The following article originally appeared in the newsletter of the Kansas Bar Association Real Estate, Probate and Trust Law Section. It is reprinted here by permission.
By Mike Cannady
Fleeson, Gooing, Coulson & Kitch, L.L.C.
CASES
1. Distributions from Widow’s IRA Subject to Tax and Penalty: Ozimkoski v. Commissioner, T.C. Memo 2016-228, 2016 WL 7362679 (Dec. 19, 2016)
In Ozimkoski, Mrs. Ozimkoski, the surviving spouse, and her step-son, reached an agreement in relation to the step-son’s challenge to his father’s Will. The agreement called for Mrs. Ozimkoski to pay to her step-son $110,000 as a “net payment free of tax.” The parties presumably contemplated that the payment would come from the decedent’s IRA, as it provided for the payment to be made within 30 days after Wachovia unfroze the IRA. Although Mrs. Ozimkoski was not the beneficiary of the IRA (the court did not indicate who was), the IRA was rolled over into Mrs. Ozimkoski’s IRA. Thereafter, Mrs. Ozimkoski received distributions from the IRA totaling $142,000, and wrote a personal check for $110,000 to her step-son. Mrs. Ozimkoski did not report the IRA distribution from her IRA as income, and the IRS issued a notice of deficiency for the income tax, the Code Sec. 72(t) tax, and the Code Sec. 6662 accuracy-related penalty.
The Tax Court noted that Mrs. Ozimkoski’s probate attorney had failed to counsel her on the full tax ramifications of paying the $110,000 from her own IRA, and that Wachovia should have distributed the IRA assets to the decedent’s estate and not into Mrs. Ozimkoski’s IRA. However, it held that it had no jurisdiction to unwind that transaction, and found that the distributions she received were from her own IRA, and thus were considered taxable income to her. In addition, those distributions were subject to the 10% tax under Code Sec. 72(t), as she had not yet reached the age of 59½. The Tax Court did reduce the amount of the Code Sec. 6662 accuracy-related penalty, applying it only to the portion of the IRA distribution in excess of the $110,000 used to make the payment required under the settlement agreement. Because of Mrs. Ozimkoski’s inexperience, her absence of knowledge, and lack of legal education, the Tax Court found that she had reasonable cause regarding, and had acted in good faith with respect to, the portion of her underpayment attributable to her failure to include in her taxable income the $110,000 she had paid to her step-son.
2. Failure to Obtain Proper Acknowledgement Leads to Loss of Multi-million Dollar Charitable Deduction: 15 West 17th Street LLC v. Commissioner, 147 TC No. 19, 2016 WL 7406988 (Dec. 22, 2016)
The taxpayer in this case is an LLC that executed in favor of the Trust for Architectural Easements a historic preservation deed of easement. The deed granted the Trust a perpetual conservation easement over a parcel of property that had been placed on the National Register of Historic Places. The Trust sent the LLC a letter acknowledging receipt of the easement, but the letter did not state whether the Trust had provided any goods or services to the LLC, or whether the Trust had otherwise given the LLC anything of value, in exchange for the easement. The LLC secured an appraisal concluding that the easement had reduced the property’s value by $64,490,000. The LLC filed its partnership tax return and deducted the $64,490,000 as a charitable contribution to the Trust. The LLC included with its return a copy of the appraisal report, a copy of the Trust’s letter acknowledging receipt of the easement, and Form 8283, Noncash Charitable Contributions, executed by the appraiser and by a representative of the Trust.
Thereafter, the Trust filed its Form 990, and an attachment thereto summarized easement donations it had received. Six years later, it filed an amended Form 990, on which the LLC easement donation was specifically described, and a statement that the Trust provided no goods or services to the LLC was included.
The Tax Court held that the LLC could not take any part of the $64.49 million income tax deduction because it failed to obtain a contemporaneous written acknowledgement of the donation, noting, among other things, whether the donee provided the donor with any goods or services in exchange for the gift. The court also held that, because the Treasury has not yet issued regulations on how the substantiation requirements can be met if the charity “files a return, on such form and in accordance with such regulations as the Secretary may prescribe,” the charity cannot satisfy this requirement by filing such information.
3. Double Deduction Allowed – Tax Benefit Rule Not Applied: Estate of Backemeyer v. Commissioner, 147 TC NO. 17, 2016 WL 7166579 (Dec. 18, 2016)
In Backemeyer, the Tax Court held that a surviving spouse could deduct expenses for seed, fertilizer and fuel when she used them in her farming activities, even though they had already been deducted by her late husband when he bought them. The taxpayer’s late husband was a cash basis taxpayer who had purchased seed, fertilizer and fuel in 2010, intending to use them to cultivate crops in 2011. He deducted the costs in 2010, but died in 2011, before he had used any of them. His spouse received the items as the beneficiary of his revocable trust and used them in her own farming business. The Service’s primary contention was that “allowing Mr. Backemeyer to deduct farm input expenses on his 2010 Schedule F, while allowing Mrs. Backemeyer to deduct expenses for the same farm inputs on her 2011 Schedule F, would amount to a double deduction and thereby contravene axiomatic principles of tax law.” The Tax Court, however, refused to apply the tax benefit rule, and held that the surviving spouse could deduct the value of the farm inputs she had inherited, despite her husband’s earlier deductions.
4. Relying on Advice of Attorney Avoids Late Filing Penalties: Estate of Hake v. United States, 234 F. Supp. 3d 626 (M.D. Pa. 2017), appeal filed, March 4, 2017
In Hake, the decedent’s two sons, who, according to the Court, had no experience with probate law, federal estate taxation or related matters, were appointed as the executors of the decedent’s estate. In order to assist them with the administration of the estate, they engaged a law firm that had assisted the family with business matters for many years. Because of ongoing family disputes surrounding valuation of the estate’s assets, it became apparent that a federal estate tax return was not going to be ready for filing by the due date for the return. Therefore extensions were obtained both for the filing of the return, and for the payment of tax. The attorney advised the executors that the extension for filing the return was a one year extension, when in fact it was a six month extension. The executors eventually filed the estate tax return and paid the estate tax within the time period that their attorneys had told them they had. The IRS then notified the estate that a penalty in the amount of $197,868.26, and interest in the amount of $17,202.44, had been assessed under section 6651 of the Internal Revenue Code for failure to file a timely return.
The Court, acknowledging that the circuits were split on this issue, relied on precedents in its own Third Circuit in holding that the executors were not liable for substantial penalties for filing the estate tax return late because they filed it within the time their attorney had told them it was due.
The executors, then asked that they be able to recover their attorney’s fees from the government. However, the Court held that they could not, as the estate’s net worth was far above the limit for an individual or estate seeking to recover attorney’s fees under Code Sec. 7430, and the position of the government was substantially justified, based on a division among the circuits.
The government has filed an appeal with the Third Circuit Court of Appeals, which is pending.
5. Denial of Ira Rollover Hardship Waiver Overturned: John C. Trimmer, et ux. v. Commissioner, 148 T.C. NO. 14, 2017 WL 1408496 (April 20, 2017)
The Taxpayer, while suffering from major depressive disorder after retiring from the NYPD in 2011, received two distributions from his retirement accounts but did not roll them over into another qualified retirement account within the requisite 60-day period of Code Sec. 402(c)(3)(A). When a tax return preparer pointed out the problem some months later, the funds were rolled over into an IRA. The taxpayer never used any of the funds, and on his tax return he reported the two distributions as nontaxable. During an examination of his tax return, the taxpayer requested a hardship waiver from the 60-day rollover requirement. The IRS denied the request.
The IRS contended that the Examination Division lacked the authority to consider a hardship waiver under § 402(c)(3)(B) and that, in any event, the discretion of the IRS in denying a hardship waiver is not subject to judicial review.
The Tax Court held that the Examination Division did have authority to consider the request for a hardship waiver under § 402(c)(3)(B), that it was subject to judicial review, and that the denial of the waiver would be “against equity or good conscience,” within the meaning of § 402(c)(3)(B).
6. Two Cases with Negative Results for Family Entities Holding Cash and Marketable Securities: Estate of Powell v. Commissioner, 148 T.C. No. 18, 2017 WL 2211398 (May 18, 2017) and Estate of Koons v. Commissioner, 585 Fed. Appx. 779 (11th Cir. 2017)
In Powell, prior to the decedent’s death, the decedent’s son, acting on the decedent’s behalf, transferred cash and securities to a limited partnership in exchange for a 99% limited partner interest. The LP’s partnership agreement allowed for the entity’s dissolution with the written consent of all partners. On that same date, the son also transferred the decedent’s LP interest to a charitable lead annuity trust, the terms of which provided an annuity to a charitable organization for the rest of the decedent’s life, and upon the decedent’s death, the CLAT corpus was to be divided equally between the decedent’s two sons. The decedent died a week later. After the filing of a gift and estate tax returns, the IRS determined a deficiency of $5,870,226 in the Federal estate tax and $2,961,366 in Federal gift tax. The estate contended that there was no deficiency in either estate or gift tax.
The Tax Court held that the decedent’s ability, acting with the LP’s other partners, to dissolve the partnership was a right “to designate the persons who shall possess or enjoy” the cash and securities transferred to the LP “or the income therefrom,” within the meaning of Code Sec. 2036(a)(2). Furthermore, because the decedent’s limited partnership interest was transferred, if at all, less than three years before her death, the value of the cash and securities transferred to the LP is includible in the value of her gross estate to the extent required by either Code Sec. 2036(a)(2) or 2035(a).
The Court also held that the transfer of the decedent’s interest to the CLAT was either void or revocable under applicable State law because the decedent’s power of attorney did not authorize the making of gifts in excess of the annual Federal gift tax exclusion; consequently, the value of the 99% limited partner interest in the LP, as of the date of the decedent’s death, is includible in the value of her gross estate under Code Sec. 2033 or 2038(a).
In Koons, the decedent’s estate held a 70.4% interest in an LLC that held cash and marketable securities. A year after the decedent’s death, the LLC made a large loan to the decedent’s revocable trust to provide cash for the payment of estate and gift taxes. The Eleventh Circuit, affirming the Tax Court, held that, due to the size of the decedent’s controlling interest and the liquidity of the LLC assets, the appropriate valuation discount for the LLC interests was 7.5%, rather than the 31.7% claimed by the estate. The court also denied the deduction for the loan interest because the estate, given its controlling interest in the LLC, could have caused the LLC to distribute the needed assets to the trust.
STATUTORY AND REGULATORY DEVELOPMENTS, AND IRS RULINGS
7. No Charitable Deduction for Distributions Made Pursuant to Court Reformation: I.R.S. Chief Couns. Advis. 201651013, 2016 WL 7314664 (Dec. 16, 2016)
In Chief Counsel Advisory 201651013, the IRS Chief Counsel denied an income tax deduction for trust distributions of income made by a trust to two private foundations. The distributions had been made after the trust was modified by a State court. According to the Chief Counsel, there was no conflict with respect to the trust, and the trust terms were unambiguous. The purpose of the court ordered modification was simply to obtain the economic benefits that the parties believed they would receive from the modification. The Chief Counsel ruled that the distributions were not deductible as charitable contributions under Code Sec. 642(c) because they were not made “pursuant to the terms of the governing instrument.” Furthermore, income distributions from a trust to a charity are not alternatively deductible as distributions to a beneficiary under Code Sec. 661. Therefore the distributions were not deductible.
8. Guidance to Avoid 5% Probability Test for CRATS: Rev. Proc. 2016-42, 2016-34 I.R.B. 269, 2016 WL 4199667 (Aug. 10, 2016)
To qualify as a charitable remainder trust under Code Sec. 664, a Charitable Remainder Annuity Trust must satisfy a number of requirements, including the requirement that it pass the ‘’probability of exhaustion’‘ test, which requires that the probability be no more than 5 percent that the qualified remainder beneficiary (i.e. the charity) will not receive any property. Under the current low interest rate environment, it is not possible in many cases to meet the 5% probability of exhaustion test applicable to a CRAT payable over one or more measuring lives. In response to those situations, the IRS has issued Rev. Proc. 2016-42, 2016-34 IRB 269 , which provides a sample provision containing specified “qualified contingency” language that, if included in the governing instrument of a CRAT, will not subject the CRAT to the 5% probability of exhaustion test.
The sample qualified contingency provision provides for the early termination of the CRAT on the date immediately before the date on which any annuity payment would be made if such payment would cause the value of the corpus of the CRAT, when multiplied by a specified discount, to be less than 10% of the value of the initial trust corpus. Upon such early termination, annuity payments otherwise required to be paid to a noncharitable beneficiary or beneficiaries are discontinued. Rev. Proc. 2016-42 applies an alternative only to meeting the 5% probability of exhaustion test and has no application to the statutorily prescribed 10% remainder interest requirement. The sample provision contained in Rev. Proc. 2016-42 supplements the sample forms that the IRS had previously issued for CRATs.
9. Court Change to Ira Beneficiary Didn’t Result in Inherited IRA: I.R.S. Priv. Ltr. Rul. 201706004, 2017 WL 537745 (Feb. 10, 2017)
In PLR 201706004, the decedent had an IRA, the beneficiary of which was a trust that he had purportedly created. However, there was no evidence that he actually created the trust, and therefore the state court approved a change in the beneficiary designation so that his widow was the beneficiary. A request for a Private Letter Ruling was made in order to determine if the widow was the designated beneficiary, and if she could, therefore, roll the IRA into her own IRA.
The IRS determined that a court order cannot create a “designated beneficiary” for purposes of section 401(a)(9) because the widow was not the designated beneficiary of the IRA as of the date of decedent’s death. Accordingly, there is no “designated beneficiary” of the IRA. As the decedent died before the required beginning date and without a “designated beneficiary,” the entire interest in the IRA must be distributed using the 5-year rule described in section 401(a)(9)(B)(ii).
10. Spousal IRA Rollover Permitted from a Trust: I.R.S. Priv. Ltr. Rul. 201707001, 2017 WL 652048 (Feb. 17, 2017)
In PLR 201707001, the IRS ruled that a surviving spouse could roll over her deceased spouse’s IRAs, payable to a trust of which she was sole trustee and beneficiary, into her own IRA. The election to treat the decedent’s IRA as the surviving spouse beneficiary’s IRA is available only if the spouse is “the sole beneficiary” of the IRA and has an unlimited right to withdraw amounts from it. The sole beneficiary requirement is not met if a trust is named as the IRA’s beneficiary, even if the spouse is the sole beneficiary of the trust.
However, in this situation, the IRAs were allocated to the Survivor’s Trust, and because the surviving spouse was the trustee and sole beneficiary of the Survivor’s Trust and was entitled to the income and principal of the Survivor’s Trust up to and including the entire trust estate of the Survivor’s Trust, for purposes of applying Code Sec. 408(d)(3)(A), the surviving spouse was effectively the individual for whose benefit the accounts were maintained. As a result, the surviving spouse was entitled to rollover the distributions into an IRA established and maintained in her name.
11. Tax Aspects of Funding a Trust Pursuant to Divorce: I.R.S. Priv. Ltr. Rul. 201707007, 2017 WL 652061 (Feb. 17, 2017)
In PLR 201707007, the IRS ruled that a husband’s transfer of property to a trust to benefit his ex-wife pursuant to a divorce agreement was a transfer for full and adequate consideration.
The divorce settlement agreement called for the husband to transfer half of his shares in a company to a trust, the net income from which was to be distributed to the ex-wife. The trustee was prohibited from distributing company shares from the trust to the ex-wife or selling shares to fund principal distributions, and the ex-wife had no power to appoint the trust property during her life or at death. In exchange, the ex-wife relinquished all marital rights and property claims that she might have acquired during the marriage. When the ex-wife died, the remaining trust principal reverted to the husband or his estate.
Assuming that the final divorce decree was entered within the time period provided in Code Sec. 2516, the IRS ruled that the husband’s transfer to the trust was considered a transfer for full and adequate consideration, and therefore not a taxable gift.
The IRS noted that the husband’s retained rights over the property resulted in inclusion of the trust property in his gross estate under Code Sec. 2036. The fair market value of the trust property on the valuation date would be reduced by the fair market value of the wife’s outstanding term interest.
12. Consequences of Divorce-Related CRUT Division: I.R.S. Priv. Ltr. Rul. 201648007, 2016 WL 6909837 (Nov. 25, 2016)
In PLR 201648007, the IRS rules that the division of a charitable remainder unitrust into two separate successor CRUTs as a result of a couple’s divorce did not cause the original trust or the successor trusts to fail to qualify as charitable remainder trusts under Code Sec. 664.
The CRUT was established by the husband while the couple was married. When they got divorced, the couple agreed to a property settlement, pursuant to which the CRUT was divided into two new trusts, with each successor CRUT receiving a pro rata share of each asset of the original CRUT’s corpus. The general terms of the successor CRUTs were the same as the terms of the original trust, with the following exceptions: (1) the former spouses would possess no interest in the other’s CRUT; (2) each former spouse would be allowed to select the charitable remainder beneficiaries who would receive the remaining assets of their respective CRUT upon that spouse’s death; (3) each former spouse would be the sole noncharitable beneficiary of their respective CRUT; and (4) each former spouse would receive their unitrust payments from their respective CRUT.
The trust division did not cause the successor trusts to lose their status as charitable remainder trusts, nor did it result in the realization of any gain or loss for income tax purposes. Each party’s basis in the new trusts would be a pro-rata portion of his or her basis in the original trust and their holding periods in the original trust would be tacked. As long as the couple’s divorce was finalized within two years of the date that the property settlement agreement was executed, the IRS ruled that the division of the original trust and the distribution of the trust assets to the successor CRUTs would be treated as transfers made for full and adequate consideration in money or money’s worth.
13. Trust Treated as Non-Grantor Trust: I.R.S. Priv. Ltr. Rul. 201650005, 2016 WL 7167530 (Dec. 9, 2016)
In PLR 201650005, the IRS ruled on whether a particular trust should be treated as a grantor trust.
The trust was created by the Grantor as an irrevocable trust. It was held for the benefit of himself, his spouse, his mother, and his issue.
The trust states that Grantor’s intentions in creating the trust are, generally, that (1) the trust is a non-grantor trust for federal tax purposes, (2) no gifts to the trust are completed gifts for federal tax purposes, and (3) the assets of the trust will be includable in Grantor’s gross estate.
During Grantor’s lifetime, the trustee generally must distribute such amounts of net income and principal to one or more beneficiaries as directed by the Distribution Committee (acting in various circumstances either by majority vote or unanimously). The Distribution Committee is initially composed of the Grantor, his mother, and the guardians of his two children. A vacancy on the Distribution Committee must be filled by the eldest of Grantor’s adult issue other than any issue already serving as a member of the Distribution Committee, or if none of Grantor’s issue not already serving as a member of the Distribution Committee is an adult, the individual who has legal authority to act on behalf of Grantor’s eldest issue under State law.
Upon the Grantor’s death, the trust will terminate and the remaining balance of the trust will be distributed to such persons, corporations, or entities, other than Grantor’s estate, Grantor’s creditors, or the creditors of Grantor’s estate, as Grantor may appoint by living trust or will.
The IRS concluded that none of the circumstances that would cause Grantor to be treated as the owner of any portion of Trust exists as long as the Distribution Committee remains in existence and the trust remains a U.S. person. Dissolution of the Distribution Committee without a suitable replacement would likely cause the Trust to become a grantor trust.
14. Account Transcript Can Substitute for Closing Letter: I.R.S. Notice 2017-12, 2017-5 I.R.B. 742, 2017 WL 66407 (Jan. 23, 2017)
Before June 1, 2015, the IRS issued an estate tax closing letter for every estate tax return filed (except in certain cases relating to making a portability election). However, for estate tax returns filed on or after June 1, 2015, the IRS changed its policy and issues an estate tax closing letter only at the request of an estate, which request is to be made at least four months after the filing of the estate tax return.
The IRS has now issued a notice in relation to the use of an account transcript as a substitute for an estate tax closing letter. The IRS indicates that it understands that executors, local probate courts, state tax departments, and others have come to rely on estate tax closing letters for confirmation that the IRS examination of the estate tax return has been completed and the IRS file has been closed. Therefore, estate tax closing letters will continue to be available upon request. However, an account transcript may substitute for an estate tax closing letter and is available at no charge.
An account transcript is a computer-generated report that provides current account data. The information reported on an account transcript includes the return received date, payment history, refund history, penalties assessed, interest assessed, the balance due with accruals, and the date on which the examination was closed. Receipt of an account transcript with a transaction code of “421” confirms the closing of the IRS examination of the estate tax return. In other words, an account transcript showing a transaction code of “421” can serve as the functional equivalent of an estate tax closing letter.
The IRS may reopen the examination of the estate tax return after the issuance of a closing letter or the entry of transaction code “421” on the account transcript for the purpose of determining the estate tax liability of a decedent in a circumstance described in both the closing letter and Rev Proc 2005-32 . Further, as provided in Code Sec. 2010(c)(5)(B), Reg. § 20.2010-2(d), and Reg. § 20.2010-3(d), the IRS may examine the estate tax return of a decedent after the issuance of a closing letter, or the entry of transaction code “421” on the account transcript, for the purpose of determining the transfer tax liability of the surviving spouse of that decedent when portability has been elected.
Estates and their authorized representatives may request an account transcript by filing Form 4506-T, Request for Transcript of Tax Return. Currently, Form 4506-T can be filed with IRS via mail or facsimile (per the instructions on the form). Although account transcripts for estate tax returns are not currently available through the IRS’s online Transcript Delivery System, the IRS website, www.irs.gov, will have current information should an automated method become operational. To allow time for processing the estate tax return, requests should be made no earlier than four months after filing the estate tax return.
Estates and their authorized representatives who wish to continue to receive estate tax closing letters may call the IRS at 866-699-4083 to request an estate tax closing letter no earlier than four months after the filing of the estate tax return, said IRS.
CHANGES IN STATE LAW
15. Revised Uniform Fiduciary Access to Digital Assets Act, K.S.A. 58-4801, et seq.
The Kansas Legislature has passed, and Governor Brownback has signed into law, the Revised Uniform Fiduciary Access to Digital Assets Act. The Act gives powers of attorney, executors, administrators, guardians and conservators, and trustees access to digital assets. A digital asset is defined as an electronic record in which an individual has a right or interest, but it would not include an underlying asset or liability unless the asset or liability is itself an electronic record.
Among other things, the Act also:
Allows a person who has an account with a custodian (a “user”) to use an online tool to direct the custodian to disclose to a designated recipient or not disclose some or all of the user’s digital assets, including the content of electronic communications.
Outlines a custodian’s responsibilities in disclosing digital assets and the timeline for disclosure as well as other actions allowed, such as charging a reasonable administrative fee or choosing not to disclose deleted assets.
States that a custodian must disclose the content of electronic communications to a personal representative acting for a decedent if the deceased user consented or a court directs disclosure.
Directs that, absent a user’s prohibition or a court order, a custodian must disclose a catalog of electronic communications and digital assets to a representative acting for a decedent if the representative provides certain documentation to the custodian, including a written request for disclosure; a certified copy of the user’s death certificate; and a certified copy of a letter appointing the representative, small estate affidavit, or court order.
Specifies legal duties imposed on a fiduciary charged with managing tangible property apply to the management of digital assets, including the duties of care, loyalty, and confidentiality, and describes the scope of a fiduciary or designated recipient’s authority over a user’s digital assets.
16. Senate Bill No. 30
The Kansas Legislature has passed, and has overridden Governor Brownback’s veto of, Senate Bill No. 30 which amends and repeals several existing statutory sections. Under the bill, the income tax breaks for businesses implemented in 2013 have ended. Business income earned on and after January 1, 2017, is no longer exempt from Kansas income tax. The bill includes a provision that relieves taxpayers from being assessed penalties and interest for underpayment of taxes due to the retroactive nature of this change, as long as the underpayment is rectified on or before April 17, 2018.
SB 30 also replaces the current two-bracket individual income tax system with three brackets. For tax year 2017, the bottom bracket will be 2.9%, the middle bracket 4.9% and the top bracket 5.2%. Those rates increase in 2018 to 3.1%, 5.25% and 5.7%.
The bill also brings back the child and dependent care tax credit (12.5% of the allowable federal amount in 2018, 18.75% in 2019 and 25% in 2020 and thereafter), and the deduction for medical expenses (50% of the allowable federal amount in 2018, 75% in 2019 and 100% in 2020 and thereafter), and increases the mortgage interest deduction (75% of the allowable federal amount in 2019 and 100% in 2020 and thereafter).