these facts.

It may be a lazy summer day in the Eastern United States, but not on the transfer tax news front.

The Hill reports here and Pat Lynch’s blog reports here that Senators Kyl and Lincoln introduced legislation late on Tuesday, July 13 that would require the Senate Finance Committee to amend to amend H.R. 5297 (the Small Business Lending Fund Act of 2010) to permanently set the estate tax rate at 35%, with a $5m exemption amount phased in over 10 years and indexed for inflation.

The bill would also provide a stepped up basis for inherited assets.

It is not often that the GWOT affects the world of T&E law, but  the Supreme Court’s June 21 6-3 opinion in Holder v. Humanitarian Law Project, 561 U.S. ____ (2010) is an exception to the general rule. The opinion upheld the Patriot Act provision providing for fines and up to 15 years’ imprisonment for persons who knowingly provide material support or resources to groups designated as foreign terrorist organizations by the Secretary of State. For purposes of the statute, “material support and resources” includes lots of sketchy and obviously terrorist things like explosives, weapons, and safehouses. Relevantly for charitable donors, however, it also includes any property, tangible or intangible.

Humanitarian Law Project involved a law professor and others who wished to provide instruction to Kurdish separatists (the PKK) and the Tamil Tigers (in Sri Lanka) on how to advance their objectives through international law and other (allegedly) peaceful means. The Court noted that some terrorist groups conduct both peaceful and violent activities, but that the violent activities may so taint the organization that “any contribution to such an organization facilitates [the criminal] conduct.”

Milton Cerny, Mark Brzezinski, and Michele A.W. McKinnon at McGuire Woods note in their useful white paper on international charitable giving and estate planning that Humanitarian Law Project means that ”any provision of charitable assistance to a terrorist organization, including humanitarian aid, would be considered ‘material assistance’ precluded by Federal law until the Court rules otherwise.”

Most clients’ charitable plans aren’t affected by the Supreme Court’s opinion, but any client making international charitable contributions now needs to be mindful not only of deductibility issues, but also staying out of jail. The Secretary of State’s list of terrorist groups is available here. In addition to the usual suspects in Palestine and Our Friends the Saudis, the list also includes Basque, Irish, and Colombian groups.

It’s been said, perhaps too glibly, that one man’s terrorist is another man’s freedom fighter (e.g., here and here). Without ignoring the reality of the terrorist threat, it’s fair to describe Humanitarian Law Project as a broad decision that, in its pursuit of national security objectives, opts to basically regard everything a terrorist does as terrorism. (Consider whether this is the national security law equivalent of the “collateral source rule” many readers learned in Torts during 1L year?) The breadth of the opinion concerned Justices Breyer, Ginsburg, and Sotomayor (their dissent is here).

We can’t know which group will be responsible for a future terrorist attack. It’s not impossible that a client who had given to such a group before an attack on the US could face very serious questions, risks, and criminal prosecution after the fact, even if the client had only been a fellow traveler, at most. For the time being, caution should be the order of the day for any possibly questionable international contributions, and the State Department list should be consulted before any gift is made.