Kansas State Contact Information University Income Tax...

Kansas State University Income

Tax InstitutesPittsburg, Kansas

December 15, 2016Roger A. McEowen

Kansas Farm Bureau Professor of Agricultural Law and Taxation, Washburn University School of Law

and

Ross I. Hirst

IRS Senior Stakeholder Liaison, Kansas, Retired

Contact Information

[email protected]

Also: www.washburnlaw.edu/waltr

Blog: http://lawprofessors.typepad.com/agriculturallaw/

Twitter: @WashburnWaltr

5-Years Old

Day 2 AgendaNew Developments – A247-A279 and A293-A302

(Roger)IRS Update – A185-A245 and A280-A292 (Ross)

Wealth Accumulation – B183 – B224 (Roger)Agricultural Issues and Rural Investments – A303-A352

(Roger)Individual Taxpayer Issues – B24-B28 (Roger); B29-B57

(Ross)Small Business - B72-B98 (Roger)

Rulings and Cases -

Extender Bill (Dec. 17, 2015)• Enhanced child tax credit made

permanento The Act permanently extends the threshold for

determining the portion of the child tax credit that is refundable at $3,000.

o The dollar amount will not be indexed for inflation. o Effective for taxable years beginning after the date of

enactment (December 18, 2015).

6

A247-248

Extender Bill• Enhancements:

o AOTC made permanento Enhanced EITC made permanento Extension and permanency of schoolteacher deduction

$250 amount indexed for inflation after 2015 and can include “professional and development expenses”

o Extension of deduction of state and local general sales taxes in lieu of state income taxes (made permanent)

o Extension and modification of rule for contributions of capital gain real property made for conservation purposes (made permanent)

7

A248

Extender Bill

• Enhancementso Charitable conservation easements

15-year carryforward 50% of AGI; 100% for farmers

A250

Extender Bill

• Extension of tax-free distributions from IRA to charity for taxpayers age 70.5 and older (made permanent)• Benefit if not itemizing• Not an increase to AGI causing phase-outs of

benefits• Reduce effect of NIIT?

A250

Extender Bill• Extension and modification of provision that

excludes from gross income discharge of qualified principal residence debto $2 mill. Limit (MFJ)o Effective for 2015 and 2016

• Extension of mortgage insurance premiums treated as qualified residence interest through 2016

10

Extender Bill

• Extension of above-the-line deduction for qualified tuition and related expenses through 2016

A251

Extender Bill

• Research credit permanento Offsets AMT in 2016 and after if < $50 mil. gross Average annual gross receipts Prior three years Gross receipts test at pass-through entity and owner level

o Offsets payroll taxes in 2016 and after if < $5 mil. gross receipts in current year Must have <$5 million gross receipts in prior 5 years Corporation and partnership determined at entity level Elect by due date including extensions

A252

Extender Bill

• Permanent extension of 15-yr straight-line cost recovery for…o Qualified leasehold improvementso Qualified restaurant buildings and improvementso Qualified retail improvements

13

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Extender Bill

• Extension and modification of I.R.C. §179o $500,000 for 2016 (and made permanent)o Phase-out starts at $2 mill. of qualifying purchaseso Indexed to inflation in $10,000 increments for future years

Indexing starts in 2016 ($2,010,000 for 2016) Applies to both the $500,000 and $2 mill. amounts

o Air conditioning/heating units eligible for 2016 and later

14

A255

Extender BilloUp to $250,000 of $500,000 of the Sec. 179

amount on 15-year realty (for 2015; $500,000 (indexed) thereafter) Qualified leasehold improvement property Qualified retail improvement property Sale of 15-year real estate = Sec. 1245 on Sec. 179

oAbility to make or revoke Sec. 179 election on amended return made

A255

Extender Bill• Extension of exclusion of 100 percent of gain on certain

small business stock > 5 years (made permanent) Not available for farming business Is available for agribusiness activities

• Processing• Retailers, wholesalers

o Non-corporate taxpayers o Stock acquired after September 27, 2010, and held

for more than five years (temporary)o Gain does not count as an AMT preference item. o Effective for stock acquired after December 31, 2014

(permanent)16

A255-256

Section 1202 Benefits• Use Section 11 tax rates, rather than Section 1

o Top rate effectively 34%o No NIITo But no capital gain benefit

• Build equity• Don’t pay dividends

o Dividends reduces benefit of strategy• Don’t hold appreciating assets• Ultimate liquidation tax-free to original issuee

o Recipients of giftso Heirso Corporate level tax still applicable

Extender Bill• Extension of reduction in S-corporation

recognition period for built-in gains tax (made permanent)o 5 years for tax years beginning after 2014o Year of election doesn’t matter

• Pre-existing installment sales continue to be governed by the holding periods for the years of sale.

• Effective for taxable years beginning after December 31, 2014.

18

A256

Extender Bill• WOTC

o Extended through 2019 New group in 2016: unemployed at least 27 consecutive

weeks Compliance deadline for Forms 8850 is June 29, 2016 for

2015 and 2016 employment

Extender Bill

• Bonus depreciationo Made retroactive and extended through 2019o 50% for 2015-2017o 40% for 2018o 30% for 2019o 0% for 2020 and thereafter

20

A257

Extender Bill

• Bonus Depreciationo 15-year qualified leasehold improvements qualify But not restaurant or retail improvement property

o Effective starting 1/1/16, interior building improvements qualify Interior improvements to non-residential realty Improvement after building placed in service Not an enlargement, elevator/escalator or structural IRS guidance for fiscal and short-year filers who did not claim 50%

bonus

Extender Bill

• Effective 1/1/16, may elect bonus for fruit/nut plants at planting/grafting vs. when productiveo Rev. Proc. 2015-48

Extender Bill – more permanency

• S corporation charitable asset contribution reduces shareholder basis by basis of property, not FMV deduction

Extender Bill – S Corp. Charitable Asset Contribution Provision

• Strategy for the charitably inclined with respect to land Donate corporate land to charity

• Deduct FMV• Basis in stock is decreased by basis in land

Individual shareholder buys land from charity Follow concepts of Rev. Rul. 78-197 and Palmer case Cannot have binding agreement to repurchase Follow all charitable contribution rules

• Appraisal deadlines• Acknowledgement and receipt

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Extender Bill - Above-Basis Deduction for Food Inventory

• Made permanent• Any entity allowed (C, S, partnership,

individual)• Income limit to 15% beginning in 2016

o C corporation – taxable incomeo Others – net income from the business from which

contribution made• Donation to organization which uses food in its

exempt functiono Food bank

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Basis Determination

• If zero basis grower, deem basis = 25% FMV for food ready for human consumption (Sec. 170(e)(3)(C))o FMV determined without regard to internal standardso Considering price at which type and quality are sold

at the time of contribution• Result: 50% of FMV (2 x basis)• Example of use:

o Grower/packer/shipper

Extender Bill – Other Provisions• Delays “Cadillac tax” until 2020 and makes it

deductible (I.R.C. §4980)• Eliminates annual fee on health insurance

providers for 2017• Credit for wind facilities extended through 2019

(with phase-down for 2018 and 2019)• Extend solar energy credit through 2021, with

phase-out beginning in 2020• Extends 2 of the 5 energy credits through 2021

and 3 of them through 201627

A258-259

Extender Bill – Other Provisions

• 1099-Misc and W-2 due dateo January 31

• Safe harbor from penalty for failure to file correct information return and penalty for failure to furnish correct payee statemento $100 or less ($25 for errors relating to an amount of

withholding or backup withholding)


• Due diligence requirements if return prepared on which a CTC, ACTC or AOC is claimed

• Can’t claim CTC or AOC if it was denied due to fraud or reckless or intentional disregard of the ruleso Can’t claim for next 10 years (CTC) or two years

(AOC)


• Penalty for understatement due to willful or reckless conducto Greater of $5,000 or 75% or income derived by

taxpayer for the return or refund claim.

A266

Extender Bill – Other Provisions• As for the 1098-T, eligible educational

institutions need only report the aggregate amount of qualified tuition and related expenses received during the calendar year. o Effective for expenses paid after 2015 for education

furnished in academic periods beginning after 2015.• Note:

o The credits in question are only available for amounts actually paid during the year in question It’s not surprising that many taxpayers simply use the amount

on the 1098-T to claim the credit, even if the actual payment was made in a different year

1098-T

• Eligible institutions continue to have the option of reporting either the amount of payments of qualified tuition and related expenses received or the amount billed for 2016 without being subject to penalties (Ann. 2016-17)

• Update:o No penalties will be assessed against institutions that

report tuition billed rather than tuition paid on Form 1098-T for 2017

1098-T

• Due Diligence requirementso New $500 penalty on preparers who fail to meet due

diligence requirements documenting qualifications for the AOC starting with 2016 returns If AOC improperly claimed (such as by using the billed

rather than paid amount for tuition), potential 2-year ban on claiming it

o Advice: Ask about the payments, but may need to obtain other

evidence to meet the rule for 2016 returns Don’t just copy the numbers from Form 1098-T

Extender Bill – Other Provisions• Sec. 529 plans

o Qualified expenses include (beginning in 2015) Computer or peripheral equipment Computer software Internet access and related services

o If multiple distributions received from a QTP during the tax year, the portion of a distribution representing earnings is computed for each distribution

o If refund received of higher ed. expenses, any distribution used to pay the refunded expenses is tax-free if ben. recontributes within 60 days

A267

Tax Increase Prevention Act of 2014

• Contained the ABLE Act of 2014o Created I.R.C. §529A Accounts can be established for a person receiving (or is

eligible to receive) SSI and Medicaid based on a disability that began before age 26.

• Maximum $14,000 annual contribution• Grows tax-deferred• If distributions used for qualified expenses, not included in income• Amounts in an ABLE account don’t count as eligible resources up

to $100,000• The excess is a “resource” for SSI purposes, but not Medicaid

Extender Bill – ABLE Accounts

• Can establish account in state other than account owner’s state of residence

• Can roll over amounts from a Sec. 529 QTP to an ABLE account without penalty

Extender Bill – Simple IRAs

• Can rollover distributions from employer-sponsored retirement plans and traditional IRAs into a Simple IRA after the 2-year period after the date the employee first participated in the Simple IRA (effective beginning in 2016)

Social Security File and Suspend Strategy

• Old rule:o An individual who has reached full retirement age

(FRA) could apply for social security retirement benefits and then request to have the payments suspended.

o This entitled the individual’s spouse to receive a spousal benefit (which is generally half of the higher earner’s benefit) while the worker continued to earn delayed social security retirement benefits at the rate of 8% per year up to age 70.

A269

Suspend and File• Spouse with the higher primary insurance amount (PIA) [the formula

used to calculate benefits], files for benefits at FRA then immediately files a notice to suspend payment of those benefits. o This permits the lower-PIA spouse to file for a spousal benefit,

which is equal to half of the other spouse’s benefitso Higher-earner spouse continues to accrue higher benefits until

filing to start payments, perhaps as late as age 70o Then, the other spouse converts to their own full benefit (if at

FRA)• The couple benefits from higher individual benefits for the rest of

their liveso Upon the higher earner spouse’s death, the widow converts to a survivor

benefit, equal to 100 percent of the decedent’s benefit

File and Suspend

• Where did it come from?o Senior Citizens’ Freedom to Work Act of 2000 Main point of the provision was to give people incentives

to work longer by allowing them to work and receive full Social Security benefits after they have reached their FRA

• Allows married couples to start receiving some benefit to meet living expenses while they wait to get more later

Social Security File and Suspend Strategy

• BBA provision:o If an individual suspends benefits, no one can claim

benefits based on that individual’s earnings record. The provision is effective for benefits payable beginning

May 2, 2016. • This means that individuals who are now using the file and

suspend strategy can continue to do so, and those who are currently eligible to use this strategy will have the opportunity to do so until May 2, 2016

Deemed Filing Concept Extended

• What is deemed filing?o If a married person files for social security benefits,

they are deemed to file for both their own retirement benefit and their spousal benefit, and social security will pay only the larger of the two benefits.

o Under current social security rules, deemed filing ends at an individual’s full retirement age.

Deemed Filing• Under the BBA, the deemed filing rule is extended

to age 70. • Under prior law, individuals could defer their own

benefit at full retirement age in order to continue to earn delayed retirement credits (8% per year up to age 70) and to collect only the spousal benefit instead.

• Under the BBA, this option is no longer available. o However, an individual will still be entitled to the larger of

their own retirement benefit or their spousal benefit.o Effective for individuals who attain age 62 after 2015.

Bipartisan Budget Act of 2015 (BBA – 11/2/15)

• New partnership audit ruleso The new rules, make it easier for the IRS to audit large

partnerships by making a determination of taxes at the partnership level, ensuring that a partner's return must be consistent with the partnership return, and the designation of a partnership representative.

o Allows the IRS to audit partnerships, make a tax adjustment in the year in which the audit is done, and have the general partner have the income flow through to the partners.

A271

Current System for Auditing Partnerships

• For partnerships with 10 or fewer partners, the IRS generally applies the audit procedures for individual taxpayers, auditing the partnership and each partner separately.

• For partnerships with 11 to 100 partners, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. o Once the audit is completed and the resulting

adjustments are determined, the IRS must recalculate the tax liability of each partner in the partnership for the particular audit year.

Current System for Auditing Partnerships

• For partnerships with 100 or more partners that elect to be treated as Electing Large Partnerships (ELPs) for reporting and audit purposes, partnership adjustments generally flow through to the partners for the year in which the adjustment takes effect, rather than the year under audit. o As a result, the current-year partners’ share of current-year

partnership items of income, gains, losses, deductions, or credits are adjusted to reflect partnership adjustments relating to a prior-year audit that take effect in the current year.

o The adjustments generally do not affect prior-year returns of any partners (except in the case of changes to any partner’s distributive share).

BBA Provision

• Under the provision, the current TEFRA and ELP rules are repealed, and the partnership audit rules are streamlined into a single set of rules for auditing partnerships and their partners at the partnership level.

• Similar to the current TEFRA rule excluding small partnerships, the provision would permit partnerships with 100 or fewer qualifying partners to opt out of the new rules, in which case the partnership and partners would be audited under the general rules applicable to individual taxpayers.

Balanced Budget Act

• The new rules are effective for tax returns filed for tax years beginning on or after January 1, 2018. o However, a taxpayer can elect to have the BBA

provisions apply to any partnership return filed after the date of enactment (November 2, 2015).

New Audit Rules

• By default, a partnership will pay a computed tax at the end of any partnership examination rather than a tax being assessed at the partnership level. o This tax will be assessed to the partnership in the year

that the audit is completed (the adjustment year), rather than the year of the examination (the reviewed year).

o The tax will be computed at the highest income tax rate applicable to corporations and individuals (currently the individual rate, at 39.6%). I.R.C. §6221(a).

New Audit Rules

• The partnership would be permitted to issue adjusted Schedules K-1 to the partners of the reviewed year.

• The recomputed tax for the reviewed year would be paid in the adjustment year. If so, the partners would take the adjustment into account on their individual returns in the adjustment year (not the reviewed year).

• I.R.C. §6226(b)(1).

New Audit Rules

• In addition, rather than amending the partnership tax return, partnerships will have the option of initiating an adjustment for a reviewed year.

• The adjustment could be taken into account at the partnership level or the partnership could issue adjusted information return to each partner of the reviewed year.

New Audit Rules

• The definition of a “small partnership” is changed such that a partnership with fewer than 100 partners that satisfies other criteria can elect to not be covered by the new partnership exam rules and be able to utilize the reasonable cause exception for failing to file a partnership return

BBA and Partnership Audits• The revised audit language also eliminates a joint

and several liability provision, which could have subjected partners to pay adjustments disproportionate

• A partnership's adjustment would be based on the character of the income, rather than at the highest rate as suggested in prior proposals.

• Partnerships of all sizes would have the option to push an adjustment through to each of the partners, rather than paying the tax at the entity level.

New Definition of a “Small Partnership”

• The partnership must make the election out of the BBA partnership audit provisions;

• The partnership must be required to furnish 100 or fewer K-1s for the year;• Every partner of the partnership must be an individual, C corporation (or any

foreign entity that would be considered to be a C corporation if it was domestic), S corporation or estate of a deceased partner

• The election must be made on a timely filed return (i.e., the election is made when the partnership return is originally filed, and not later upon receiving a notice of examination) and include the name and identification number of each partner;

• The partnership must notify each partner that the election has been made; and• For S corporation partners, the partnership must disclose the name and

taxpayer identification number of each S corporation shareholder. • I.R.C. §6221(b)(1)(D)-(E). The IRS has the authority to develop provisions for

the identification of foreign partners for disclosure purposes. I.R.C. §6221(b)(2)(B).

• For purposes of the 100 K-1 limitation, each S corporation K-1 is treated as if it were the partnership’s own K-1.

What Does The Election Get You?

• For IRS audit purposes, a small partnership applies the audit procedures for individual taxpayers. o That means that the partnership is audited separately

from each partner and the TEFRA rules do not apply. o Just because a partnership qualifies as a “small

partnership” does not mean that it is not a partnership for tax purposes. It only means that if the defense is successfully raised

that the entity is a small partnership, then the penalties for failure to file a partnership return do not apply.

Family Partnership Rule Tinkering

• Old Ruleo Section 704(e)(1) provided that a person is

recognized as a partner of a partnership if capital is a material income-producing factor, whether the partnership was obtained by purchase or gift. This was commonly referred to as the “family partnership

rule.”

Family Partnership• Purpose of old rule:

o A transfer of a partnership interest by gift (or even by sale) opens the door to an impermissible assignment of income. That is, income from property or a business can be transferred in a manner that would be a disrespected assignment of income if such a transfer was conducted outside of the partnership form.

o The family partnership rule is a safe harbor from IRS attack based on assignment of income principles when capital is a material income-producing factor in the partnership. By focusing on capital, the safe harbor will not provide

protection for service businesses or other businesses where capital is not a major requirement.

Concern of Congress

• To be considered partners for federal income tax purposes, the legal partners must have joined together with an intent to conduct an active trade or business.

• Some taxpayers have argued that this rule does not apply if the family partnership rule applies.o They claim that the family partnership rule is an

alternative way of being considered a partner, without the requirement of an active trade or business.

BBA

• The BBA moves the family partnership rule out of Section 704(e)(1) and into Section 761(b). As it now reads, Section 761(b) makes clear that one still has to meet the general requirements of being a member of a partnership.

• The family partnership rule is now only a qualification to the above general rule such that in testing whether one is a partner a gift transfer cannot be used as a challenge if capital is a material income-producing factor.

BBA

• Section 761(b) now reads:o (b) Partner. For purposes of this subtitle, the term

“partner” means a member of a partnership. In the case of a capital interest in a partnership in which capital is a material income-producing factor, whether a person is a partner with respect to such interest shall be determined without regard to whether such interest was derived by gift from any other person.

• Effective for partnership tax years beginning after 2015

• Fixing America’s Surface Transportation Act (12/6/15)

• Sec. 32101o Amends FATCA by adding new I.R.C. §7345 If the IRS certifies that a taxpayer is delinquent in federal

taxes to the tune of $50,000 or more, the U.S. Secretary of State can take action to deny, revoke or limit the taxpayer’s passport.

• Note: Federal government employees presently owe $3.3 billion in back taxes

A275 Surface Transportation and Veterans Health Care Choice Improvement Act of

2015 (Jul. 31, 2015)• Additional information required on Form 1098

o Beginning mortgage balance and property address, etc.

• Consistent basis reporting for estates and beneficiaries

62

Transportation Bill – Statute of Limitations and Basis

• H.R. 3236 - Surface Transportation and Veterans Health Care Choice Improvement Act of 2015o Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012) vacated.

The Supreme Court held that the extended six-year statute of limitation under Sec. 6501(e)(1)(A), which applies when a taxpayer “omits from gross income an amount properly includible” in excess of 25% of gross income, does not apply when a taxpayer overstates its basis in property it has sold.

o The act amends I.R.C. §6501(e)(1)(B) as follows: “An understatement of gross income by reason of an overstatement

of unrecovered cost or other basis is an omission from gross income.” o The change applies to returns filed after the date of enactment

(7/31/15) as well as to previously filed returns that are still open under Sec. 6501 (determined without regard to the amendments made by the act).

A276

Transportation Bill…• Modified due dates…

o 1120; 1065; 1041; FBAR

64

New Legislation• Trade Preferences Extension Act (signed into law on

June 29, 2015)o Increase in penalties for incorrect information returns, including

those required by Obamacare Penalty for filing incorrect return (was $100, now $250) Penalty for incorrect returns if corrected within 30 days (was $30,

now $50) Penalty for incorrect returns if corrected by Aug. 1 (was $60, now

$100) Penalty for intentionally disregarding to file timely and correct

returns (was $250, now $500) Maximum penalty per calendar year (was $1.5 mill., now $3 mill.) Max. penalty per calendar year if corrected within 30 days (was

$250,000, now $500,000) Max. penalty per calendar year if corrected by Aug. 1 (was

$500,000, now $1.5 mill.)

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Increased Penalties

• Obamacareo Penalties not imposed on entities that show they

made a good faith effort to comply with the reporting requirements for 2015 An untimely filed return won’t meet the good faith

requirement Could still get penalty waived if failure due to reasonable

cause

Increased Penalties• The increased penalties for incorrect forms are

applied with respect to each incorrect formo Try to take advantage of the combined form

reporting when possible Ex: employer may use one Form 1094-C to transmit all

Forms 1095-C rather than multiple Forms 1094-Co Remember, the larger penalties now exist for failures

in reporting and the penalties apply to each incomplete or incorrect form. Ex: Intentionally incorrect information with respect to

one employee could trigger a $500 penalty for both the Form 1095-C filed with IRS and the Form 1095-C provided to the employee

Trade Preferences Extension Act (6/29/15)

• Beginning with 2016 returns…o Form 1098-T is required to claim the AOTC, lifetime

learning credit or Sec. 222 deduction (qualified tuition and related expenses)

• Penalty relief for higher education institutions unable to provide a student taxpayer i.d.number

68

House Ways and Means Committee Proposal

• Blueprint for Pro-Growth Tax Reformo Tax rate of 25% on business income

Makes farm income averaging largely irrelevanto 20% C corporate rateo Individual income tax rates of 12%, 25% and 33%o Net interest expense not deductibleo Depreciable assets fully deductible in year purchased

§1031 exchanges for depreciable assets irrelevant Repair regs. irrelevant §263A likely inapplicable (except for nurseries that buy products that

aren’t seedlings and grow them to larger stock). But orchards and vineyards could deduct all costs

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Trump Tax Plan

Table 1. Individual Income Tax Brackets Under Donald Trump’s Tax Plan

Ordinary Income

Capital Gains and Dividends

Single Filers Married Filers Head of Household

0% 0% $0 to $25,000 $0 to $50,000 $0 to $37,500

10% 0% $25,000 to $50,000

$50,000 to $100,000 $37,500 to $75,000

20% 15% $50,000 to $150,000

$100,000 to $300,000 $75,000 to $225,000

25% 20% $150,000 and up $300,000 and up $225,000 and up

Trump Tax Plan• Other individual income tax items:

o Steepens the curve of the Personal Exemption Phase-out (PEP) and the Pease Limitation on itemized deductions.

o Eliminates the Alternative Minimum Tax.o Eliminates the Net Investment Income Tax of 3.8

percent, which was passed as part of the Affordable Care Act.

o Taxes carried interest at ordinary income tax rates instead of capital gains and dividends tax rates.

o Phases out the tax exemption on life insurance interest.

Trump Tax Plan• Business Tax Changes

o Cuts the corporate income tax rate from the current 35 percent to 15 percent.

o Ends the deferral of income from controlled foreign subsidiaries, but preserves the foreign tax credit. It would also enact, as a transitional revenue raiser, a one-time

deemed repatriation tax of 10 percent on all foreign profits currently deferred. Eliminates all corporate tax expenditures that have nothing to

do with capital cost recoveryo Taxes pass-through businesses at the rate of 15 percent

commensurate with the traditional corporations.o Caps the deductibility of interest expenses.

Trump Tax Plan

• Transfer taxeso Eliminates the federal estate tax

What’s Likely To Happen?• Short term:

o No finalization of proposed §2704 regulationso Elimination of §385 anti-inversion regulations Involves foreign acquisition of a U.S. company

• Longer term:o Tax cutso Repeal of the NIITo Corporate tax reformo Repatriation holiday for off-shore earningso New IRS Commissioner

Protecting Affordable Coverage for Employees Act (10/7/15)

• Amends Obamacare by including employers with 51-100 employees as “large employers” for purposes of health insurance markets.

• Provides that states can chose to treat these employers as small employers.

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New Regulation -Partners Aren’t Employees – No Self-Help Fix

• Background - Key employees like equity o LLCs are a popular way to structure businesses. But

employees who get LLC interests are no longer employees.

o LLCs with multiple owners are taxed as partnerships, and their owners as partners. A 1969 revenue ruling sets a rule that once employees of a

partnership get an equity interest, they stop being W-2 employees and have to treat their compensation as a “guaranteed payment” subject to self employment tax.

• This can come as an unhappy surprise to the owner-employees, who no longer have their employers depositing withheld income and Social Security taxes on their behalf. They have to make quarterly estimated tax payments.

76

Partners Aren’t Employees – No Self-Help Fix

• Some LLCs ignore the ruleo After all, the employment taxes all get paid. That’s dangerous — particularly if employee benefit plans are

involved, as treating a non-employee as an employee can put the plan itself at risk.

• To solve the problem, some LLCs have tried a form of self-help. o If the LLC itself is a sole owner of another LLC, the subsidiary LLC is

“disregarded,” but must file its own employment tax returns for any employees as if it were a corporation.

o Some taxpayers and advisors decided that rule allowed equity holders of the parent LLC to be treated as employees of the subsidiary, allowing them to get a W-2 and skip the quarterly estimated tax hassles.

77

IRS Says “No” to “Self-Help”

• Effective May 4, 2016 (TD 9766)o Existing regulations already provide that the entity is disregarded

for self-employment tax purposes and specifically note that the owner of an entity treated in the same manner as a sole proprietorship under § 301.7701-2(a) is subject to tax on self-employment income. These temporary regulations apply this existing general rule to illustrate that, if a partnership is the owner of a disregarded entity, the partners in the partnership are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.

• The new rules allow LLCs that are using the now-discredited self-help plan until August 1 to comply.

78

What About an S Corporation?

• An equity owner to set up an S corporation contribute the LLC interest to it. o This makes the corporation the “partner” in place of

the employee, allowing W-2 treatment. But,… Compliance costs of filing an annual 1120-S Possibly being forced to draw a “reasonable” salary from

the S corporation and file quarterly payroll tax returns for that.

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W-2s and Partners - Comment

• It should be possible for at least those LLC owners with small percentage interests to qualify for W-2 treatment.

• S corporation owner employees have been able to deal with this problem for years. But for now, you are either a partner or an employee. It’s one or the other.

80

Healthcare Law and Return Prep.

• Minimum essential coverage (MEC)o Generally includes coverage offered in the

“marketplace” Many exchanges have failed Some insurers operating in exchanges have increased

rates 50 percent to 67 percent in the past year In some states there is only one insurer selling in an

exchangeo Does not include short-term, limited duration

coverage

A293

Minimum Essential Coverage

• Issue for tax practitioner:o Determine whether client has MEC 1095-A 1095-B 1095-C

o Note,…it is possible that client has insurance obtained on marketplace that does not qualify as MEC Reconciliation discrepancies Unexpected tax liability

A297

Due Dates

• Deadlines for providing 1095-B and 1095-C to individuals:o Was Jan. 31, 2017o Now is Mar. 2, 2017 (IRS Notice 2016-70)

• Deadline to file the forms with IRSo Feb. 28 (paper filers)o Mar. 31 (electronic filers)o No impact on other years

Penalties

• Notice 2016-70o Extended to reporting entities that show they have

made good-faith efforts to comply with the information reporting requirements Covers reporting errors including “missing and inaccurate

taxpayer I.D. numbers and dates of birth and other information required on the return or statement

Note on Penalties

• The estimate is that total employer penalties related to the health insurance mandates from Obamacare are expected to be $31 billion for 2016o Failure to offer coverageo Offer compliant coverage, but didn’t meet IRS

reporting requirements needed to show compliance

MEC

• If taxpayer doesn’t have MEC, the “Roberts” tax must be paid, unless an exemption applieso Religious exemptiono Member of healthcare sharing ministryo No access to affordable coverageo Household income under the filing threshold for a

federal returno Hardship Death of family member, domestic violence, utilities shut-

off, unpaid medical bills, etc.

MEC

• What’s the amount of the “Roberts” tax in 2016? It’s the larger of…o 2.5% of “household” income up to a maximum of the

total yearly premium for the national average of a bronze plan sold through the “marketplace”; or

o $695 per adult ($347.50 per child under 18) up to $2,085.

PTC Reconciliation

• Who’s qualified for the PTC?o Those with incomes between 100% and 400% of

federal poverty guidelines tied to family size Remember, the PTC is a refundable credit

o Must have MECo The PTC is tied to the number of coverage months

during the year that the taxpayer qualifies for the PTC.

A298

PTC Reconciliation

• If client qualifies,…o Can pay the full amount of monthly health insurance

premiums for the year; oro Receive an advance PTC based on estimated income

for the year Reconcile with actual income as ultimately reported on

return using form 8962• Watch for, births, adoptions, divorce, marriage, ineligibility during

year, eligibility for employer-sponsored coverage Any excess reported as additional tax on return, unless

income is less than 400% of fed. poverty guideline

A299

Reconciliation Measures

• Health insurers give IRS taxpayer insurance coverage information o IRS checks the amount of any APTC receivedo IRS can adjust return

“Household Income”

• It’s the sum of…o MAGI of the taxpayer and aggregate MAGI of other

family members who must file a return for the year “Family” means someone for whom the taxpayer may

claim a personal exemptiono MAGI includes… SS benefits Disability income, etc.

A300

MEC and Return Prep.• Caps on repayment of the APTC:

o Is household income less than 400% of federal poverty guideline for family size? See Table

o If household income greater than 400% of federal poverty guideline Are there ways to reduce MAGI?

• IRA deduction• HSA deduction• Retirement plan contributions• Other above-the-line deductions?• See Example 1 on p. 302

A301

H.R. 34

• Passed House on Nov. 30 by 392-26 vote, and passed Senate on Dec. 7 by 94-5 vote

• Sec. 18001 contains an amendment to Obamacare that allows a “small employer” with less than 50 full-time employees who does not offer a group health plan to offer an HRA without the existing restrictions under Obamacare

H.R. 34

• Employees covered by an HRA generally not eligible for the PATC for the months covered by the HRA, if the HRA provides “affordable coverage”o Affordable coverage: If the excess of the amount that would be paid by the

employer as the premium for such month for self-only coverage under a silver plan, over 1/12 of the employee’s permitted benefit under the HRA does not exceed 1/12 of 9.5 percent of the employee’s household income

H.R. 34

• Max. annual reimbursemento $4,950o $10,000 for family coverageo Amounts are pro-rated for months of coverage

H.R. 34• Other requirements:

o Funding of HRA only by employer contributions, with no salary reduction contributions

o Employee must have health insurance that satisfies Obamacareo HRA to be provided on same terms to all eligible employees, but

some can be excluded Those lacking 90 days of employment Those under age 25 Part time Seasonal Non-resident aliens without U.S. income

H.R. 34• Employer requirements:

o Notification and reporting Employees must be given notice within 90 days of beginning of

tax year (or 90 days of beginning of tax year, or 90 days of from date of eligibility)

• Amount of permitted benefit• Employee must provide info. to health insurance exchange

if they apply for an advance PATC• Employee must disclose that they don’t have MEC

• Penalty• HRA reimbursement included in income

Failure to provide notice triggers $50 penalty/employee/incident capped at $2,500 annually

• Exception for reasonable cause and no willful neglect

H.R. 34

• Effective dates:o Plan years beginning after 2016 HRA will not be a violation of Obamacare. So, not

$100/day penalty/person (for a “small employer”)o Initial penalty relief of Notice 2015-17 applies to any

plan year beginning on or before 12/31/2016 The relief of Notice 2015-17 applies to any plan year

beginning before 2017 Thus, it apparently means that the $100/day penalty

won’t apply, but law is unclear

H.R. 34

• Tax impact:o In accordance with Rev. Rul. 61-146, 1961-2, CB25,

reimbursed medical expenses are excluded from employee’s gross income, even if the employer pays the premiums directly to the insurer

Ross I. Hirst

[email protected]‐249‐7936

IRS UPDATECHAPTER 5

Page A185

2017 IRS Mileage Rates

• Business: $.535• Moving and medical: $.17• Charity: $.14

Compliance Programs for Undisclosed Foreign Assets

Bank Secrecy Act

Foreign Account Tax Compliance Act

Page A185

Offshore Voluntary Disclosure Program

• Eligibility:• Voluntary Disclosure Practice• Legal‐Source Funds

POA Subject to FBAR Reporting

OFFSHORE

Defined as what is not offshore

Filing Requirements

Who Must File

US Person

$10,000 Aggregate Maximum

IRS Response to Identity Theft

• Among the fastest growing crimes• Constantly evolving• Security Summit

Page A207

SUMMIT WORKING GROUPS

• Authentication• Strategic Threat Assessment & Response• Information Sharing

Page A208

COLLABORATIVE RECOMENDATIONS

• Drivers Licenses• Form W‐2 Verification• IP Pin

• “Get Transcript” application• Form W‐2 Phishing• E‐Filing PIN application

BREACHES Page A212

BREACHES

• “Get Transcript” application• Form W‐2 Phishing• E‐Filing PIN application

IDENTITY THEFT ISSUESPublication 4557

Checklists • 1 Administrative Activities • 2 Facilities Security• 3 Personnel Security • 4 Information Systems Security• 5 Computer Systems Security • 6 Media Security • 7 Certifying Information Systems For Use

Page A280

Protect Your Clients; Protect Yourself

CRITICAL STEPS RECOMMENDED BY THE IRS

E‐FILING SECURITYPUBLICATION 1345

Page A281

Page A213

A Proposal for Taxpayers’ Future Interaction with the IRS

VIRTUAL TAXPAYER ASSISTANCE

Page A 214

IDENTITY AUTHENTICATION

Page A215

UPFRONT ISSUE IDENTIFICATION

Page A215

END‐TO‐END TAXPAYER EXPERIENCE ANALYTICS

Page A216

INITIATIVES

Page A216

RESPONSIBLE PERSON FOR TRUST FUND RECOVERY PENALTY

Page A219

RESPONSIBLE PERSON

• Responsible for required actions• Willfully fails responsibilities

Page A220

RESPONSIBLE PERSON

FACTS AND CIRCUMSTANCES

• Significant authority• Title not determinative• Passive investors

Page A222

OUTSOURCING PAYROLL

• Third party payerso Responsibilityo Willfulnesso Outsourcing employer still responsible

Page A223

MULTIPLE RESPONSIBLE PERSONS

AMOUNT OF PENALTY

EARLY INTERACTION INITIATIVE FOR EMPLOYERS

Page A226

APPEALS UPDATE

• Emphasize impartial quasi‐judicial nature of process• Appeals employees do not engage in other compliance functions

Page A226

KEY COLLECTION POLICY CLARIFICATIONS

Page A227

KEY EXAMINATION POLICY CLARIFICATIONS

ITIN CERTIFICATION PROCESS

• Background• Protecting Americans from Tax Hikes Act of 2015• ITIN Application Process

o Form W‐7o Form W‐7SP

Page A229

Certain ITINs will need to be renewed beginning in 2017

• 3 Year Rule• Expiration

o Issued before 2008 – expire 1‐1‐2017o Issued in 2008 – expire 1‐1‐2018o Issued in 2009 or 20010 – expire 1‐1‐2019o Issued in 2011 or 2012 – expire 1‐1‐2020

Page A234

HOW TO RENEW AN ITIN

• Expiration due to 3 year rule• ITINs with middle digits of 78 or 79• Family option

ITIN MISCELLANEOUS

• WHAT MAY HAPPEN IF AN ITIN IS NOT RENEWED• USE OF AN ITIN SOLELY ON AN INFORMATION RETURN

Revised Power of Attorney

• Removed Registered Tax Return Preparer Designation

• Updated Unenrolled Return Preparer Designation

Page A236

Annual Filing Season Program —Record of Completion Requirements

• 18 Hours of Continuing Educationo 6 Hours of Federal Filing Season Refresher (with test)o 10 Hours of Federal Tax Lawo 2 Hours of Ethics

AUDIT TRENDSPage A240

s

SPECIAL ENROLLMENT EXAMCHANGES

• Administered by Prometric• 3 Parts

o Individualso Businesseso Representation, Practices and Procedures

Page A243

CASH PAYMENT OPTIONPage A245

Chapter B5 –Page B183

Wealth Accumulation and Preservation

Tax Planning for Higher-Income Individuals

• ATRAo Higher income tax rateso Higher capital gain rate (top end)

• Health care lawo NIIT (passive tax)

Tax Planning for Self-Employed Taxpayers

• Retirement planso SEP IRA Sole proprietorships and partnerships

o Simple IRA C corporations, S corporations, sole proprietorships and

partnerships with 100 employees or less and no other retirement plan

o Self-employed 401(k) plan Only if business is comprised of owner and spouse

o 401(k) plan

B184

Other Tax Planning Strategies• Tax-advantaged healthcare accounts

o HSAo HRAo Sec. 125 plans

• Employing a childo No FICA (unless C or S corp.)o No FUTAo Child can contribute to an IRA out of earned income

• Employing the spouseo Example 1

B187

Portfolio Income• What is it?

o Investment income (ordinary income rates)o Interest (ordinary income rates)o Dividendso Royalties (ordinary income rates)o Capital gains

• What to do?o Include more tax-exempt muni’s in regular accountso Move investment into retirement accountso Lend money to family members

Commodities and Collectibles

• What is it?o Gold, silver, etc. Taxed at 28% on sale if held longer than 12 months Taxed at ordinary income rates if held for less than 12

monthso May want to hold indirectly through an investment

vehicle.

Mutual Fund Investments

• Dividends and Distributionso Ordinary dividends – Box 1a of 1099-DIVo Qualified dividends taxed at 20% (plus additional

3.8%) if taxpayer in 39.6% bracket Taxed at 15% if taxpayer in bracket between 15% and

39.6% Taxed at 0% if taxpayer is in 10% or 15% ordinary

income tax bracket Reported in Box 1b of Form 1099-Div

B188

Mutual Funds

• Computing basiso Easy to determine if all of the shares in a fund are

disposed of Acquisition cost (or carryover basis) plus commissions and

sales charges + fund Then subtract distributions that represent a return of

capital

B188

Mutual Funds

• Determining basis when only a portion of the fund shares are disposed ofo Share were likely acquired at different times and at

different priceso Can use one of several methods to identify shares

and determine basis

B189

Methods for Determining Basis• FIFO

o Shares sold are deemed to be the first ones owned• LIFO

o Shares sold are deemed to be last ones owned• Highest cost method• Lowest cost method• Beneficial tax approach• Specific lost method• Average basis (cost) method

Tax Loss Harvesting

• A technique that is used to see if large realized gains can be offset by large realized losses

• Example 2

B190

Timing of the Sale of Mutual Fund Shares

• Technique can result in the conversion of what would normally be ordinary income to capital gainso Selling the shares before the fund makes an income

distribution Example 3 on p. B191

Deferring Year-End Purchases

• Funds must pay out gains and income at least annually to avoid federal taxo Timing of purchase of mutual fund shares is

important part of tax planningo What is the record date?

Other Tax Planning Strategies

• IRA contributionso Phased-out?o Roth IRA?o Non-deductible traditional IRA?o “Backdoor” Roth IRA contributions

B192

Other Tax Planning Strategies

• Gifting stock to children• Funding college expenses

o Sec. 529• Donating securities to a charity

Passive Activities

• Investing in activities in which the taxpayer doesn’t materially participateo Generates passive activity incomeo Potentially subject to the 3.8% passive taxo Losses deductible only to extent of passive income

for the year Can deduct all deferred losses in year of disposition

B193

Real Estate Professionals

• Proposed regulations;o All rental income was considered to be investment

income unless it rose to the level of a trade or business. There is no bright-line test for trade or business

Real Estate Professional• Rents are always passive unless the

taxpayer qualifies as a real estate professional• Spend more hours on real estate activities than

non-real estate activities; and• Perform more than 750 hours of services during

tax year in real property trades or businesses in which the taxpayer materially participates• Can group all rental activities together to get to 750

hours• See Example 4 on p. B194

Can’t group rental activity with another type of real estate activity (B195)

• Gragg v. United States (9th Cir. Aug. 4, 2016)

B193

Real Estate Professional

• A trust can attain the status of a real estate professional (B194)o Frank Aragona Trust, 142 T.C. 165 (2014)

Real Estate Professional – Final Regulations

• Example:o Chris owns 12 mini-storage properties. Chris spends

1,500 hours per year managing the properties. While he does not spend more than 500 hours on any one property, he has elected to aggregate all rental activities, thus he materially participates in the combined activity Chris spends more than half of his time during the year on real

estate trade or businesses in which he materially participates. In addition, he spends more than 750 hours in real estate

activities in which he materially participated. As a result, Chris qualifies as a real estate professional and the rental activities are no longer passive to him.

Real Estate Professional Safe Harbor

• What if the safe harbor test is not satisfied?o Taxpayer can still take the position that their rental

activity rises to the level of a trade or business But, it would then generate income subject to self-

employment tax

Passive Activities

• Grouping election• Can group all rental activities together to get to

750 hours See Example 4 on p. B194

o Can’t group rental activity with another type of real estate activity (B195) Gragg v. United States (9th Cir. Aug. 4, 2016)

o Can group a rental activity with a business activity if either the business or rental activity is insubstantial in relation to the other or each owner of the business activity has the same proportionate ownership interest in the business activity and the rental activity

Points on Grouping

• Can elect to group multiple businesses or multiple rentals as a single activity to meet the material participation testo Must be an appropriate economic unit Similarities and differences in types of businesses Extent of common control Extent of common ownership Geographical location Interdependence between the activities

Grouping Disclosure

• Written statement must be filed with original return when…o New groupingso Addition of a new activity to an existing groupingo Regroupings

• No written statement needed when…o Existing groupings before guidance issued in 2010o Disposition of activity from existing groupingo Partnerships and S corps.

B196

Other Points on Groupings

• A timely grouping disclosure is made if all affected tax returns have been filed consistent with the claimed grouping.o Must make required disclosure in year failure is first

discovered by taxpayero If IRS first discovers the failure to disclose, the

taxpayer must have reasonable cause for not making the disclosure

• Prior groupings are grandfathered – so once grouped, can’t regroup in later years

B197

Strategies Involving Disposition of Passive Activities

• Any disallowed PAL is suspended and carried forward indefinitelyo Offsets passive incomeo Allocated to the passive activities that generated

losses during the yearo Complete disposition of passive activity allows use of

previously suspended PALs attributable to the disposed passive activity

o Ordering rule

B197

Grouping Restrictions• C corp activity can be grouped with another activity only

for purpose of determining whether taxpayer materially participated in the other activity

• C corp activity can’t be grouped with a rental activity for purpose of treating the rental activity as an active business

• Normally can’t group real estate rental activity and activity involving rent of personal property, unless personal property is provided in connection with real property or real property is provided in connection with the personal property

B198

Other Grouping Issues• Grouping a rental and a business

o Same proportionate ownership present? Can group Report rental activity on Schedule E and no impact on SE

income• Flows to page 1 of Form 1040 instead of Form 8582

o Example 5• What if no proportionate ownership?

o Grouping allowed if one activity is insubstantial in relation to the other Example 6

B198

Grouping by Pass-Through Entities

• Not subject to written grouping requirements• Follow form 1065 instructions• See examples on page B200

Material Participation by Limited Partners and LLC Members

• How does a limited partner establish m.p.?• An LLC /LLP member - see regulations

o Management rights?

Grouping and NIIT

• Could make a regrouping election on 2013 return if subject to NIITo If election not made for 2013, taxpayer could make

election for first post-2013 year that taxpayer was subject to the NIIT

The Use of IDGTs and GRATs for Wealth Transfer and

Business Succession

B201

The Use of GRATs and IDGTs for Wealth Transfer and Business

Succession• Techniques that allow the grantor to “freeze”

the value of the transferred assets while at the same time providing the grantor with a cash flow stream for a set period of time

• Excellent technique for business succession planning for S corporations, FLPs and LLCs

What is an IDGT?

• An irrevocable grantor trust designed to avoid any retained interests or powers in the grantor that would pull the assets into the grantor’s gross estate at death.

• It is a grantor trust so any transaction between the trust and grantor is not a tax evento Trust’s income, loss, deductions and credits are

reported by the grantor on the grantor’s return The payment of the tax is not a gift

B201-202

Why Is It Termed “Defective”?• Because the grantor and the trust are treated as

the same taxpayer for income tax purposeso Grantor does not have gain on sale of assets to the

trust and is not taxed on the interest payments received from the trust

o Grantor does not have capital gain if note payments are paid to the grantor in-kind

o Trust is an eligible S corporation shareholder• But, the transfers between the grantor and the

trust are respected for estate and gift tax purposes

What Can An IDGT Hold?

• A broad array of investments, including life insurance, on the grantor’s lifeo Sec. 677(a)(3) says that a trust will be considered to

be a grantor trust to the extent the income of the trust is applied for the benefit of the grantor -including the payment of insurance premiums on the grantor’s life

o As long as the IDGT owns the policy and the grantor does not retain “incidents of ownership” in the policy, the death benefit of the policy will be paid to the IDGT free of estate, gift and income tax

The IDGT Transaction• Step 1:

o The grantor sells highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note. It is suggested that the grantor make an initial “seed” gift

of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payment to the grantor

• This provides economic substance to the sale• Can gift up to $5,464,000 gift tax free• Discount strategies can be used on the transfer

o Alternatively, the grantor could make an outright gift to the trust utilizing unified credit to offset the taxable gift Three-year “look-back” rule applies

B202 The IDGT Transaction• For example…

o Could sell $8 million of FLP interests to an IDGT (FMV) with a discounted value that is set at the maximum value that can be transferred gift-tax free

o Transferor gets a note in returno Shares are determined based on the value transferredo Sell the non-voting interest to the IDGT for market

value No gain on sale No gift tax Grantor gets an installment note bearing interest at the AFR

• No income recognition when interest on notes received Grantor taxed on income earned by IDGT shares

What if the Grantor Dies During the Term of the Sale?

• The balance of the installment note that has not been paid off at the time of death is included in the grantor’s estate

• The assets held by the IDGT at the time of death and any appreciation from the date of sale are not included in the grantor’s estateo An advantage over a GRATo Can overcome the early death risk by using a “SCIN” or a private

annuity in lieu of an installment note to finance the sale• Note – loss of stepped-up basis in stock that would result

if grantor owned the stock at death

In Reality, What is Happening?• Because the grantor is paying the income taxes

on the IDGT assets and is relieving it of that obligation, the grantor is, in essence, making transfers of tax-free gifts to the children and future generations equal to the income taxes paid on behalf of the IDGTo Shifts to future generations, free of estate and gift

tax, the value of the stock exceeding the discounted purchase price and any future appreciation in that stock; and the value of the payments of the income taxes the grantor makes that the IDGT would have otherwise paid that would have decreased the assets that ultimately pass to future generations

IDGT Example

• Example 9 on page B204o Using an IDGT as a succession planning deviceo 10-year term

IDGTs and ILITs

• An IDGT is a good way to acquire large amounts of life insurance with no taxable gifts on the premium payments

• For wealthy clients that have put-off estate planning, they are often advised to create an ILIT so that the death benefit can pay the estate taxes that will be dueo Clients don’t like finding out that they have to pay

gift tax on some of the premium gifted to the ILIT

IDGT Advantage over ILIT

• Discount the value of the property sold to the ILIT

• Interest-only installment payment• IDGT has sufficient tax-free cash flow to allow

the funding of significant amounts of life insurance

• Life insurance proceeds used to repay the note on grantor’s death (which discounts the cost of repaying the note)

B205

Other IDGT Advantages• Value freezing of contributed assets at the low

interest rate on the promissory note• No capital gain taxes due on the promissory

note• Income on promissory note is not taxable to

grantor• Grantor pays income tax on trust income which

leaves more assets in IDGT for remainder beneficiaries

• Valuation discounts

IDGT Disadvantages

• If grantor dies during term of note, note is included in grantor’s estate

• No stepped-up basis in trust-owned assets on grantor’s death

• Trust income is taxable to grantor during grantor’s life

• Potential cash-flow problem • Gift and estate tax exposure may result if

insufficient assets are used to fund the trust

Grantor Retained Annuity Trust

• What is it?o An irrevocable trust to which assets are transferred

and the grantor receives the right to a fixed annuity payment for a term of years with the remainder beneficiaries receiving any remaining assets at the end of the GRAT term The fixed payment is typically a percentage of the asset’s

initial FMV computed so as to not trigger gift tax The term of the annuity is fixed in the instrument and is

either tied to the annuitant’s life, a specified term of years or a term that is the shorter of the two

The Annuity Payment

• Can be the same each year• Can increase up to 120% annually• Once the annuity is established, additional

property cannot be added to the GRAT?

What Does a GRAT Accomplish?

• “Freezes” the value of the senior family member’s highly appreciated assets at today’s value

• Provides the senior family member with an annuity payment for a term of years

• The bottom line…o Benefits without potential transfer tax disadvantageso Today’s present low interest rate environment makes

GRATs more attractive

Technical Requirements

• At least one annuity payment every 12 months paid from either the GRAT’s income or principalo 105-day window within which to satisfy the annuity

payment requiremento Notes cannot be used to fund the paymento Trustee cannot prepay the annuity amount or make

payments to any person other than the annuitant during the qualified interest term

Tax Consequences• A GRAT is treated as a grantor trust

o By definition, the retained interest exceeds 5 percent of the value of the trust at the time of creation

o No gain or loss to grantor on transfer of property to the GRAT in exchange for the annuity Treated as a tax-free installment sale

o Grantor taxed on trust income, including interest, dividends, rents and royalties, as well as pass-through income from business entity ownership

o Grantor claims GRAT’s deductionso Grantor not taxed on annuity paymentso Transactions between GRAT and grantor are ignored for income

tax purposeso GRAT assets grow without the burden of income taxes

Gift Tax Consequences• Value of the gift equals the value of the

property transferred to the GRAT less the value of the grantor’s retained annuity interesto In essence, the transferred assets are treated as a

gift of the present value of the remainder interest in the property Allows asset appreciation to be shifted from the grantor’s

generation to the next generation• Can zero-out the gift value so there is no

taxable gifto Example 10

GRATs and the GSTT• Appreciation on the GRAT’s assets is suspended

during the term of the GRAT because the grantor can only allocate GSTT exemption to the GRAT’s assets only after the GRAT term expires based on the value of the assets at that time

• The determination of whether the transfer to the beneficiaries is subject to the GSTT is made based on the relationship at that time the trust is created, rather than when the trust interest ends.

• See Example

What if the Grantor Dies During the GRAT’s Term

• A portion or all of the GRAT is included in the grantor’s gross estateo It’s the lesser of the FMV of the GRAT’s assets as of

the grantor’s date of death or the amount of principal needed to pay the GRAT annuity into perpetuity Example

GRAT Advantages and Disadvantages

• Advantageso Reduced gift tax cost as compared to a direct gifto Grantor trust statuso Grantor can borrow funds from the GRAT and the GRAT can

borrow money from third partieso GRAT term can be as short as two years

• Disadvantageso Some applicable exclusion might be used on formationo Grantor must survive GRAT term to avoid estate tax inclusiono No GSTT exemption allocated to GRAT during the GRAT termo Notes or other debt can satisfy the required annuity paymentso Grantor pays income tax on all of GRAT’s income that is earned

during the GRAT term

Proper Structuring

• Promissory note must be bona fide debt and not an equity interesto In that event, there is not any retained interest in the

property transferred to the IDGT, and the transferred property is not included in the grantor’s estate at death

Proper Structuring• The tax benefits of the IDGT depend on the

promissory note being bona fide debto Sufficient seed moneyo Beneficiaries personally guarantee small portion of

amount to be paid under the noteo Note payments not tied to return on IDGT assetso Note payable from trust corpuso Grantor not having control over property sold to

IDGTo Keeping note term short

IDGT Administrative Issues

• The IDGT is a separate legal entityo Separate bank account is used to receive the “seed”

gift and handle annual cash inflows and outflowso Must track interest payments to grantoro Annual records of trust must be maintained

B206

Grantor Retained Annuity Trust

• What is it?o An irrevocable trust to which assets are transferred

and the grantor receives the right to a fixed annuity payment for a term of years with the remainder beneficiaries receiving any remaining assets at the end of the GRAT term The fixed payment is typically a percentage of the asset’s

initial FMV computed so as to not trigger gift tax The term of the annuity is fixed in the instrument and is

either tied to the annuitant’s life, a specified term of years or a term that is the shorter of the two

B206

The Annuity Payment

• Can be the same each year• Can increase up to 120% annually• Once the annuity is established, additional

property cannot be added to the GRAT

What Does a GRAT Accomplish?

• “Freezes” the value of the senior family member’s highly appreciated assets at today’s value

• Provides the senior family member with an annuity payment for a term of years

• The bottom line…o Benefits without potential transfer tax disadvantageso Today’s present low interest rate environment makes

GRATs more attractive

Technical Requirements

• At least one annuity payment every 12 months paid from either the GRAT’s income or principalo 105-day window within which to satisfy the annuity

payment requiremento Notes cannot be used to fund the paymento Trustee cannot prepay the annuity amount or make

payments to any person other than the annuitant during the qualified interest term

B207

Tax Consequences• A GRAT is treated as a grantor trust

o By definition, the retained interest exceeds 5 percent of the value of the trust at the time of creation

o No gain or loss to grantor on transfer of property to the GRAT in exchange for the annuity Treated as a tax-free installment sale

o Grantor taxed on trust income, including interest, dividends, rents and royalties, as well as pass-through income from business entity ownership

o Grantor claims GRAT’s deductionso Grantor not taxed on annuity paymentso Transactions between GRAT and grantor are ignored for income

tax purposeso GRAT assets grow without the burden of income taxes

Gift Tax Consequences• Value of the gift equals the value of the

property transferred to the GRAT less the value of the grantor’s retained annuity interesto In essence, the transferred assets are treated as a

gift of the present value of the remainder interest in the property Allows asset appreciation to be shifted from the grantor’s

generation to the next generation• Can zero-out the gift value so there is no

taxable gifto Example 10

B208

GRATs and the GSTT• Appreciation on the GRAT’s assets is suspended

during the term of the GRAT because the grantor can only allocate GSTT exemption to the GRAT’s assets only after the GRAT term expires based on the value of the assets at that time

• The determination of whether the transfer to the beneficiaries is subject to the GSTT is made based on the relationship at that time the trust is created, rather than when the trust interest ends.

• See Example 11

What if the Grantor Dies During the GRAT’s Term

• A portion or all of the GRAT is included in the grantor’s gross estateo It’s the lesser of the FMV of the GRAT’s assets as of

the grantor’s date of death or the amount of principal needed to pay the GRAT annuity into perpetuity Example 12

B209 GRAT Advantages and Disadvantages

• Advantageso Reduced gift tax cost as compared to a direct gifto Grantor trust statuso Grantor can borrow funds from the GRAT and the GRAT can

borrow money from third partieso GRAT term can be as short as two years

• Disadvantageso Some applicable exclusion might be used on formationo Grantor must survive GRAT term to avoid estate tax inclusiono No GSTT exemption allocated to GRAT during the GRAT termo Notes or other debt can satisfy the required annuity paymentso Grantor pays income tax on all of GRAT’s income that is earned

during the GRAT term

The Use of Charitable Trusts in the Estate and Business

Planning Process

B211

Charitable Remainder Trusts (CRT)

DonorChar.

Rmdr.Trust Charity

Asset

Term

Income

Rmdr.

After Term

(No TaxOn AssetSale)

CRT Features• Irrevocable• Valid under state law• Set up either as a CRAT or CRUT• Donor and income beneficiary can be an

individual, corporation or partnership• IRS pre-approved copies of annuity and unitrust

instruments

B211 CRT Features• Minimum % distributions to beneficiary of 5% and

not more than 50% of initial value of CRAT or annual market value of CRUT

• Fixed term not to exceed 20 years or payments continuing for life of beneficiary

• Value of remainder interest must be at least 10% of initial net FMV of all property contributed

• For a CRUT, distributions for any year will not be made in excess of the trust’s accounting income.o Make up distributions can be made in later yearso CRUT can accept additional contributions; CRAT cannot

Establishing the Trust• Donor creates the CRT

o Terms specify annual income stream to donor, and remainder to charity after donor’s death or after term of years

o Donor transfers assets to CRT Charitable deduction if property is LT cap gain property (less

value of retained interest) No charitable deduction if no basis

o CRT sells assets No taxable gain

o CRT invests proceeds of sale to fund annual income payment to donor

o Upon donor’s death (or end of term), remainder passes to charity

B213

Charitable Remainder Trusts

• ANNUITY TRUSTo Fixed payouto No additional funding

• UNITRUSTo Payout is % of annual valueo Additional assets can be contributed

Charitable Deductions

• Donor’s charitable income tax deduction (if any) is limited to 30% of AGIo Excess eligible for 5-year carry overo Thus, may want to fund CRUT over several years

• What does the charitable deduction depend upon?o The percentage of the retained income interesto Life expectancy or term of years lengtho IRS Sec. 7520 rate (current month or prior 2)

B213

CRT for Farmers

• Funding a CRT with ordinary farm assets (PLR 9413020)o No income or SE tax to proprietor for inventory or

fully depreciated equipment (other than potential Section 179 recapture)

o Expenses allowable for current year cropo CRT sells inventory tax-freeo Distributions from CRT = ord. income but not SE

income

B214

Pairing of ILIT with CRT

• Many farmers will use tax savings of CRT to fund an Irrevocable Life Insurance Trust (ILIT):o Provide liquidity to estateo Vehicle to pass on assets to off-farm heirso Increase the amount of assets on an estate tax free

basis.

CRT Examples

• Example 13o Should you sell or gift business assets?

• Example 14o Using a 10-year CRT

• Be careful transferring unmarketable assets to a CRTo Need qualified appraisalo Watch out for UBTI

CRT Anti-Abuse Rules

• 10% charitable remainder minimumo At time of set-up, the amount of residual expected to

pass through to the charity must be calculated to be at least 10% of the current contribution. The actual amount does not need to be 10%, but the

expected amount based on the terms of the trust must be at least 10%

o New IRS sample language

CRT Anti-Abuse Rules

• 50% maximum payouto Max. annual payout percentage cannot exceed 50%

of initial FMV of all property placed in a CRAT and 50% of the net FMV of assets as annually revalued for a CRUT

5% Probability of Exhaustion• In 1977, IRS indicated that there would be no deduction

at time of CRAT creation if there is a greater than 5% actuarial probability that the income beneficiary will survive the exhaustion of the trust corpuso This is not applicable to a CRUT with a net income limit

(NIMCRUT) since under this formula the trust corpus is never invaded

o As a practical matter, with today’s low interest rates, CRATs based on a donor life expectancy will fail the 5% rule even though they pass the 10% rule.

o Software is used to determine whether the structure will meet all three tests.

B218

CRT Design Issues

• Select the highest of the 3 AFRs to maximize the income payouto Example 15 on page B219

• Use a fixed term CRAT to reduce income tax exposure in early years

• Analyze other factorso Social securityo NIITo MRD, etc.

CRT Illustrations

• 1.4% AFR• 10 yr. term, annual payout at year-end• $750,000 funding• Payout amount - $72,800• Charitable Remainder – 10%

B220Illustration – Section 1245

• After-tax accumulation after 10 years:o Outright sale $460,238o 10 Yr. CRAT $504,151o 10 Yr. CRUT $504,190

• Savings using CRT – About $44,000 plus $75,000 to charity

B221

Illustration – Inventory (SE)


• Savings using CRT – About $90,000 plus $75,000 to charity

Illustration - BIG


• Savings using CRT – About $125,000-$179,000 plus $75,000 to charity

CRT Cautions

• Need appraisal if transfer “unmarketable securities”

• No active business interests: UBI tax• No debt into CRT• No self-dealing (CRT sells assets in open

market, not to related party of donor. No loans to donor or related party)

CRTs and Other Concerns

• CRT’s accumulated NII may be hit with NIIT• Taxability of SS benefits

o Example 19 on page B223o Example 20 on page B223

CRT Compliance

• Form 5227, Split-Interest Trust Information Returnso Schedule K-1 (Form 1041) to beneficiaryo Copy of CRT document in 1st year filing.

Agricultural IssuesChapter A7 – A303

Self-Employment Tax on Farming Activity of Trusts

A303 Self-Employment Tax on Farming Activity of Trusts

• Sec. 1402 regs say that a trade or business is to be carried on by an individual, either personally or through agents or employeeso Not estates or trusts

• Definition of trust is a keyo Examples on page A304

• Are the beneficiaries insulated?

Alternatives to I.R.C. §1031 Exchanges For Farmland

Reinvestment (a.k.a. Indirect farmland ownership/investment)

A305

The REIT

• A company that owns and (usually) operates income-producing real estate.o Sec. 856 – any corporation, trust or association that

essentially acts as an investment agent specializing in real estate and real estate mortgages

232

The REIT

• Basic tax ruleso Annually distribute at least 90 percent of taxable

income to shareholders in the form of dividendso Can deduct dividends paid to shareholderso Elect REIT tax treatment by filing Form 1120-REIT

233

REIT• Key characteristics

o Structured as a corporation, trust or partnershipo Be managed by one or more directors or trusteeso Issue transferable shares or transferable certificates of

interesto Be taxable as a domestic corporationo Not be a financial institutiono Have the shares or certificates owned by 100 persons

or more (no attribution rules apply)o Have 95% of its gross income derived from dividends,

interest and property income

234

REIT• Key characteristics (continued)

o Pay dividends of at least 90 percent of the REIT’s taxable income (excluding net capital gain)

o Have no more than 50% of the shares held by 5 or fewer individuals during the last half of each tax year

o Have at least 75% of its total assets invested in real estate, cash and cash items, and government securities

o Derive at least 75% of its gross income from “rents” from real property, “interest” from loans secured by real property or interests in real property, gain from sale of investment real property, REIT dividends, income from foreclosure property, qualified temporary investment income, and other specified sources

o Maintain required recordso Have no more than 25% of its assets invested in taxable REIT

subsidiaries235

REITs and Taxation

• Potentially subject to tax at corporate rates on…o Undistributed REIT taxable incomeo Undistributed net capital gaino Income from foreclosure propertyo Income “shortfall” in failing to meet the 75% or 95%

testso Income from prohibited transactionso Income from re-determined rents

236

REIT Shareholder Taxation

• REIT dividends received to extent of REITs earnings and profits

• REIT dividends of capital gain are taxed to the shareholders in the year received as L.T. capital gaino Holding period doesn’t matter

237

A306 UPREIT - Structure• REIT contributes cash to operating partnership

in exchange for Units • Real estate owners (farmers) contribute

properties to the operating partnership in exchange for Units that are convertible into REIT shares at the option of the Unit-Holder at a rate of one Unit per one REIT shareo Contributions tax-free under Sec. 721o Built-in gain recognized in the future upon exercising

right to convert Units into REIT shareso If debt on property and the amount allocated to

taxpayer decreases, gain may result238

A307

UPREIT - Structure

• Lockout periodo Usually negotiated as part of the dealo Prevents the UPREIT from selling contributed

property for a certain term If it is sold during the period, the UPREIT usually provides

an indemnity payment to the taxpayer Can dispose in a tax-free exchange, however

239

Benefit of UPREIT

• Diversification to taxpayer by allowing a farmer to pool farmland with farmland of others or other real estate investments

• More liquidity without immediate tax liability

240

Delaware Statutory Trusts• Structured as “securities”

o Allows the taxpayer to buy interests in the trusts, which holds title to the property

o Investment in the real estate is shared amongst many investors

• Trusteeso National real estate developers who buy the property

and structure it as a securities DST• Annualized income

o Usually in the 5-7% range depending on investment opportunities

241

A307 Delaware Statutory Trusts• Drawbacks

o Passive investmento Holding period is usually 2-10 years Roll-over the investment at a later time

o Investment returns usually capped in 5-7% range• Benefits

o Greater exit strategies for investoro More diversification optionso Offerings can be to more than 100 investorso More reasonable minimum investmento No need to set up single-member LLC

242

UPREITs and Delaware Statutory Trusts

• UPREIT - REIT assets are owned indirectly through an umbrella partnershipo Sec. 721 applieso Possibility for gain if debt of contributed propertyo “Lockout” period

• DSTo Basically, trusts structured as securitieso Pros and Cons

Purchase and Sale Allocations To Conservation Reserve Program

(CRP) Contracts

A308

What if the CRP Land is Sold Before the Contract Ends?

• Sellers must pay back to the USDA all CRP rents that have already been received, plus interest and liquidated damageso Liquidated damages are not “penalties”

Purchase Price Allocation to CRP Contract

• When an owner pays a penalty for early termination, it’s synonymous with a lessee’s termination of a lease when the obligations under the lease exceeds the benefits (and pays a cancellation fee)o Generally gets a deduction (as long as the

cancellation payment is not integrated with the acquisition of another property right)

A309

Sale Price Allocation to CRP Contract• CCA 200519048

o Taxpayer selling right to 90 percent of revenue from 3 CRP contracts with 11 years remaining had to report the lump sum payment as ordinary gross income in year of receipt. Reported on Form 4835 and in next year included

remaining 10% on 4835 and deducted the part sold in prior year. Then in the next year, included the total CRP payment with no offset with amount received from buyer. Amended returns then filed to remove amount reported as income in year of sale and remove expense deduction. Taxpayer claimed lump-sum was not income in year of sale. IRS disagreed.

What if the Buyer Pays the Early Termination Costs?

• Payment is considered part of the lando Additional cost incurred to acquire full rights to the

property

Early Termination Payments

• General points…o A capital expenditure that the lessor can amortize Amortization period tied to intended use of the property

subject to the cancelled leaseo If early termination costs incurred solely to allow sale

of farm, then add costs to basis of land and deduct as part of sale

A310 Early Termination Payments and CRP

• Farm owner capitalizes and amortizes the costs over the remaining term of the CRP contract being terminated. o As long as lease cancelation not tied to substantial

improvements made to the property.• IRS could claim that the costs over the term of

the new lease if the new lease is for a longer period of time than the remaining term of the CRP contracto 9th Circuit disagrees with this approach Write-off the lease cancellation costs over the unexpired term

of the canceled lease.

Farm Tile Tax Issues

A311

Economics of Tiling

• Yield increaseso 10-15 percento Translates into dollars

Rental Contracts and LL/Tenant Payment Options When Adding Tile

• Tiling pays for itself in 3-5 years, but might take 7-10 years

• Is the cost financed?• Who pays for it?• How does the rental contract reflect the change

Various options

• Tenant and landlord split the cost of tilingo Base rent established comparable to what well tile

land would rent foro Tenant and LL each depreciate the cost each incurso Repairs completed by the tenant until initial

agreement completeo If land sold before end of initial contract, LL pays

tenant any undepreciated tile amount remaining

Tenant Pays for Tiling

• Example on page A311o Tenant pays initial costo Tenant pays base rento Rent increases 4 percent annually for three-year life

of contract with rent then tied to amount paid on comparable land

o If land sold, LL repays tenant for tiling cost remainingo When contract ends LL owes nothingo Tenant claims depreciation

Landlord pays tiling cost

• Example:o LL pays for the tile.o Base rent is set at comparable amount for tiled lando Tenant pays bonus rento LL takes depreciation

Crop Share

• LL pays same percentage of tiling cost as they receive in crop

• Tenant does the same• Both LL and tenant share depreciation

Tile Depreciation Related Issues• 15-year property• 150% • Eligible for Sec. 179 (new or used) if used in farming

business• LL normally eligible, but not if LL is merely engaged in

rental activityo Cash rent

• If LL is “non-corporate” lessor, can claim Sec. 179 if LL manufactures or produces the property, or leases it under a lease with a term less than ½ of the MACRS class life of the leased property and in the first year, the Sec. 162 deductions exceed 15% of rental income

A312

Tile Depreciation Tax Issues

• If tenant pays for tile…o Tenant claims Sec. 179 (must own for length of

lease) Need LL repayment clause if land terminated early (based

on lease period)o Balance depreciated over 15 yearso If lease terminated early, could result in depreciation

recapture to the tenant

Tile Depreciation Tax Issues

• If LL pays for the tile…o Land basis increases upon installation and then

declines as tile is depreciated• If tenant pays for the tile…

o No impact on land basis• Upon lease termination…

o LL generally owns the tile• Check state laws

Farm Loss Deductibility Limitation for Taxpayers Receiving Farm

Subsidies

A313 Farm Losses Not Covered by Insurance

• Fully deductible if…o “At-risk” rules satisfiedo Passive loss rule satisfiedo Excess farm loss rule satisfied

Excess Farm Loss Rule

• Non-C corporations that have received “applicable subsidies” are subject to a limitation on deductible farming losses…o Greater of $300,000, oro Aggregate net farm income over prior 5-yr. period Carryover of any disallowed amount to next year is

allowed

Excess Farm Loss Rule• What is an “applicable subsidy”?

o Direct or counter-cyclical payment These have been eliminated

o Receipt of CCC loan• What about an LDP?

o It’s a direct payment to a producer for a commodity in which the producer has a beneficial interest in lieu of a marketing assistance loan Pays when the CCC determined value is less than the

county loan rate (the payment is the difference between the two amounts times the quantity)

o Is an LDP an applicable subsidy?

Handling Losses on the Return

• Use them to reduce taxable incomeo For prior or future years also Back 5 Forward 20 Farming losses – elect to carry back 2 or elect to only

carryforward 20 years

Employment of Children in a Family Farm Business

A315

Basic Planning Points

• Standard deduction allowed in full against child’s earned incomeo Salaries and wages and commodity wageso Kiddie-tax does not apply to earned income

• FICA exemptionso Wages from parentso Wages paid to child under 21 for in-home domestic

services to a parent

Employing Children• Roth funding

o Child’s earned income not subject to income tax if it is less than the standard deduction amount

o Can be used to fund a Roth IRAo Example 3

• College fundingo Wages; gifts of unsold graino Offset taxable income by education credits (if parents

don’t claim child’s dependency exemption)• AOTC example – No. 4 on p. A317

A316

Spousal Employment and Commodity Wages

A318

In General

• Wages paid in kind (grain, milk, lodging, clothing, etc.) are:o Not subject to FICA, FUTA and FWTo Usually best for owner/employees or long-term

employees o FMV of in-kind payment is income to recipiento Should be supplemented with some cash wages to

maximize Tier SS benefits• Example 5

Rules – 1994 P.I.K. Guidelines• Employee recognizes income on amount of transfers• Employer receives wage deduction equal to income amount• Must issue W2 to employee and include these wages in Box 1

o Reported as 0 for FICA and Medicare wages• FMV is based on the date of transfer• Title must pass to employee• Employee must have control of commodity, sell the commodity and

incur the costs of holding the commodity• Any gain or loss on later sale is reported as capital gain or loss on

employee’s Form 8949 (flowing to Schedule D)• Carrying costs associated with commodity (e.g., storage or marketing

costs) are miscellaneous itemized deductions subject to 2% of AGI limitation, reportable on employee’s Schedule A

A319

Rules (cont.)

• Sale by employee results in short/long term capital gains/loss

• Should have written employment agreement specifying the commodity terms

• Should be raised by the employer• Do not need to allocate costs for current year

crop

Other Points• Potential s.e. tax treatment to employee if

employee uses the commodity to produce other grain or to conduct a businesso Exposure limited to appreciation of commodity after

receipt• Have written employment contract detail

relationship and quantity or percentage of commodity paid in exchange for labor

• The longer the employee holds the commodity the better

• Tougher to accomplish with livestock

Various Examples

• These examples are from numerous private letter rulings that IRS has issued both before and after the issuance of the 1994 guidelines

A320-321

Trading Machinery(Ag Financing Issues)

A324

Capital Lease v. Operating Lease

• Capital leaseo Involves a financing of the “leased” asseto Rights of ownership transfer to lesseeo Recorded as fixed asset in “lessee’s” general ledgero “Lessee” deducts interest expense

• Operating leaseo Owner transfers a use right and possession reverts to

owner at end of termo Lease payment is deducted

Importance of Characterization

• Leases are kept off of lessee’s financial statementso Could provide misleading picture of lessee’s finances

• Tax o Deduction of lease payment doesn’t impact lessee’s

balance sheeto Under a capital lease, lessee recognizes the leased

property as an asset and lease payment as a liability on the balance sheet. Lessee claims depreciation and deducts interest expense

FASB

• When is a transaction a capital lease?o Ownership shifts to lessee by end of lease periodo Lessee can buy asset from lessor at end of term for

below-market priceo Lease term is at least 75% of estimated economic life

of asset (and lease can’t be canceled during that time)

o Present value of minimum lease payments required under lease is at least 90% of fair value of asset at time lease entered into

A324

Various Scenarios

• Exchanging owned equipment for the lease of new equipment

• Exchange of equipment for a capital lease• Trade-down in value

Exchanging Equipment for Operating Lease

• The “exchange value” is treated as sales priceo Gain or loss based on this value

• Exchange value is treated as a lease prepaymento Amortized over the term of the lease

• Farmers not expecting gain in year of signing

Exchanging Example

• Farmer Bean has a fully-depreciated tractor with an exchange value of $200,000 that he “trades-in” on a new operating lease calling for 4 $50,000 payments over next three years ($50,000 at time of signing).

• Result is $200,000 Section 1245 gain in year one, a $50,000 lease deduction in year one and then $50,000 deduction in years 2-4

Exchanging into Capital Lease

• A capital lease is treated the same as debt• Therefore, the normal 1031 rules apply and

there should be no gain or loss assuming farmer receives no boot.

Trade Down in Value

• Trading down in value and receiving cash results in gain to the farmero This gain is not pro-rata, 100% of cash received is

usually gain (only changes with high basis assets)

Trade Down Example

• Farmer Bean trades in his $200,000 valued tractor for a new tractor costing $125,000 and receives cash of $75,000

• Assuming the basis of the tractor is less than $125,000, the old basis will carry over to the new tractor and Farmer Bean will recognize $75,000 gain on the trade

• If basis exceeds $125,000, the excess will reduce gain by that amount

Selling an Asset For More Than Its Depreciated Value

• It’s a taxable event• Can it be structured as a like-kind exchange?

o What are the consequences?o How do you compute and account for depreciation

on the property received in the exchange?

The Basic Problem• Sales of assets which have been depreciated

often result in taxable gain. o The taxpayer may have elected to write-off some or the

entire purchase price under I.R.C. §179, may have claimed bonus depreciation on new assets together with regular MACRS depreciation, or some combination of all three.

o In high income years, many taxpayers likely claim the I.R.C. §179 deduction in the year of purchase, resulting in no future depreciation deductions.

o Since the tax basis was fully expensed, the sale of the asset generates gain. That gain would normally be capital gain, but it is treated as ordinary income (due to depreciation recapture).

Structuring as a Tax-Deferred Exchange

• Whether a simple trade-in of equipment or a more formal exchange of real estate, both result in the deferral of taxable income under I.R.C. §1031

• So, how is the depreciation computed on the replacement property? There are two methods:o Add the remaining tax basis (i.e., the undepreciated portion) of the

old property to the cost (after trade-in allowance) of the new property. Then, the replacement property is depreciated as one asset, placed in service when acquired. Or…

o Continue depreciating the old property over its remaining life, and depreciate the cost (after trade-in allowance) of the new property as a separate asset.

The Two Methods

• The total depreciation to claim over the life of the replacement asset is the same under both methods.

• If the old asset was fully depreciated, there is no difference in the timing of depreciation deductions.o However, if the old asset was not fully depreciated,

the second method will provide depreciation deductions sooner than the first method.

What Happens When the Replacement Asset is Sold?

• Let’s say that the tractor traded-in has substantial value, but was nearly fully depreciated due to bonus depreciation.

• The replacement tractor ends up with very low tax basis on the depreciation schedule. o If it is sold for an amount greater than the amount

reflected as cost, does the farmer have I.R.C. §1231 gain, taxable as capital gain? Depreciation claimed on equipment is recaptured upon the sale

of the equipment, up to the amount of the total gain (I.R.C.§1245). Gain in excess of the depreciation recapture is I.R.C. §1231 gain, which may be taxed as capital gain.

Example

• John purchased a tractor some time ago with a cost of $250,000. He traded it in when its basis was $40,000. The trade-in allowance was $150,000. Replacement tractor has a list price of $200,000; John pays $50,000 after the trade-in. The replacement tractor is put on the books at $90,000 (after trade-in cost of $50,000 plus remaining tax basis of the old tractor of $40,000). John sells the tractor for $120,000 next year.

The Result• While the “cost” of the tractor is listed on the

depreciation schedule at $90,000 and the sales price is $120,000, is the $30,000 excess a capital gain? o No. The depreciation potential on the old tractor (the

trade-in) carries over into the replacement tractor (Treas. Reg. §1.1245-2(c)(4)).

• In this example, John’s entire gain upon the sale of the replacement tractor is ordinary income due to I.R.C. §1245 depreciation recapture.

Split-Interest Land Acquisitions

A325 Split-Interest Land Acquisitions• Defined

o One party acquires a temporary interest in the asset and another party acquires the remainder interest

o Temporary interest Specific term Life estate

• Benefito Mechanism for removing after-tax income from a

family corporationo If the farmland is being purchased, most of the cost

can be covered by the corporation without trapping the asset inside the corporation

294

Hansen Case

• Key case confirming use of the concept –Richard Hansen Land, Inc. v. Comr., T.C. Memo. 1993-248o Related parties can enter into split-interest

acquisitions Corporation acquired 30-year term in farmland Controlling shareholder got the remainder Corporation paid 94% of land cost Controlling shareholder paid for 6% Term interest holder’s ownership was amortizable

295

Tax Implications

• Buyer of term amortizes the basis ratably over its expected lifeo But, T.C. has said that amortization deduction not

available when underlying property is non-depreciable and has been split into two interests without any new investment

296

Tax Implications

• Related party restrictionso No amortization allowed if remainder portion held

directly or indirectly by a related partyo Term holder’s basis is increased annually by the

amount of disallowed amortization Results in remainder holder getting full ownership after

the term expires and a full tax basis (less any depreciation to which term holder entitled)

o Allocation Example 14 on p. A327

297

Split-Interest Land Acquisitions• Advantages

o Avoiding risk of double taxation on land trapped in a C corporation

o Individual succeeds to full basis without economic outlay

• Disadvantageso Buyer of remainder interest does so from other

sources of after-tax earningso Land produces no income to remainder holdero Example 15 on p. A329

298

Sale of Split-Interest Property

• Proceeds allocated between term holder and remainder holder based on IRS interest rate and remaining term certain period as of date of sale

• Gain or loss recognized by each partyo Example 16 on p. A330

299

Split-Interest Transaction with Unrelated Parties

• Two IRS rulingso Buyer of term entitled to depreciate commercial real

estate ratably over termo Holding period for buyer of remainder interest began

at time of purchase

300

Hansen Case

• Key case confirming use of the concept• Term interest amortizable

Tax Implications• Buyer of term gets to amortize the basis of the

interest ratably over its expected life• Lomas Santa Fe, Inc. case

o What if underlying property is not depreciable?• Related party restrictions• IRS ruling and analysis• Allocation• Pros and Cons• Sale of the property

LLCs and FLPs as Farm Succession Planning Vehicles

A331

The FLP

• A limited liability business entity created and governed by state lawo Generally composed of two or more family memberso Typically utilized to reduce income tax and transfer

taxeso A device to distribute assets to family heirs while

keeping control of the family business and ensure continuity and provide liability protection for limited partners

304

A332

Key Features of the FLP• Distribution of interests to family members• Reasonable compensation paid to partners who

actually work for the FLP• FLP income distributed to a partner can’t be

disproportionately greater than capital contributed by that partner

• FLP owns income-producing capital• All formalities observed• Bona fide transfer of FLP interests

305

FLPs – Initial Considerations and Procedure

• Formed by family members that transfer property in return for ownership interest in capital and profits of FLP

• At least one family member designated as general partner (or a corporation could be established as the general partner)o Retains control over assets and operations of the

business and determines income distributionso Personal liability for debts and liabilities not satisfied by

the FLP• Limited partner(s) has no say in how the FLP is

operated306

FLP – Common Set-Up• Formed by senior generation and they become

the general partners with gift of l.p. interests to younger generation

• FLP created by spouses transferring assets to entity in return for FLP interestso One spouse gets 99% l.p. interest and other spouse

a 1% g.p. interesto Spouse with l.p. interest then makes annual

exclusion gifts of l.p. interests to the children (or their trusts)

o Other spouse retains control of the “family assets” o No Sec. 2036 concern

307

A333

Advantages of the FLP• Pass-through entity for tax purposes

o Example• Guaranteed payment to g.p. for management

fee (services rendered) is ordinary income• Transfers interests to family members in lower

tax brackets• Possible to transfer interests to minor children

(usually in trust)• Potential “kiddie-tax” problems

308

A334

Avoidance of Transfer Taxes

• Removal of future asset appreciation• Utilization of present interest annual exclusion

for gift tax purposes• Valuation discounts

309

Transferring Assets and Maintaining Control

• G.P. can control cash flow, income distribution, asset investment and all other management decisionso Be mindful of Sec. 2036(a)(1) and (a)(2)

310

Consolidation of Family Assets

• L.P.s are restricted by the terms of the partnership agreemento No transfer of FLP interest unless other partners are

first given opportunity to buy (or refuse) the interests Discounts

311

Provision for Non-Business Heirs

• FLP can provide an economic benefit to non-business heirs and allow for even distribution of estate assets among all family members

312

Asset Protection

• L.P.s have no ownership over the assets contributed to the FLPo Creditor may not be able to attach the assetso Charging orders

313

A337

Other FLP Advantages

• Flexibility• Consolidation of assets• Minimization or elimination of probate• Partnership accounting rules• Ease of gifting

314

A337

Preservation of Discounts Against IRS Attack

• “Charitable Lid” Planningo An estate plan is created where the testator leaves a

set dollar amount of the estate to the children with the residuary estate passing to a charitable organization. The portion passing to the charity qualifies for the estate

tax charitable deduction and, thus, puts a lid on the amount of estate tax owed

NIM

Formula Allocation Clauses With Excess Passing To Charity

• McCord (5th Cir. 2006)• Christiansen (8th Cir. 2009)• Petter (9th Cir. 2011)• Hendrix (Tax Court 2011)

“Charitable Lid” Planning

• Attractive technique when combined with hard to value assets such as business interests or family partnership interests

• Good way to defeat an IRS audito If IRS challenges the valuation of assets on audit,

any increase in value on audit does not increase the estate tax due – it simply passes to the charity

“Charitable Lid” Planning

• Key case – Christiansen v. Comr., 130 T.C. No. 1 (2008)– Decedent owned cattle ranches in South Dakota with

her husband. He died in 1986 and she continued to operate the ranches until her death in 2001. Her entire estate passed to her daughter, but the will said she could disclaim all or any portion of her inheritance, with the disclaimed property passing 75 percent to a CLAT and 25 percent to a private foundation

Christiansen Case

• Daughter filed a disclaimer. Largest asset in estate were FLP interests that carried out valuation discounts.– With discounts, decedent’s estate was just over $6.5

million– Daughter’s disclaimer resulted in the foundation and

the CLAT receiving about $140,000– IRS audited and increased FLP interests by about

35% - but that resulted in more property passing to charity and no increase in estate tax• Daughter did not retain a continuing interest in the CLAT

after the disclaimer, so no charitable deduction

Christiansen Case

• IRS appealed the portion of the decision allowing the enhanced deduction for the amount passing to the foundation– Attacks the disclaimer:

• Any amount passing to the charity was contingent on a condition subsequent (i.e., the Service’s ultimate determination of value of the decedent’s estate)

• Adjustment clause in disclaimer should be declared void on public policy grounds – discourage them from examining estate tax returns

– Court disagreed with IRS (586 F.3d 1061)

Petter v. Comr., T.C. Memo. 2009-290

• Court upheld a defined-value gift tax clause and rejected IRS’ policy-based argumento UPS stock in LLC transferred to IDGTs and charities,

with split determined by formulao IRS tried to negate defined-value clause based on

policy reasons, but court determined that gift was of ascertainable value of stock rather than a specific number of shares or percentage interests in LLC

• 9th Circuit affirmed on appeal (Aug. 4, 2011)

Hendrix v. Comr., T.C. Memo. 2011-133

• Court approved transfers with “defined value” formula provisions to limit gift tax exposure from the transfers– Transfer of closely held stock in a gift/sale

transaction to family trusts and gift to Foundation under coordinated formula provisions was at arm’s length and not contrary to public policy

– Clause at issue allocated stock between family trusts and Foundation based on values as determined by IRS willing buyer/willing seller test

Wandry v. Comr., T.C. Memo. 2012-88

• Facts: – Married couple gifted membership units in LLC to

children and grandchildren; transfers made in accordance with dollar value of gifts and were determined by a fraction (numerator was state dollar amount and denominator was value of entire company as determined by IRS or court)

– IRS claimed gifts were of fixed fractional interests in LLC and, as a result, LLC unit value understated; court determined that defined value clause reallocated LLC membership units among parties in conformance with formula in which unit value as of transfer date was "unknown constant“

– IRS lost

Wandry• IRS filed notice of appeal on 8/28/12, but then

filed dismissal and dropped appealo Appeal would have been to 10th Cir.

• IRS then filed non-acquiescence in A.O.D. 2012-4, I.R.B. 2012-46

Disadvantages of the FLP• Complexity and cost of formation• Unlimited liability of general partners• Ineligibility of FLP members for many of the tax-

free fringe benefits that employees are eligible for

• The gifts of FLP interests must be carefully planned to not trigger unexpected estate, gift or GSTT liability

• Additional complications in community property states

325

A338

The Limited Liability Company

• Hybrid business organization• It’s a separate legal entity• No restriction on number of members• Tax advantages of a partnership• No corporate formalities• Profit and loss allocation can be different than

ownership of interests• Operating agreement is key

326

Management Structure and S.E. Tax

• Member-managed LLCo Owners responsible for managing the companyo All members treated as general partners and have

s.e. tax liability on their distributive shares• Manager-managed LLC

o Operated by managers who are appointed to run the company (can be members, but don’t have to be) Designated in LLC formation documents or operating

agreemento At least one member is passive No s.e. tax and limited liability

327

Manager-Managed LLC

• Can provide for separate classes of membership o Managers Authority to bind the LLC under a contract

o Non-managers No authority to bind the LLC No s.e. tax

328

Self-Employment Tax and NIIT Implications

• If income is subject to s.e. tax, then it’s not subject to the NIIT

• General partners of LLC have s.e. income• Not sure about s.e. tax treatment of income

flowing to LLC owners who do not participate in the operations of the businesso Guaranteed payments are subject to s.e. tax (even if

paid to a member holding a limited interest), but otherwise, limited partners don’t have s.e. tax liability

329

S.E. Tax Treatment of LLC Members

• There is s.e. tax if… o Personal liability for debt of, or claims against, the

partnership by reason of being a partner or membero Authority to contract on behalf of the partnershipo Participated in the business for more than 500 hours

during the tax year

330

Exceptions to S.E. Tax Treatment

• The fact that the LLC can have separate classes of membership is the key to the exceptionso If the passive investors own a “substantial continuing

interest” in a specific class of interests in the LLC, and these members’ rights and obligations in that class of interests are the same as the rights and obligations that other members (who are not passive) hold in that class.

o Member participates for more than 500 hours and there are other members who satisfy the first exception

331

Exceptions to S.E. Tax Treatment

• If there are non-managers who spend less than 500 hours with the LLC and own at least 20 percent of the LLC interests, those non-managers who spend more than 500 hours are not subject to s.e. tax on the pass-through income, but are subject to tax on the guaranteed payments

332

Structuring the Manager-Managed LLC

• All of the LLC interests can be owned by investors with a third party non-owner named as manager

• Pay the manager a reasonable management fee• LLC owners who provide services must be paid

reasonable compensation from the manager• LLC owners who do not render services do not

have income that is subject to self-employment tax

333

A341

Special Spousal Rule - NIIT

• A spouse can take into account the material participation of a spouse who is the manager.o Thus, if the manager spouse materially participates,

then all non-manager interests owned by both spouses avoid the NIIT

334

IRS Attack on Minority Discounts

NIMProposed IRS Sec. 2704 Regulations

• Released on August 2, 2016• Impose major restrictions on discounts for

minority interest / other discounts• Earliest adaptation is December 2, 2016

Three Pronged Attack

• Three-year look back for gifts made before deatho Effectively eliminate death-bed transfers to take

advantage of minority discounts• Introduction of new “disregarded restrictions”

o If family is in control, no minority discount and perhaps no lack of marketability discount

• Shift away from looking at only restrictions that are more restrictive than state law

Three-Year Look Back Proposed Rule

• Any lapse of a restriction or liquidation rights as a result of a transfer within three years is treated as if it happened at death

• Effectively adds back the minority discount taken at time of gift

• Creates a “phantom asset” included in a taxable estate taxed at 40%

Example

• Farmer controls a farm partnership worth $10 million.

• Farmer owns 80% and spouse owns 20%• Farmer gifts 20% to son and 20% to daughter• He owns 40% after transfer• Took 25% discount for minority interest at time

of gift

Example - Continued

• Each gift had gross value of $2 million• After application of minority discount, gift value

reported of $1.5 million• Reduced lifetime exemption by $3 million

instead of $4 million

Example – Farmer Dies Within Three Years

• Estate is increased by $500,000 times two for the minority discount taken at time of gift or $1 million increase.

• Extra estate tax of $400,000 (40% estate tax rate)

Introduction of New “Disregarded Restrictions”

• New Disregarded Restrictions include anything that:o Limits the ability of the holder of the interest to

liquidate that interest, oro Limits the liquidation proceeds to an amount that is

less than a “minimum value”, oro Defers payment of the liquidation proceeds for more

than six months, oro Permits payment of the liquidation proceeds in any

manner other than cash or property, with notes only being property if for an active business

Family Control

• Family Control is defined as:o Holding at least 50% (by vote or value) of any entityo Family members include Ancestor or descendent of transferor Siblings of transferor Any spouses of any listed above

o Note it is not more than 50%, but rather at least 50%

Non-Family Ownership

• Non-family ownership is ignored if:o Held the interest for less than three yearso Have a less than 10% interest in the entity, wheno Combined with all other non-family owners it is less

than 20% of entity, oro Lacks the right to “put” the interest to the entity for

“minimum value” for cash or property

Transfer to Assignee

• Transfers to Assignees will be ignored for discounts if:o The assignee does not have full rights and powers of

an owner For example, if the assignee lacks voting power or

liquidation rights

Minimum Value

• Minimum value is:o Defined as the interest’s share of the net value of the

entity, oro Effectively a pro rata share of the enterprise value,

rather than a discounted value

Minimum Value Example

• Farmer has $10 million farm partnership and owns 40% of the partnership

• He transfers 20% to son and daughter, leaving 20%

• Normal valuation rules would apply a 25% for lack of marketability and 15% minority discount (assumption).

• Gift would normally be valued at $1.2 million instead of $2 million

Minimum Value Example -Continued

• Under proposed new Regulations –o Farmer could have to value the interest at 20% of

the $10 million “enterprise” valueo Results in gift of $2 milliono Increase of $800,000o Extra “gift/estate” tax cost of $320,000 (40%)

• Still not certain of the effect on the lack of marketability discount in these situations

State Law Restrictions

• An applicable restriction is a limitation on the ability to liquidate an entity that is more restrictive than state law

• Most states allow entities to add provisions to override any restrictions on transfer, there will now be few applicable restrictions that will reduce the value of family-controlled entities

State Law Restriction Example• Farmer owns 98% of Limited Partnership. Son

and Daughter each own 1%.• Partnership agreement calls for termination in 50

years, or earlier by agreement of all partners• Otherwise, prohibits any withdrawal from LP• Partnership agreement requires all partners to

approve any changes to amend• None of these provisions are required by local law• Farmer transfers a 33% LP interest to son &

daughter

State Law Restriction Example -Continued

• The prohibition of withdrawal of LPo Imposes a restriction that is not required by local law

ANDo May be removed by the family members

• Therefore, the transfer is valued at FMV of the 33% LP interest determined without considering the liquidation restriction of a minority interest

Notes to Qualify as Property

• For notes to qualify as property, it must:o Be an entity engaged in an active trade of business,o At least 60% of the value consists of non-passive

assets,o Note is adequately secured,o Requires periodic payments,o Issued as market interest rates (may be higher than

AFR),o Has a FMV on date of liquidation equal to liquidation

proceeds

Pluses & Minuses• Pluses

o Eliminates the minority discount for family entities at time of death Allows step-up in value for those estates that do not owe

a death taxo May still be allowed discounts for lack of

marketability and some suggest this discount will be higher

• Minuseso Essentially eliminates all minority discounts for any

family transfers where “family” owns/controls at least 50%

Constitutionality of Regulations

• Some suggest these Proposed Regulations are not constitutional

• However, Congress granted broad powers to the IRS to issue Regulations in this area of the law

• Any final ruling will likely take many years if not decades to resolve

Future of the Proposed Regulations

• Any final court ruling will likely take many years, if not decades, to resolve

• Legislation has been proposed to kill the finalization of the proposed regulationso Davidson (R-OH)

Repair Capitalization Update

A343

Capitalization and Repair Regulations

• Final regulations issued Sept. 2013 & Aug. 2014• Effective taxable years beginning after 2013• Unit of property is base on which to determine

whether an improvement exists• All components of property that are functionally

interdependent comprise a single Unit of Property (UOP)o Functionally interdependent if the placing in service

of one component is dependent on the placing in service of another

Materials and Supplies – Two Types• Incidental

o Deduct when purchasedo No record of consumptiono Expensing does not distort income

• Non-incidentalo Record of consumption maintained or year-end

physical inventories maintainedo Deduct when first used or consumed

• Farmers (Don’t Care) – all deductible when purchased

Materials and Supplies• Definition: TPP used/consumed in

operations, but not inventory, that is a:o Component to maintain, repair or improve a

UOP that itself is not a UOPo Fuel, lubricants, water, similar itemso UOP with economic life ≤ 12 monthso UOP with cost ≤ $200, oro Other property identified by IRS as materials or

supplies

De Minimis Safe Harbor• Elect to deduct assets if have:

o An Applicable Financial Statement (AFS)o Written accounting procedures at beginning of yearo Treated as expense on AFS, ando Amounts < $5,000 per invoice or per item are

deducted• AFS defined as:

o SEC statement o Certified audit by independent CPA, oro Required by federal or state agency

De Minimis Safe Harbor• Taxpayers without AFS can also elect the safe

harboro Same requirements except $500 limit per invoice or

itemo Accounting policy need not be writteno Note: In Notice 2015-82, IRS increased the $500

amount to $2,500• Cannot use the safe harbor for inventory

property that is held for resaleo But, purchased livestock held for productive use

qualify for the de minimis safe harbor election

A343

Safe Harbor is Not Limiting• Safe harbor not

intended to prevent taxpayers from reaching an agreement with IRS revenue agent to use larger amount

• Should elect $2,500 even if use larger amount

Applying the De Minimis Safe Harbor• A taxpayer may attach a safe harbor

election annually to timely filed tax return• Applies to all amounts within the threshold• Election: Annual statement; no Form 3115

Sale of Property on Which De Minimis Election Had Been Used

• Sale of assets may result in SE taxo However, IRS has issued informal communication

that sale of breeding stock under de minimis safe harbor not subject to SE tax

• May want to consider written accounting policyo Capitalize breeding stock, expense all other under

$2,500

Sale of Property on Which De Minimis Election Had Been Used

• Property is not treated as a capital asset under Sec. 1221 or as property used in the trade or business under Sec. 1231o All gain on disposition must be reported as ordinary

income, with no Sec. 1231 that qualifies for capital gain rates

A343 S.E. Tax on Gains From Sale of Property Expensed Under Safe Harbor

• Two possible interpretations:o Gains are S.E. income because the disposition is

excluded from Sec. 1221 and Sec. 1231o Gains are excluded from S.E. income based on Treas.

Reg. Sec. 1.1402(a)-6(a)

S.E. Tax on Gains From Sale of Property Expensed Under the Safe

Harbor• Treas. Reg. §1402(a)-6(a)(3)

o No s.e. tax on sale unless either… The property is stock in trade or other property that would be

included in inventory if on hand at close of year; or• Purchased livestock don’t fit here

Property is held primarily for sale in ordinary course of business• This is fact-dependent, but not likely at all

o Immaterial whether gain or loss is capital or ordinary income for other tax purposes when determining S.E. income Conversion of 1231 gain to ordinary income does not convert it

to S.E. income

Reporting of Gain

• Report the sale in Part II of Form 4797• Note:

o IRS has informally (and unofficially) said that the gains on sale of livestock expensed under the de minimis safe harbor is not to be included in S.E. income Based on assumption that livestock are neither inventory

nor held for sale Considering clarifying language in Pub. 225

S.E. Tax on Gains From Sale of Property Expensed Under Safe

Harbor• Another view is that the gains should be

included in S.E. incomeo It’s other income with the same characterization as

the original expense Non-commodity receipts would be included in other

income for Sched. F purposes when the original tax benefit was claimed on Sched. F

o Report on Sched. C or F (subject to S.E. tax) Example 20 on p. A345

Strategy for Using the Safe Harbor (Or Not)

• Should you use the safe harbor for purchased livestock?o Get same result with §179 and/or bonus depreciation On later sale, excess gain gets capital gain treatment No s.e. tax on later sale Ordinary income recapture is limited to original cost of

the animals

A345

Hobby Losses

• Roberts v. Comr. (7th Cir. Apr. 15, 2016)o Tax court basically said that every business starts as

a hobby and becomes business only when it achieves a level of profitability

o Appellate court said that conclusion was “untenable” and that the Tax Court’s finding that the petitioner’s land purchase and improvements were irrelevant to the issue of profit motive until he began using the new facilities is “unsupported and an offense to common sense.”

371

A345-346

Hobby Losses

• Estate of Stuller (7th Jan. 26, 2016)o Operated restaurants, but started breeding and

training horses via an S corporationo Owned a farm that the rented to the S corp.o Husband died and wife ran the restaurants Had big losses pre death in the horse activities for 15

years IRS denied the losses

o Multi-factor test not satisfied (no factors favored them)

A347

Tax Liens• United States v. Sanders (S.D. Ill. Feb. 18,

2016)o Farmer didn’t file returns or pay tax from 1991 on

due to belief that he didn’t have too IRS had a different view Farmer didn’t cooperate during audit and IRS

reconstructed income Put property into “pure trusts”

o Court said IRS could enforce its lien for back taxes by foreclosing and selling the farmer’s property Trusts were shams

A348

No Tax Exemption for Farmer’s Market

• Facts:o Farmers could sell goods directly to the publico Special events where vendors could sell goods, have

demonstrations and conduct educational programs, etc.

• IRS said no tax exemptiono Providing space to private businesses to sell their

products Primary purpose was to benefit private businesses

DPAD of Ag Cooperative

• Facts:o Ag cooperative wanted to combine grain marketing

function with another cooperative, and proposed to form an LLC with each co-op getting a fixed percentage interest in the LLC

o IRS said… Distributive share of net income or loss from LLC that was

attributable to marketed grain on behalf of members would be patronage-sourced Grain payments to members would be PURPIMs Qualifies for DPAD

A349

Investment in Oil and Gas Activity Triggered S.E. Tax

• Methvin v. Comr., T.C. Memo. 2015-81 [aff’d by 10th Cir. on Jun. 24, 2016]o Taxpayer invested in oil and gas interestso Normally, investment income would not be s.e.

taxable, but court said that the operating agreement created a partnership and generated partnership income under agency principles S.E. tax applied even though the taxpayer took no part in

management or operation of the ventures Election out of Subchapter K does not change the nature

of the entity IRS can pursue an issue that it conceded in a prior year

A349

How to Not Pay Wages to Kids (and other errors)

• Embroidery Express, Inc. v. Comr., T.C. Memo. 2016-136o Petitioners bought 176-acre tract to raise cattle

No goo Then to raise deer

No goo Then to operate resort

Didn’t work (but did make property improvements)o Big losses – not deductible under 9-factor test

• Paid kids wages in family embroidery businesso No records, but court used Cohan to allow deductions during first

11 months that were small and roundedo Year-end bonus not deductible

A350

When is Accrual Method Required?

NIM

Background

• Cash method of accounting is allowed for all farmers except:o C corporations with more than $1 million of saleso Farm Family C corporations with more than $25

million in saleso Farm Syndicateso Farm Tax Shelter

Farm Family Corporation

• If at least 50% of voting and value is owned by one family

• Member of 2 families own at least 65%• Members of 3 families own at least 50% and

rest is owned by pension plan (does not happen often)

Gross Receipts Test

• Once the corporation hits gross receipts of $25 million, then it is required to convert to the accrual method of accounting

• Gross receipts is determinativeo Purchase items that are sold are valued at gross

sales amount, not net margin• Related party rules apply• Section 481(a) spread over 10 years

Farm Syndicate & Tax Shelters• Mandatory Accrual Accounting• Applies if more than 35% of interests are held by persons

who are limited partners• Five key exceptions

o Individual participated in farming for five yearso Individual principal residence is on the farmo Individual actively participates in any farming businesso Individual principal business is farmingo Interest is held by member of family that is related to

one of the previous four exceptions

Farming Syndicate – “Active Participation”

• IRS view – the exception for active management only applies to an “individual”o CCA 200840042 (partnership interest held by S

corporation with only one shareholder (individual) was to be treated as held by a limited partner for purposes of the farming syndicate rule)

• Burnett Ranches, Limited v. United States (5th Cir. May 22, 2014)o Ranch qualified for active participation exception even

though majority owner actively participated in managing the cattle operation through the owner’s wholly-owned S corporation

More on Cash Method of Accounting• Agro-Jal Farming Farming Enterprises, Inc., et

al. v. Comr., 145 T.C. No. 5 (2015)o What’s at stake? The IRS attack on pre-paid expenses as a back-door to

eliminating the cash method of accountingo Rules on pre-paying: Rev. Rul. 79-229

• Actual payment for deductible items• Pre-purchased items used within the next year• 50% limitation

Farming syndicate can’t pre-pay and deduct• Deduct when actually used or consumed

Agro-Jal Farming Enterprises, et al.• Facts:

o Farming operation on cash methodo Raised strawberries and vegetableso Used field packing materials in its field-packing process Purchased in bulk, in advance of harvest Supplies not used by year-end reflected as expenses in accrual

basis financial statements in year consumed, rather than when paid

• Issue:o Can the farm deduct the packaging materials in the year

of payment for the materials or only when used?

Agro-Jal Farming Enterprises, et al.• Position of IRS:

o Cash method farmers can deduct for farm supplies immediately on purchase, but deductions are only allowed for “feed, seed, fertilizer or other similar farm supplies” (based on a definition contained in the farming syndicate rules) Field-packing materials are not “other similar farm supplies”

o Farm’s position: Field-packing materials are “other similar farm supplies” Only farm syndicates are barred from using cash accounting

• Since not a farming syndicate, can use cash method for all farm supplies consumed within a year

Agro-Jal Farming Enterprises, et al.• Tax Court:

o Field packing expenses fully deductible in year of purchaseo Farm syndicate rules aimed at abusive taxpayers and abused expenses

Situation not presento “Feed, seed, fertilizer and other similar farm supplies” involve expenses

associated with the growing of crops or raising of livestock Field-packing materials don’t fit (IRS wins this point)

o Issue analyzed under Treas. Reg. §1.162-3 Supplies not limited to being deducted in year consumed, but can be deducted

when paid for if they are not again deducted when consumedo No discussion of Treas. Reg. §1.162-12(a)

Can deduct all amounts actually expended in carrying on farming business IRS didn’t focus here It was briefed, but court didn’t need to use it

Agro-Jal Farming Enterprises, et al.• Take home points:

o Farmers can deduct amounts actually expended that are attributable to items used in conducting their farming business Only limitations:

• Some other Code provision that provides otherwise:• Uniform cap. rules• 50% rule• Farming syndicate rule• Soil and water conservation expenses

Estate of Backemeyer, 147 T.C. No. 17 (2016)

• Facts:o Sole proprietor farmer bought approx. $235,000 of

crop inputs in 2010 to use in planting 2011 crops Cost deducted on 2010 return

o Farmer died on Mar. 13, 2011 before using the inputs Listed on estate inventory at value of purchase price 2010 crop sold in 2011 reported on 2011 Sched. F Farm inputs passed to a family trust that named his

surviving wife as the trustee


• Facts:o Surviving wife ran farming operation after his death

and took an in-kind distribution of the farm inputs from the trust Grew corn and soybeans in 2011 Sold a portion of the crops in 2011 and reported the crop

sale proceeds ($301,000) on line 3b of her 2011 Schedule F Balance of crops sold in 2012


• Facts:o Joint return filed for 2010 Input cost deducted

o Two Sched. F’s filed for 2011 (his and hers) Wife’s Sched. F claimed the inputs as an expense in the same

amount that had been deducted in 2010o IRS objected – “double deduction” Because the “…petitioners use the cash method for [their]

farming activity, prepaid expenses that were paid in 2010 are deductible in 2010, and are not added to basis.” If allowed on wife’s 2011 Sched. F, then add same amount to

husband’s 2011 Sched. F• Otherwise, there would be a material distortion of income

No basis step-up in the inherited farm inputs


• Facts:o IRS asserted tax deficiency of $78,387 and accuracy-

related penalty of $15,864


• Facts:o At trial, IRS only claimed the tax benefit rule

controlled the outcome Wife properly deducted the inputs because she received

them with a stepped-up basis and used them in her faming business But, they should be included on his 2011 return


• IRS claimed that Bliss Dairy, Inc. v. Comr., 460 U.S. 370 (1983), controlledo Corporate dairy deducted purchase cost of cattle feed

and then liquidated the next year with a lot of feed on hand Assets distributed to shareholders in non-taxable

transaction Shareholders operated dairy and deducted their basis in

the feed as a business expenseo Court disallowed the shareholders’ deductions

because liquidation changed feed to being used in a non-business use (inconsistent with earlier deduction)


• Tax Court disagreed with IRSo Four-factor test for application of tax benefit rule: Deduction taken in earlier year The earlier deduction resulted in a tax benefit An event occurred in the current year that is inconsistent

with the premise on which the deduction was originally based A non-recognition provision of the Code does not prevent

inclusion in gross income


• Factor three not satisfiedo Neither the husband’s death nor the distribution of

the inputs to his wife for use in her farming business were inconsistent with the 2010 deduction Inputs subject to estate tax at their purchase price, which

is the basis for the income tax deduction


• Factor four not satisfied:o When he died, the basis step-up rule appliedo Value of inherited assets not included in gross

income to recipiento When heir disposes of asset, heir has taxable gain to

extent proceeds exceed stepped-up basiso Depreciation recapture is not triggered on death

either under Sec. 1245 or Sec. 1250 These rules are partial codification of tax benefit rule and

don’t apply at death

I.R.C. §263A

• The uniform capitalization ruleso Certain costs of production must be capitalized and

can’t be currently deductedo Do capitalized costs include interest paid to buy land

and property taxes paid on the land attributable to growing crops and plants where the preproductive of the crop or plant exceeds two years? Answer – “YES”

“They Ain’t Makin’ No More Land”-Will Rogers

• I.R.C. §263(A)(f)(1)o “…interest is capitalized where (1) the interest is paid

during the production period and (2) the interest is allocable to real property that the taxpayer produced and that has a long useful life, an estimated production period exceeding two years, or an estimated production period exceeding one year and a cost exceeding $1 million”

• Corresponding regulation:o “…capitalization of interest under the avoided cost

method described in Treas. Reg. §1.263A-9 is required with respect to the production of designated property…”

What’s the Point?

• If you “build” long-lived property or real property (such as a building) you must capitalize the interest

• The “avoided cost” method requires taxpayers who don’t borrow for the building project to capitalize interest on loans they could have paid off had they not funded the project.

• The rules also require the capitalization of real property taxes incurred during the production period.

Wasco Real Properties I, LLC, et al. v. Comr., T.C. Memo. 2016-224

• Facts:o Taxpayer (three partnerships) bought land that they

planned to use for growing almonds. They financed the purchase by borrowing money and paying interest on the debt. They then began planting almond trees.

o They deducted the interest and property taxes on their return.

o IRS objected on the basis that the interest and taxes were indirect costs of the “production of real property” (i.e., the almond trees that were growing).


• What do the uniform capitalization rules of I.R.C. §263A apply to?o “…real property produced by the taxpayer for the

taxpayer’s use in a trade or business or in an activity conducted for profit.” I.R.C. §263A(b)(1), (c)(1)

o What’s the definition of “real property”? It includes “land” and “unsevered natural products of

land” “Unsevered natural products of land” generally include

“[g]rowing crops and plants where the preproductiveperiod of the crop or plant exceeds two years”


• Almond trees have a greater than two-year preproductive periodo Taxpayers said this didn’t matter because the interest and taxes

related to the land and not the almonds “We ain’t producin’ land”

o Court disagreed: The taxpayer grows almond trees as part of its business and

the trees grow on the land Land, itself, need not be produced because the almond trees

are intertwined – they cannot grow without the land The placing in service of the trees requires that the land be

placed in service• The interest and tax cost of the land is a necessary and

indispensible part of the growing of the almonds trees


• The court noted that:o The unit of property is the land and the almond

trees, thus the placing in service of either of them is dependent on the placing in service of the other one

o The property taxes assessed to that portion of the land directly benefiting the almond trees must be capitalized

o Taxpayers must change their method of accounting for the interest and property tax cost and pick up the amounts deducted in prior years that should have been capitalized. That will be an I.R.C. §481(a) adjustment.

Individual Taxpayer Issues(Part 2)

• Life Insurance Company Demutualizationo Policy holders own mutual life insurance companies Ownership rights

• Voting rights• Share in distributions

Policyholder rights• Contractual insurance rights

B24

Demutualization of Insurance Companies

• Conversion to publicly traded stock corporationso Raising additional capital via an IPOo Issues stock to policyholders to compensate for loss

of mutual ownership rights

Demutualization

• What’s the basis of stock received upon demutualizationo Fisher (Fed. Cl. 2008) Total amount of premiums paid

o Dorrance (9th Cir. 2015) No basis due to lack of evidence

o Reuben (9th Cir. 2016) No basis Rejected Fisher approach

B27

ALTERNATIVE MINIMUM TAX

• Enacted in 1969 (present version enacted in 1982)

• Corrects perceived abuses of regular system• Gradually affected more taxpayers• Indexed starting in 2013

Page B29

AMT

• Form 6251o Part I – AMT Incomeo Part II – Alternative Minimum Taxo Part III – Tax Computation Using Capital Gains

Rates

AMT

Adjustments and Preferences• Personal Exemptions• Standard deduction• Medical expenses• Itemized deductions for taxes• Miscellaneous itemized deductions• Overall limitation on itemized deductions

AMT

Adjustments and Preferences• Personal Exemptions• Standard deduction• Medical expenses• Itemized deductions for taxes• Miscellaneous itemized deductions• Overall limitation on itemized deductions

CREDIT FOR PRIOR YEARMINIMUM TAX

• Avoids double taxation due to timing issues• Form 8801, Credit for Prior Year Minimum Tax

Page B51

Small Business IssuesPart 2

• Repair/Cap update (selected portions)o Building property Building and its structural components are a single UOP Leased property, inventory property and capitalized

improvements are subject to different standards Distinct UOP determinations also apply to condos and co-

opso Improvements Example 10

o Leased building property Example 11

B74

Materials and Supplies

• Qualifying materials and supplies are not subject to capitalizationo Tangible, non-inventory property used or consumed

in a taxpayer’s business that… Are units of property with economic useful life of 12

months or less• See Examples 12-14 on p. B77

Units of property costing $200 or less Items that can be consumed in 12 months or less Components used to improve, repair or maintain a UoP

B76

Materials and Supplies• But, some items are not eligible to be

capitalized…o A part that is intended to be used as a component of

a UoP that… Has an economic useful life of 12 months or less; The part costs $200 or less; or The part is identified in the Fed. Reg. of IRB

o No election has been made to capitalize the property the part is intended to fix

o Taxpayer uses the optional method of accounting for rotable and temporary spare parts

B79

Distinguishing Between Repairs and Maintenance vs. Improvements

• Is it a betterment, adaptation or restoration?o Ameliorationo Material additiono Increase productivity, efficiency, etc.o Replace a major component of a UoPo Return to ordinary efficient operating condition Example 18 and 19

B81

Election to Capitalize Repairs and Maintenance Costs

• Costs must be incurred in carrying on a trade or business; and

• The taxpayer treats the amounts as capital expenditures on its books and records regularly used for computing income

• Must apply the election to all repair and maintenance amounts that it treats as capital expenditures on its books and records for that tax year

• Irrevocable – attach statement

B82

Safe Harbors

• Routine maintenance• Small taxpayers

o Eligible building property Average annual gross receipts of $10 million or less for the

three preceding years Each building unit has an unadjusted basis of $1 million or less Qualified expenditures – lesser of 2% of building’s unadjusted

basis or $10,000

• De Minimiso But no application to inventory prep costs, land costs,

and certain expenses related to parts

The Regs. and Sec. 179

• Materials under $200 can be expensed without regard to Sec. 179

• Amounts expenses under de minimis safe harbor don’t impact Sec. 179 limitation

• De minimis safe harbor election applies to all items that must be capitalized and cost less than taxpayer’s de minimis threshold.

• Sec. 179 can’t reduce taxable income below zero, but expensing under safe harbor can

B91

The Regs. and Sec. 179• It’s ordinary income upon disposition of items

deducted under the safe harboro Might also trigger S.E. tax

• No S.E. tax on income triggered on sale of Sec. 179 items and portion might be eligible for cap. gain treatment

• When to use de minimis safe harbor:o Items are used in non-business activitieso Dollar limitation of Sec. 179 is already exhaustedo Items don’t qualify for Sec. 179

B92

Dispositions

• Upon sale, it’s ordinary income and not qualified for capital gain treatmento Example 27

• Self-employment tax?o Two schools of thought If no S.E. tax – Part II of Form 4797 If S.E. tax – Schedule C

B95-96

Building Property Dispositions

• Improvements become part of the buildingo Form 4797 (no S.E. tax)

• Can claim loss on partial disposition even if replaced component is not separately identified on taxpayer’s depreciation scheduleo Replacement component must be capitalized and is

not treated as a repair deduction

B97

Mandatory Imposition of Partial Disposition Rule

• Partial disposition resulting from a casualty event

• Where gain is not recognized in whole or in part under a like-kind exchange or eminent domain process

• The transfer of a portion of an asset in a “step-in-the-shoes” transaction

• The sale of a portion of an asset

B97

Planning Considerations• You get an immediate tax deduction for portion

of basis allocable to asset that was retired. But, what if the asset is sold in a later year?o Gain on sale will be higher that it would have been

without the election, but portion of gain attributable to depreciation will be lower. So, that portion might be capital gain.

o May have NIIT on the gaino Gain may increase AGI so watch phase-outso AMT?o Loss on disposition is subject to Sec. 1231 recapture

B97

Rulings and CasesChapter B6

• Debt discharge reporting evento I.R.C. §6050P(c)(2)(D)requires an “applicable

entity” (lenders and financial entities) to issue an information return if it discharges $600 or more of indebtedness.

oDebt is deemed discharged only upon the occurrence of an “identifiable event,” regardless of whether or not an actual discharge has occurred on or before that date. 7 occurrences that are actual; and The expiration of a non-payment testing period

B234

Debt Discharge Reporting Event• If testing period expired without payment by the debtor…

o Rebuttable presumption arose that an identifiable event had occurred, and the creditor had to issue a Form 1099-C.

o However, the presumption might be rebutted by the creditor, and the creditor was not required to issue a Form 1099-C, if… Creditor, or a third party on its behalf, engaged in significant bona fide

collection activity at any time during the 12-month period ending at the close of the calendar year; or

The facts and circumstances existing as of January 31 of the calendar year following the expiration of the non-payment testing period indicated that the indebtedness had not been discharged.

Debt Discharge Reporting Event• The fact that a creditor reported under the 36-month rule did not necessarily

reflect a discharge of debt.

• But, debtor might conclude that debtor had taxable income even though the creditor had not discharged the debt and continued to pursue collection.

• Issuing a 1099-C before a debt had been discharged might also cause IRS to initiate compliance actions even though a discharge had not occurred.

• No additional reporting is required if a subsequent identifiable event occurs. o Therefore, in cases in which the Form 1099-C was issued because of the 36-month

rule but before the debt was discharged, IRS did not subsequently receive third-party reporting when the debt was actually discharged. IRS's ability to enforce collection of tax for discharge of indebtedness income might be

diminished when the information reporting did not reflect an actual cancellation of indebtedness.

Debt Discharge Reporting Rule

• 36-month rule and related provisions are eliminated

• Applicable to information returns required to be filed, and payee statements required to be furnished, after Dec. 31, 2016

Rulings and CasesChapter B6

• Clark v. Comr., T.C. Memo. 2015-175o Taxpayer financed the purchase of a vehicle and then

defaulted with the vehicle being repossessed. Car was sold at auction and a balance remained due as of 2005.

o Ultimately the balance was written off and a 1099-C was issued in 2011. The taxpayer didn’t report it.

o IRS said because collection action occurred within 36-month period

o Court said IRS couldn’t show that collection action was actually taken and debt discharge occurred in 2008, so no debt discharge in 2011.

B234

New Regulation

• T.D. 9793 (Nov. 9, 2016); Treas. Reg. §1.6050P-1o Final reg. that eliminates the rule under which,

subject to exceptions, a creditor had to furnish Form 1099-C, Cancellation of Debt, if there was a 36-month period during which the creditor hadn't received any payment on its indebtedness.

o Designed to eliminate confusion as to whether and when an actual debt discharge has occurred.

IRA Prohibited Transactions

• Kellerman v. Rice (E.D. Ark. Sept. 14, 2015)o IRA claimed as exempt in bankruptcyo However, IRA was to contribute land and cash to the

acquisition and development of real estate. IRA purchased the land and spent funds to develop it

o Bankruptcy court said IRA lost its exempt status before bankruptcy filed IRA used as a lending source for buying and developing

the land IRA owner also dealt with the income and assets of the

IRA as a fiduciary for his own interest

Capital Gains and Losses• Poppe v. Comr., T.C. Memo. 2015-205

o High school math teacher engaged in trades with his Fidelity account 4-5 hours daily, executing about 60 trades a month

o Accountant said to file mark-to-market electiono Return said he made the election but did have a copy

of Form 3115 Return showed $142,000 of business income and occupation as

“teacher”o Later became full-time trader (400 trades/month) and

ran up a big loss and didn’t timely fileo Court said election invalid and losses were capital

B240

Partners’ Income• United States v. Stewart, et al. (S.D. Tex. Aug. 20 2015)

o LLC bought oil and gas properties and asked the seller to manage the wells. The defendant was one of the execs. of the seller (a limited

partnership)o The defendant got a K-1 and reported the income as ordinary

(from commissions), but the L.P. later amended its return and reclassified the ordinary income as capital gain. New K-1s were issued and the defendant amended his return and requested a refund A fifth partner’s refund was refused and IRS investigated

o Court said it was a partnership and the profits were l.t. capital gain and IRS had accepted the return

B242

Casualty Loss

• Alphonso v. Comr., T.C. Memo. 2016-130o Taxpayer was tenant/stockholder in cooperative

housing corp. that owned a 7-acre tract on which a high-rise residential apartment building and cottage was constructed. The grounds were supported by a retaining wall.

o The wall collapsed and taxpayer claimed a casualty loss which IRS denied due to it being gradual in nature

o Court agreed with IRS – bad expert witness and underlying deficiencies never corrected

B244

Theft Loss• Haff v. Comr., T.C. Memo. 2015-138

o Taxpayer invested in an LLC that was a development company and a joint venture with GSX via his single member LLC

o SEC claimed what he invested in was a Ponzi schemeo Taxpayer claimed he lost all his investment and claimed a bad debt

deduction of over $2 million for investment and fees owedo IRS said no, but allowed a theft loss deduction for contributions to

development companyo Court agreed with IRS - fees were not a “qualified investment”

B245

Carried-Over Credits• They die with the taxpayer

o Vichich v. Comr., 146 T.C. No. 12 (2016)

436

B246

Forfeited Gain

• Esker v. United States (Fed. Cir. Jun. 10, 2016)o Taxpayer couldn’t deduct amounts he forfeited to the

government Gains were associated with insider trading Forfeiture was a non-deductible penalty Public policy controlled

B247

Split-Dollar Life Insurance

• Estate of Morrissette, et al. v. Comr., 146 T.C. No. 11 (2016)

• Arthur Morrissette, Sr. started a moving company in 1943 with a single truck and grew his business to become an industry leader.

• In 2006, Clara Morrissette – now widowed – set into motion a plan to pass company stock to her sons and, ultimately, to trusts for her grandchildren.o First, Mrs. Morrissette made her sons trustees in her revocable trust; o Second, she created three dynasty trusts – one for each of her

sons.

B251

Morrissette

• The structure of the dynasty trustso The shareholder agreements set forth arrangements whereby the dynasty trusts

would purchase the stock held by each of the Morrissette brothers when one of them died.

o In order to fund these buyouts, each dynasty trust would secure a life insurance policy on the lives of the two other brothers. Mrs. Morrissette arranged to pay all the projected premiums for the policies in lump sums out of her own revocable trust, which she managed.

o The lump-sum amounts Mrs. Morrissette advanced to pay premiums on the policies was sufficient to maintain them for her sons' projected life expectancies (which at the time ranged from approximately 15 to 19 years). Finalizing this plan, Mrs. Morrissette was confident that company stock held by or for the benefit of her sons would be acquired by the dynasty trusts, and would eventually benefit her grandchildren and future generations of her family.

Morrissette• Mrs. Morrissette advanced approximately $30 million to make lump

sum premium payments on the insurance policies for her three sons.o The financing for these life insurance policies was structured as “split-

dollar arrangements,” meaning that the cost and benefits would be split between the trusts.

o In this case, while Mrs. Morrissette paid a lump sum amount to cover the premiums on these policies, the policies themselves were designed to pay out varying amounts to the trusts for both Mrs. Morrissette and her sons. Specifically, upon the death of any of her sons, Mrs. Morrissette’s revocable

trust would receive the greater of either the cash surrender value of that policy or the aggregate premium payments on that policy, while each dynasty trust would receive the balance of the policy death benefit. The amounts Mrs. Morrissette retained are known as split-dollar receivables (the “Receivables”).

The Issue• In a typical case, a company advances funds to a trust to

pay premiums on insurance on the life of the owner of the company, and the split-dollar receivable is payable upon the death of that owner.

• What was unique in this case is that the split-dollar receivable wasn’t payable until the death of one of Mrs. Morrissette’s sons. o Here, the split-dollar receivable became an asset in Mrs.

Morrissette’s estate. Given her sons’ life expectancies, this asset was not likely payable to the Estate for 20 years.

o So, a seminal issue arose upon filing the estate tax return: how should the Receivables be valued for gift and estate tax purposes?

The Assertion• From 2006 through 2009, Mrs. Morrissette

reported gifts made to the dynasty trusts based upon the cost of the current life insurance protection based on tables published by the IRS determined under the economic benefit regime.

• After Mrs. Morrissette’s death, her estate retained an independent valuation firm to value the Receivables includible in her gross estate as of the date of her death. The total value reported on her estate tax return for the Receivables was $7.48 million.

The IRS Claim

• The IRS ultimately issued two notices of deficiency to the Estate. o The first notice was for a gift tax liability for the tax

year ending December 31, 2006, which determined that the Estate had failed to report total gifts in the amount of $29.9 million – the amount that Mrs. Morrissette paid in a lump-sum payment of policy premiums.

o The second notice grossed up Mrs. Morrissette’slifetime gifts by $29.9 million, and determined additional estate tax liability attributable thereto.

The Court

• On the question of whether the split-dollar arrangements were governed by the loan regime or the economic benefit regime, the Court applied Reg. Sec. 1.61-(1)(ii)(A)(2),which provides that… o If “the only economic benefit provided under the

split-dollar life insurance arrangement to the donee is current life insurance protection, then the donor will be the deemed owner of the life insurance contract, irrespective of actual policy ownership, and the economic benefit regime will apply.”

The Court• Because the split-dollar arrangements were carefully structured to

only pay the dynasty trusts that portion of the death benefit of the policy in excess of the Receivables payable to the revocable trust, the Tax Court concluded that the dynasty trusts could not have any current access under the final regulations.

• Further, the Tax Court also agreed with petitioner that no additional economic benefit was conferred by the revocable trust to the dynasty trusts on account that…o (i) The lump sum premium payment advanced by the revocable trust assured the

revocable trust had sole access to the cash surrender value of the life insurance policies (which was essential to accomplish Mrs. Morrissette’s goal to assure that life insurance proceeds would be available to buy the stock held by any of her sons at death) and;

o (ii) The fact that the revocable trust made the lump sum payments did not obviate the dynasty trusts of any obligation to pay the premiums on an ongoing basis because the dynasty trusts were not required to do so.

The Importance of the Decision

• We now know that compliance with the economic benefit split-dollar regulations protects clients from gift tax liability, with the result that the value of the receivables would be determined based on typical valuation principles (i.e., the amount a third party would pay to purchase the receivables).

Taxable Income

• Barbato v. Comr., T.C. Memo. 2016-23o USPS letter carrier sustained neck and back injuries

while on the job. 13 years later got reassigned to a mail route and

experienced more pain. Managers created a hostile work environment Suffered stress and emotional difficulties EEOC judge said physical pain not caused by USPS

discrimination, but awarded $70,000 in damages Excluded from income No – payment was tied to emotional distress

B259

IRS PROCEDURES ‐ MISCELLANEOUS

BASR PARTNERSHIP v. U.S.

Third Party’s Fraudulent Intent Insufficient to Extend Limitations Period

B262


PAUL W. GRAUER V. COMM’R

Tax Debt Uncollectable Due to Expiration of Limitations Period

“May 8, 2015”


FELIX GURALNIK V. COMM’R

Snow Day Treated as Legal Holiday

B264


JOHN N. ALPHSON V. COMM’R

IRS Was Justified in Rejecting Offer in Compromise

Page B265


JONATHAN AND CHERYL HUNSAKER V. U.S.

IRS Collection Actions Caused Debtors Emotional Distress

B266


ROBERT TILDEN V. COMM’R

Online Postmark Is Not evidence of a Timely Filed Petition

B268

IRS PROCEDURES ‐ PENALTIES

BRINKS GILSON & LIONE A PROFESSIONAL CORPORATION V. COMM’R

Reasonable Cause Not Established


BRADLEY AND NANCY REIFLER V. COMM’R

Lack of Signature Results in Invalid Tax Return


MAURICE S. VAUGHN V. U.S.

Reliance on Agent Does Not Equate to Reasonable Cause Exception

B271

“No Nit Is Too Small for the IRS to Pick”

• Carroll v. Comr., 146 T.C. No. 13 (2016)o The donated easement protects approximately 20 acres

of land near Baltimore, Maryland. The taxpayer donated the easement in December 2005, and claimed a deduction of $1.2 million The Court disallowed the deduction due to poor wording of the

easement deed concerning the distribution of proceeds if the easement is extinguished, e.g., by condemnation. The Court ruled that the extinguishment language must track

the language of the regulation exactly; otherwise the easement fails to meet the requirements of section 170.

• Error probably was inadvertent and could have easily been avoided by a minor edit of the easement deed.

Tax Litigation Involving Blogging

• Lamas-Richie v. Comr., T.C. Memo. 2016-63o Blog drew attraction of investor and suggested a

partnership, which was formedo Employment contract entered into Reported wages, but nothing from the partnership

o Should have reported the partnership income

B281

Reporting of Installment Gain• Debough v. Comr., 142 T.C. No. 17 (2014) [aff’d by

8th Cir. on Aug. 28, 2015]o Facts: Taxpayer bought personal residence in 1966 along with 80

acres of mixed use land for $25,000. He agreed to sell it in 2006 for $1.4 million with the amount to be paid in installments through 2014. Gain of $657,796 reported $505,000 in payments reported on installment method

consisting of $56,920 of gain Buyers defaulted and property reacquired in 2009. Taxpayer treated reacquisition under I.R.C. §1038 such that he

wouldn’t have to report the portion of the gain that was previously excluded under I.R.C. §121 IRS claimed that taxpayer should recognize long-term capital

gain in 2009 when property reacquired

B2878 I.R.C. §1038

• If the sale of real property triggers indebtedness to the seller with the debt being secured by the property that is sold and the seller reacquires the property in partial or full satisfaction of the debt, generally the reacquisition does not result in gain or loss to the seller and the debt does not become worthless (even partially).o The rule bars a taxpayer from claiming any loss on

reacquisition. But, an exception exists where a principal residence is repossessed and resold within one year.

Major Exception to I.R.C. §1038• If the seller has received cash payment, I.R.C.

§1038 taxes the seller on the gain attributable to those payments to the extent these amounts have not previously been reported as income. I.R.C. §1038(b)(1).

• I.R.C. §1038(e)o With respect to Sec. 121, taxpayers that reacquire

the property and sell it within one year can treat the subsequent sale as the original sale for I.R.C. §121 purposes No application in this case

Debough• Court held that transaction fit squarely under

I.R.C. §1038 and that taxpayer must report the gaino I.R.C. §1038 does not contain any provision to allow

taxpayers to exclude I.R.C. §121 gain resulting from a sale and subsequent reacquisition of a principal residence because they didn’t re-sell it within one year.

Note on Debough• Upon reacquisition of the residence, the

taxpayer would still be required to meet the two-out-of-five year ownership and use test. o That could be difficult to satisfy in many reacquisition

settings, unless the taxpayer moves back into the residence. If the test isn’t met, the taxpayer might be able to satisfy the requirements for a reduced exclusion.

o Also, the reacquisition would cause an increase the basis of the residence to the extent of the gain recognized on repossession which, in turn, would result in less gain on resale.

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