Selected Recent Federal Tax Developments Affecting Estate Planning and Administration

Michael J. Jones and DeeAnn L. Thompson1

Prepared for The CPE Forum of the Central CoastDecember 2, 2014 Meeting

CAVEATThis document contains selected developments based on the author’s sense about what might be of interest to readers. It is not intended to be a comprehensive work detailing all recent federal tax developments.

Table of Contents

CAVEAT...................................................................................................................................................... 1

SELECTED 2015 INFLATION ADJUSTMENTS.................................................................................4EXCERPTS FROM REV. PROC. 2014-61, 2014-47 IRB 1 (OCT. 30, 2014)................................................4

§ 1: INCOME TAX RATES....................................................................................................................... 5

§ 67: 2-PERCENT FLOOR ON MISCELLANEOUS ITEMIZED DEDUCTIONS.............................5T.D. 9664, 79 F.R. 26616-26620 (MAY 8, 2014): IRS ISSUES FINAL REG. § 1.67-4, COSTS PAID OR INCURRED BY ESTATES OR NON-GRANTOR TRUSTS.........................................................................................5

§ 101: LIFE INSURANCE........................................................................................................................ 6LTR 201423043 (FEB. 15, 2014): JOINT GRANTOR TRUST’S SALE OF LIFE INSURANCE POLICY TO ANOTHER GRANTOR TRUST ISN’T TRANSFER FOR VALUE.................................................................................6ILM 201328030 (MAR. 18, 2013): RIGHT TO RECEIVE INSURANCE POLICY DIVIDENDS NOT INCIDENTS OF OWNERSHIP........................................................................................................................................8

§ 170: CHARITABLE INCOME TAX DEDUCTION............................................................................8PALMER RANCH HOLDINGS LTD. ET AL. V. COMMISSIONER, T.C. MEMO. 2014-79, NO. 17017-11 (MAY 6, 2014): CONSERVATION EASEMENT VALUED BY TAX COURT...........................................................8WHITEHOUSE HOTEL LTD. PART. ET AL. V. COMM’R, NO. 13-60131., 5TH CIR. (JUN. 12, 2014): AFF’G IN PART AND REV’G IN PART 139 T.C. NO. 13 (2012)..........................................................................9

§ 401 ET SEQ.: RETIREMENT PLANS..............................................................................................11TREASURY DECISION 9673, 79 F.R. 37633-37643 (JULY 2, 2014): REGULATIONS MODIFIED TO ACCOMMODATE “QUALIFIED LONGEVITY ANNUITY CONTRACTS”..................................................................11NOTICE 2014-19, 2014-17 IRB 1 (APR. 4, 2014) AND NOTICE 2014-37, 2014-23 IRB 1 (MAY 15, 2014): IRS GUIDANCE ON APPLICATION OF WINDSOR TO PENSION PLANS.......................................12ALVAN L. BOBROW ET UX. V. COMMISSIONER, NO. 7022-11, T.C. MEMO. 2014-21 (JAN. 28, 2014): TAX COURT INTERPRETS ONE ROLLOVER PER YEAR DIFFERENTLY THAN IRS PUBLICATION 590 AND TEMPORARY REGULATIONS.....................................................................................................................................12IRS ANNOUNCEMENT 2014-15; 2014-16 I.R.B. 973 (MAR. 20, 2014): IRS WILL APPLY BOBROW PROSPECTIVELY, BEGINNING JAN.1,2015..........................................................................................................18REG-209459-78; 79 F.R. 40031-40032: IRS WITHDRAWS PROPOSED REGULATION AT VARIANCE WITH BOBROW..........................................................................................................................................................18

1 © 2014, Michael J. Jones and DeeAnn L. Thompson. All rights reserved in all media.

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ANNOUNCEMENT 2014-32, 2014-48 IRB 1 (NOV. 10, 2014): APPLICATION OF ONE-PER-YEAR LIMIT ON IRA ROLLOVERS.....................................................................................................................................19HAURY V. COMMISSIONER, NO. 13-1780, 8TH CIR. (MAY 12, 2014), REV’G IN PART T.C. MEMO. 2012-215 (2012): 60-DAY IRA ROLLOVER WAS VALID...........................................................................................19ESTATE OF KESSEL V. COMM’R., T.C. MEMO. 2014-97 (MAY 21, 2014): NO SUMMARY JUDGMENT FOR GOVERNMENT IN VALUING DECEDENT’S PERSONAL PENSION PLAN INVESTED IN MADOFF PONZI SCHEME

..................................................................................................................................................................................... 21CLARK V. RAMAKER, 573 U. S. ____ (JUN. 12, 2014): SUPREME COURT HOLDS INHERITED IRA DOESN’T QUALIFY FOR EXCLUSION FROM BANKRUPTCY ESTATE..................................................................22

Spousal Rollover Accounts.............................................................................................................................. 23ERISA Protection................................................................................................................................................. 24

LTR 201423043 (FEB. 15, 2014): SURVIVING SPOUSE MAY ROLL OVER BOTH OF DECEDENT’S TWO ROTH IRAS, EVEN THOUGH TRUST WAS NAMED BENEFICIARY.......................................................................24LTR 201444024 (MAR. 24, 2014): TRUSTEE’S RETITLING OF DECEDENT’S IRA IN CHARITY’S NAME HELD NOT TO BE A DISTRIBUTION:.....................................................................................................................25LTR 201432029 (MAY 13, 2014): NEITHER TAXABLE GIFT NOR TAXABLE INCOME AROSE FROM DISGORGEMENT OF INHERITED IRAS PURSUANT TO SETTLEMENT AGREEMENT AND COURT ORDER......26LTR 201437029 (JUN. 5, 2014): SPOUSE MAY MAKE DIRECT TRANSFER OR ROLLOVER OF DECEDENT’S IRA, EVEN THOUGH ESTATE IS IRA BENEFICIARY BY DEFAULT...............................................28LTR 201438014 (MAY 5, 2014): SATISFACTION OF PECUNIARY BEQUESTS TO CHARITIES USING IRA ASSETS...............................................................................................................................................................29LTR 201440028 (JUL. 9, 2014): IRS WAIVES ROLLOVER REQUIREMENT FOR 1ST IRA DISTRIBUTION; BUT DENIES WAIVER FOR 2ND DISTRIBUTION.....................................................................30PLR 201444044 (AUG. 6, 2014): IRS DENIES WAIVER OF ROLLOVER REQUIREMENT FOR IRA DISTRIBUTION...........................................................................................................................................................31PLR 201444045 (AUG. 4, 2014): IRS DENIES WAIVER OF ROLLOVER REQUIREMENT FOR IRA DISTRIBUTION...........................................................................................................................................................31

§ 469: PASSIVE ACTIVITY LOSSES..................................................................................................32FRANK ARAGONA TRUST V. COMMISSIONER, NO. 15392-11, 142 T.C. NO. 9 (MAR. 27, 2014): TRUSTS MAY QUALIFY FOR MATERIAL PARTICIPATION EXCEPTION TO PASSIVE ACTIVITY CLASSIFICATION; MATERIAL PARTICIPATION OF INDIVIDUAL TRUSTEES ATTRIBUTED TO TRUST.............................................32

§ 1001: DETERMINATION OF AMOUNT OF AND RECOGNITION OF GAIN OR LOSS........34REG 15489-03 (JAN. 17, 2004): PROPOSED REGULATIONS REGARDING SALE OF ALL INTERESTS IN CHARITABLE REMAINDER TRUSTS.........................................................................................................................34

§ 1022: ELECTION OUT OF ESTATE TAX AND INTO CARRYOVER BASIS OF PROPERTY ACQUIRED FROM A DECEDENT DYING DURING 2010.............................................................34

REV. PROC. 2014-18; 2014-7 I.R.B. 513 (JAN. 27, 2014), AMPLIFYING REV. PROC. 2014-3, 2014-1 I.R.B. 111: AUTOMATIC EXTENSION OF TIME TO ELECT CARRYOVER BASIS........................................................................................................................................................ 34

LTR 201442015 (15 JULY 2014): REQUEST FOR EXTENSION OF TIME TO ELECT CARRYOVER BASIS DENIED.......................................................................................................................................................................34

§ 1411: MEDICARE TAX ON NET INVESTMENT INCOME.........................................................35T.D. 9644 (26 NOV. 2013): IRS FINAL REGS. ON NET INVESTMENT INCOME TAX; 78 FR 72393-72449, DEC. 2, 2013, CORRECTED AT 79 FR 18159-18161, APR. 1, 2014........................................35

Estates and trusts, and their beneficiaries: § 1.1411-3......................................................................35TRUSTEE CAN DISTRIBUTE NET INVESTMENT INCOME; BUT WHAT ABOUT TRUSTOR INTENT?...........37

VALUATION............................................................................................................................................ 40

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ESTATE OF HELEN P. RICHMOND ET AL. V. COMMISSIONER, NO. 21448-09, T.C. MEMO. 2014-26 (FEB. 11, 2014): APPRAISAL BY A NON-CERTIFIED APPRAISER WAS NOT “REASONABLE CAUSE” DEFENSE AGAINST ACCURACY RELATED PENALTY FOR VALUATION UNDERSTATEMENT.............................40WILLIAM CAVALLARO ET UX. V. COMMISSIONER, T.C. MEMO. 2014-189, NOS. 3300-11, 3354-11 (SEPT. 17, 2014): TAXABLE GIFT AROSE FROM COMPANY MERGER.............................................................42ESTATE OF JAMES A. ELKINS JR. ET AL. V. COMMISSIONER, NO. 13-60472, 5TH CIR. (SEPT. 15, 2014), AFF’G. IN PART, REV’G. IN PART 140 T.C. NO. 5: FIFTH CIRCUIT DETERMINES VALUATION OF ESTATE'S ART WORKS................................................................................................................................................................44

§ 2010: UNIFIED CREDIT AGAINST ESTATE TAX.......................................................................45REV. PROC. 2014-18, 2014-7 IRB 1 (JAN. 27, 2014): IRS PROVIDES SIMPLIFIED METHOD TO OBTAIN PORTABILITY ELECTION EXTENSION FOR CERTAIN ESTATES..........................................................45

§ 2041: POWERS OF APPOINTMENT.............................................................................................46LTR 201444002(JUL. 14, 2014): POA OVER TRUST PROPERTY WON'T TRIGGER ESTATE TAX INCLUSION................................................................................................................................................................. 46

§ 2044: MARITAL DEDUCTION PROPERTY INCLUDED IN TAXABLE ESTATE OF SURVIVING SPOUSE............................................................................................................................. 47

ESTATE OF OLSEN V. COMM’R., NO. 1981-12, T.C. MEMO. 2014-58 (APR. 2, 2014): COURT DECIDES ALLOCATION OF EXPENSES, IN ABSENCE OF SUBTRUST FUNDING....................................................47

§ 2053: EXPENSES, INDEBTEDNESS, AND TAXES......................................................................48ESTATE OF GERTRUDE H. SAUNDERS ET AL. V. COMMISSIONER, 9TH CIRC., NO. 12-70323 (MAR. 12, 2014), AFF’G 136 T.C. NO. 18 (APRIL 28, 2011): TAX COURT’S DENIAL OF ESTATE’S $30 MILLION DEDUCTION FOR CLAIMS AGAINST ESTATE AND ALLOWANCE OF AMOUNT ACTUALLY PAID UPHELD.......48

Tax Court Opinion.............................................................................................................................................. 48Ninth Circuit Court of Appeals Opinion..................................................................................................... 48

§ 2056: BEQUESTS, ETC. TO SURVIVING SPOUSE......................................................................49PLR 201447008 (JUL. 22, 2014): IRS GRANTS EXTENSION TO SEVER QTIP TRUST.........................49

§ 2511: TRANSFERS BY GIFT IN GENERAL...................................................................................50LTR 201440007 (JUN. 17, 2014): DISCLAIMER OF TRUST DISTRIBUTIONS WON'T TRIGGER GIFT TAX............................................................................................................................................................................. 50

§2652: OTHER DEFINITIONS; SPECIAL ELECTION FOR QUALIFIED TERMINABLE INTEREST PROPERTY......................................................................................................................... 51

LTR 201447014 (AUG. 7, 2014): IRS ALLOWS MARITAL TRUST TO BE TREATED AS TWO SEPARATE TRUSTS...................................................................................................................................................51

§ 2702: SPECIAL VALUATION RULES IN CASE OF TRANSFERS OF INTERESTS IN TRUSTS – EXCEPTION FOR GRANTOR RETAINED ANNUITY TRUST....................................................52

LTR 201442042 (JUN. 18, 2014): TRUST MODIFICATION TO CORRECT SCRIVENER’S ERROR RETROACTIVELY APPROVED BY IRS......................................................................................................................52

§ 4941: TAXES ON SELF-DEALING..................................................................................................53LTR 201445017 (AUG. 14, 2014): REDEMPTION OF DECEDENT'S INTEREST IN FAMILY CORPORATION IS NOT SELF-DEALING.................................................................................................................53

§6324: SPECIAL LIENS FOR ESTATE AND GIFT TAXES............................................................54UNITED STATES V. ELAINE T. MARSHALL ET AL., NO. 12-20804 (NOV. 10, 2014): FIFTH CIRCUIT AFFIRMS GIFT TAX DONEE LIABILITY..................................................................................................................54

§ 6662: ACCURACY RELATED PENALTY.......................................................................................55

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AD INVESTMENT 2000 FUND LLC ET AL. V. COMMISSIONER, 142 T.C. NO. 13, NOS. 9177-08, 9178-08 (APR. 16, 2014): ATTORNEY-CLIENT PRIVILEGE LOST BECAUSE REASONABLE CAUSE DEFENSE TO PENALTY INVOKED...................................................................................................................................................55

§ 6651: FAILURE TO FILE TAX RETURN OR TO PAY TAX........................................................56ESTATE OF LIFTIN V. U.S., FED. CIR. (JUN. 11, 2014), AFF’G NO. 10-589, FED. CL. (2013): PENALTY ON FAILING TO FILE ESTATE TAX RETURN UPHELD, DESPITE TIMELY PAYMENT OF THE ESTATE TAX......56

All references are to the Internal Revenue Code and regulations thereunder, except as otherwise noted.

Selected 2015 Inflation Adjustments

Excerpts from Rev. Proc. 2014-61, 2014-47 IRB 1 (Oct. 30, 2014) .33 Unified Credit Against Estate Tax. For an estate of any decedent dying during calendar year 2015, the basic exclusion amount is $5,430,000 for determining the amount of the unified credit against estate tax under § 2010. The gift tax basic exclusion amount is the same amount as the estate tax basic exclusion amount.

.34 Valuation of Qualified Real Property in Decedent's Gross Estate. For an estate of a decedent dying in calendar year 2015, if the executor elects to use the special use valuation method under § 2032A for qualified real property, the aggregate decrease in the value of qualified real property resulting from electing to use § 2032A for purposes of the estate tax cannot exceed $1,100,000.

.35 Annual Exclusion for Gifts.

(1) For calendar year 2015, the first $14,000 of gifts to any person (other than gifts of future interests in property) is not included in the total amount of taxable gifts under § 2503 made during that year.

(2) For calendar year 2015, the first $147,000 of gifts to a spouse who is not a citizen of the United States (other than gifts of future interests in property) is not included in the total amount of taxable gifts under §§ 2503 and 2523(i)(2) made during that year.

.39 Notice of Large Gifts Received from Foreign Persons. For taxable years beginning in 2015, § 6039F authorizes the Treasury Department and the Internal Revenue Service to require recipients of gifts from certain foreign persons to report these gifts if the aggregate value of gifts received in the taxable year exceeds $15,601.

.42 Interest on a Certain Portion of the Estate Tax Payable in Installments. For an estate of a decedent dying in calendar year 2015, the dollar amount used to determine the "2-percent portion" (for purposes of calculating interest under § 6601(j)) of the estate tax extended as provided in § 6166 is $1,470,000.

.43 Attorney Fee Awards. For fees incurred in calendar year 2015, the attorney fee award limitation under § 7430(c)(1)(B)(iii) is $200 per hour.

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§ 1: Income Tax RatesNow that the top federal estate tax rate is 40 percent, it’s important for planners to compare that rate to income tax rates, because avoiding estate taxes can mean loss of income tax basis step-up.

Here’s a chart showing marginal tax rates for different types of income. The Alternative Minimum Tax has been ignored. California’s top tax rates are assumed to be 13.3 percent.

Long-Term Capital Gains

§ 1250 Recapture

Tax

Collectibles; Certain S

Corporation Stock

Short-Term Capital

Gains and § 1245

Depreciation Recapture

TaxesIncome Tax 20.0% 25.0% 28.0% 39.6%Medicare Surtax 3.8% 3.8% 3.8% 3.8%California State Income Tax 13.3% 13.3% 13.3% 13.3%

Total marginal tax rate 37.1% 42.1% 45.1% 56.7%

Note that trusts begin paying the Medicare Surtax when 2015 taxable income reaches $12,300. While many trusts distribute income currently, it’s also common for trusts to retain (and therefore pay income taxes on) capital gains.

§ 67: 2-Percent Floor on Miscellaneous Itemized Deductions

T.D. 9664, 79 F.R. 26616-26620 (May 8, 2014): IRS Issues Final Reg. § 1.67-4, Costs paid or incurred by estates or non-grantor trusts.This regulation was promulgated in response to Knight v. Commissioner, 552 U.S. 181, 128 S. Ct. 782 (2008), holding that investment advisory paid by an estate or non-grantor trust generally are subject to the 2-percent floor for miscellaneous itemized deductions of § 67(a). Following that decision, Treasury and the IRS have struggled to formulate rules that identify what types of expenses “would not have been incurred if the property were not held in such trust or estate” and thus are subject to the 2-percent reduction.

The regulation is effective for taxable years beginning on or after January 1, 2015.2 For example, an estate (or a trust electing to be taxed as an estate) having a tax year that begins December 1, 2014 would not be subject to the final regulations for its tax year beginning December 1, 2014 ending November 30, 2015.

The final regulation provides that, where fiduciaries “bundle” some expenses subject to the 2-percent floor and other expenses that are not subject to the 2-percent floor, expenses must be un-bundled.

2 This date was originally published as May 9, 2014, but was soon changed to tax years beginning on or after January 1, 2015 in T.D. 9664, 79 FR 41636, July 17, 2014.

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Generally, costs that are incurred commonly or customarily by individuals are subject to the 2-percent floor. These include:

Investment advisory fees normally charged to an individual. But not subject to the 2-percent floor are certain incremental costs of investment advice beyond the amount that normally would be charged to an individual

Costs incurred in defense of a claim against the estate, the decedent, or the non-grantor trust that are unrelated to the existence, validity, or administration of the estate or trust

Ownership costs, meaning costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property. Examples include partnership costs deemed to be passed through to and reportable by a partner if these costs are defined as miscellaneous itemized deductions pursuant to section 67(b), condominium fees, insurance premiums, maintenance and lawn services, and automobile registration and insurance costs. But the regulations note that other expenses incurred merely by reason of the ownership of property may be fully deductible under other provisions of the Code, such as sections 62(a)(4), 162, or 164(a), which would not be miscellaneous itemized deductions subject to section 67(e)

Tax preparation costs other than estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent's final individual income tax returns. The regulation specifically says the cost of preparing a decedent’s gift tax returns is subject to the 2-percent floor. COMMENT: it seems odd that preparing a decedent’s gift tax returns for the year of death isn’t treated in the same manner as the decedent's final individual income tax returns. Also, note that an executor may join in a spousal gift-splitting election for gifts made before the date of the decedent’s death. That election would obligate the executor to file a gift tax return.

The cost of appraisals not needed for preparing estate tax returns, testamentary property allocations, or other fiduciary tax purposes. For example, appraisals for property insurance purposes are subject to the 2-percent floor.

§ 101: Life Insurance

LTR 201423009 (Feb. 27, 2014): Joint Grantor Trust’s Sale of Life Insurance Policy to Another Grantor Trust Isn’t Transfer for ValueA trust established by a married couple owned and was the death beneficiary of two life insurance policies. One policy insured both spouses. The other policy insured the life of Husband only.

The couple’s trust is a grantor trust as to 50 percent with respect to Wife and is also a grantor trust as to 50 percent with respect to Husband. A second trust is a grantor trust in its entirety with respect to Husband only.

The couple’s trust proposes to sell both policies to Husband’s 100 percent grantor trust.

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Generally, death benefits paid under a life insurance contract are excluded from gross income. § 101(a). But when a life insurance contract or an interest in a life insurance contract is transferred for a valuable consideration, death benefits can lose the exclusion from gross income generally accorded to life insurance death benefits. § 101(b).

There are two exclusions to § 101(b)(2)’s transfer for value rule. Under § 101(b)(2), the transfer for value rule won’t apply --

A) if such contract or interest therein has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such contract or interest therein in the hands of the transferor, or

(B) if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.

Grantor trust status of both trusts was key to each of the policies in this private letter ruling.

With regard to the policy insuring Husband only, for income tax purposes (including for purposes of § 101), transferring that contract to Husband’s grantor trust was the same thing as transferring the policy to himself. That qualified the contract for § 101(b)(2)(B)’s exception to the transfer for value rule because the contract will, for all income tax purposes, be treated as transferred to the insured (Husband).

The same was true for the portion of the contract insuring both spouses that could be attributed to insuring Husband’s life.

Not so for the portion of the contract insuring Wife’s life. That portion was, for income tax purposes, not being transferred to Wife (the insured) but rather to the insured’s spouse, Husband.

The IRS pointed out:

Section 1041(a)(1) provides that no gain or loss shall be recognized on the transfer of property from an individual to such individual's spouse.

Section 1041(b) provides that in the case of any transfer of property described in § 1041(a): (1) for purposes of Subtitle A of the Code, the property shall be treated as acquired by the transferee by gift, and (2) the basis of the transferee in the property shall be the adjusted basis of the transferor.

Grantor trust status of Wife’s portion of the life insurance meant that she owned that portion for all income tax purposes. Because Wife “owned” that portion for all income tax purposes, Section 1041’s provisions applied, meaning Husband’s basis will be equal to Wife’s basis. That brings the transfer within § 101(b)(2)(A)’s exception to the transfer for value rule.

The IRS held that neither sale of both life insurance policies will be treated as a transfer for a valuable consideration within the meaning of § 101(a)(2).

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ILM 201328030 (Mar. 18, 2013): Right to receive insurance policy dividends not incidents of ownership The IRS considered whether death benefits payable under an insurance policy to a decedent’s former spouse were includible in the estate of a decedent under IRC § 2042. Pursuant to a divorce settlement agreement, the decedent was, during lifetime, required to maintain a life insurance policy that would pay death benefits to the decedent’s former spouse. But dividends paid from the policy were to be paid to the insured. The decedent couldn’t borrow against or pledge the policies.

Because insurance policy dividends have been found by the Tax Court to constitute a reduction of premiums rather than incidents of ownership, retention of the right to receive dividends isn’t retention of an incident of ownership.

With regard to policy dividends, the ILM states:

The Tax Court considered the question of whether "dividends paid on an insurance policy" is an economic benefit that would cause the value of the insurance proceeds to be includible in a decedent's gross estate in Estate of Bowers v. Commissioner, 23 T.C. 911 (1955). In Estate of Bowers, the decedent agreed to carry life insurance on his life payable to his former wife as part of a settlement agreement in a divorce. The court held that the right to dividends, which may be applied against a current premium, is nothing more than a reduction in the amount of premiums paid rather than a right to the income of the policy. Id. at 917. See Estate of Jordahl v. Comm'r, 65 T.C. 92, 99 (1975) (stating that "it is well established that, since dividends 'are nothing more than a reduction in the amount of premiums paid,' the right to dividends is not an incident of ownership.") (citations omitted). Cf. Schwager v. Comm'r, 64 T.C. 781, 792 (1975) (finding that while certain powers may be retained which will not constitute incidents of ownership, such as the right to receive policy dividends, the ability to bar the change of beneficiary to a part of the policy does constitute a substantial incident of ownership).

Accordingly, the ILM concludes that policy’s death benefit proceeds are not includible in the gross estate of the decedent.

§ 170: Charitable Income Tax Deduction

Palmer Ranch Holdings Ltd. et al. v. Commissioner, T.C. Memo. 2014-79, No. 17017-11 (May 6, 2014): Conservation Easement Valued by Tax CourtValuation experts for the taxpayer and for the government differed greatly with respect to undeveloped land located in Sarasota, Florida that had been placed under a conservation easement. The facts surrounding the real estate were complex, involving zoning designations, requirements of local, county and state authorities for approval of proposed development, environmentally sensitive lands, and an eagle’s nest under federal protection.

Both experts used the method of valuing the property with and without the easement. Their greatest difference was valuing the property without the easement: $25.2 million (taxpayer) vs. $7.75 million (government). Finding the taxpayer’s conclusion as to the highest and best use appropriate and the government’s conclusion too restrictive, and finding a flaw in an assumption about growth in value, the Court concluded the before-restriction value was just

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over $21 million. The Court further found that the percentage decrease in valuation estimated by each appraiser (5 percent and 10 percent) was supported, but adopted 5 percent, based on the Court’s own analysis. This seems to indicate that the Court may go its own way, even when the expert opinions are found acceptable and in spite of the fact they were not far off from each other. The amount of the deduction allowed by the Court was $19,955,014.

The government sought application of the accuracy related penalty under § 6662. No penalty applied, said the Court, because the taxpayer reasonably relied on qualified professionals.

Whitehouse Hotel Ltd. Part. et al. v. Comm’r, No. 13-60131., 5th Cir. (Jun. 12, 2014): Aff’g in part and rev’g in part 139 T.C. No. 13 (2012)On its second trip to the Court of Appeals, the Tax Court’s revised valuation conclusion for purposes of the income tax deduction of a conservation easement was accepted. However, Tax Court was reversed on the 40 percent penalty for valuation error because the Appeals Court found the reasonable cause exception applied. The difference between the taxpayer’s conservation easement valuation and the final valuation by the court was a whopping 401 percent. The Appeals Court noted:

The tax court ultimately concluded that the before-restriction value was $12,473,236,9 it adjusted its after-restriction value to $10,615,520,10 and thus valued the easement at merely $1,857,716. Consequently, the tax court determined that Whitehouse had overstated its claimed deduction by the difference between $7,445,000 and $1,857,716, or $5,587,284. That difference amounted to a 401% overstatement: $7,445,000/$1,857,716 = 4.01.

The Court’s analysis of the reasonable cause exception is instructive. It’s not enough to hire apparently competent council and experts. Here’s that portion of the Court’s opinion:

Our review of the tax court's decision starts with the principle that "[w]hen an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for a taxpayer to rely on that advice." United States v. Boyle, 469 U.S. 241, 251 (1985). "Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney." Id. at 251. The Court held, though, that the relevant issue in that case of meeting filing deadlines was not an area in which tax experts were necessary. Id. at 251-52. Our earlier opinion cited Boyle for the tax court to consider on remand. Whitehouse Hotel, 615 F.3d at 343.

Different facts in these reliance-on-advice cases certainly can lead to different results. "We determine whether a taxpayer acted with reasonable cause on a case-by-case basis, evaluating the totality of the facts and circumstances." Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors, LLC v. United States, 659 F.3d 466, 493 (5th Cir. 2011). In Montgomery Capital, we analyzed the general "reasonable cause" defense, holding that "reliance on the advice of a tax professional can, but does not necessarily demonstrate reasonable cause." Id. (quotation marks and citation omitted). Nonetheless, the statute requires a "good faith investigation" for donations of charitable property. I.R.C. § 6664(c)(3)(B). In sum, reasonable reliance on the word of qualified tax professionals suffices for the general

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reasonable cause exception. Montgomery Capital, 659 F.3d at 493. We left open the question of whether Whitehouse's reliance on tax professionals was enough. We now answer the question in the affirmative.

Whitehouse argues the good faith exception should apply because it sought out and then followed the advice of tax professionals and also sought a second appraisal of the building. Whitehouse argues this satisfies the obligation to make a good faith investigation into the value of the easement beyond the appraisal under Section 6664(c)(3)(B). The Commissioner responds that simply having a tax return prepared by accountants and tax advice from tax lawyers does not suffice either as the taxpayer's investigation or as one by professionals on which the taxpayer may rely.

We conclude that the tax court imposed an excessively high standard of proof for actual reliance on the advice of competent tax professionals with respect to this statutory defense. The tax court concluded in its remand decision that "the record is bare of any evidence supporting" a conclusion that Whitehouse undertook any investigation of the amount of the deduction for the conveyance of the easement and presumed that the tax professionals also did not. Whitehouse Hotel, 139 T.C. at 361. We disagree.

Valuation of assets is a difficult task, even with the advice and counsel of accountants, consultants, and tax attorneys. It is even more complicated when, as here, the valuation is divorced from a negotiated transaction between buyer and seller. In most transactions, presumably, the final sale price is forged from competing interests. That dynamic makes the sale price a good indicator of the fair market value of a given property. Even then, that price may be altered up or down by idiosyncratic characteristics of the parties. This is not the case here. This easement was a gratuitous transfer; the PRC did not haggle over price and did not pay a final sale price.

We are particularly persuaded by Whitehouse's argument that the Commissioner, the Commissioner's expert, and the tax court all reached different conclusions. The Commissioner originally permitted only $1.15 million as a deduction. Argote valued the easement as worthless. We share the tax court's and the Commissioner's skepticism of the dramatic appreciation of value between the roughly $8,000,000 purchase price of the Maison Blanche shell and the Cohen appraisal's $96,000,000 valuation. What the taxpayer reasonably considered, though, even if not sustained by the tax court, is that its contract to transform the building into a Ritz-Carlton hotel had value. As we were in our 2010 opinion, we are skeptical of the tax court's conclusion that following the advice of accountants and tax professionals was insufficient to meet the requirements of the good faith defense, especially in regard to such a complex task that involves so many uncertainties.

As we did in Montgomery Capital for the general reasonable cause exception, we review the "totality of the facts and circumstances." 659 F.3d at 493. Whitehouse obtained a second appraisal as a "check" against the first one. Drawbridge testified and presented the 1997 Form 1065 indicating it had been prepared by Whitehouse's financial auditors. Obtaining a qualified appraisal, analyzing that appraisal, commissioning another appraisal, and submitting a professionally-

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prepared tax return is sufficient to show a good faith investigation as required by law. See I.R.C. § 6664(c)(3)(B). The tax court's enforcement of the gross undervaluation penalty was clearly erroneous.

§ 401 et seq.: Retirement Plans

Treasury Decision 9673, 79 F.R. 37633-37643 (July 2, 2014): Regulations Modified to Accommodate “Qualified Longevity Annuity Contracts”Annuity contracts having a deferred annuity starting date have been accommodated in regulations relating to Required Minimum Distributions from retirement accounts. Such annuities are termed “Qualified Longevity Annuity Contracts”.

The deferred starting date feature of such contracts posed two problems for Required Minimum Distributions. One problem was having to distribute, from retirement account funds not held within the annuity contract, each year’s Required Minimum Distribution related to the value of that annuity contract.

The regulations create a break: the annuity contract is excluded from Required Minimum Distributions, but only if that annuity contract meets qualifications under those regulations. A contract that meets the requirements is termed a “Qualified Longevity Annuity Contract” or “QLAC”.

The new rules generally apply to contracts purchased on or after July 2, 2014. Existing contracts converted to a QLAC on or after July 2, 2014 will also qualify. The fair market value of an annuity contract that is converted to a QLAC will be treated as the amount of QLAC premium paid.

QLACs must begin paying the life annuity no later than age 86.

A QLAC premium can’t exceed 25 percent of the retirement account’s value, as of retirement account’s most recent valuation date. A $125,000 premium maximum also applies.

The types of retirement accounts that may purchase QLACs are:

IRC § 401 defined contribution plans

IRC § 403(b) annuities

IRC § 457(b) governmental plans

IRC § 408 Individual Retirement Accounts

Note: Roth IRAs (authorized by IRC § 408A) may not purchase QLACs. IRC § 401 defined benefit plans also may not purchase QLACs.

The following regulations were amended to accommodate QLACs:

§ 1.401(a)(9)-5, Required minimum distributions from defined contribution plans

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§ 1.401(a)(9)-6 Required minimum distributions for defined benefit plans and annuity contracts, adding new Question- and Answer-17, What is a qualifying longevity annuity contract?

§ 1.403(b)-6 Timing of distributions and benefits

§ 1.408-8 Distribution requirements for individual retirement plans

§ 1.408A-6 Distributions (from Roth IRAs)

§ 1.6047-2 Information relating to qualifying longevity annuity contracts

Notice 2014-19, 2014-17 IRB 1 (Apr. 4, 2014) and Notice 2014-37, 2014-23 IRB 1 (May 15, 2014): IRS Guidance on Application of Windsor to Pension PlansThe IRS has provided “guidance on the application (including the retroactive application) of the decision in United States v. Windsor, 570 U.S. 12, 133 S. Ct. 2675 (2013), and the holdings of Rev. Rul. 2013-17, 2013-38 I.R.B. 201 (Sept. 16, 2013), to retirement plans qualified under section 401(a) of the Internal Revenue Code (Code).”

Alvan L. Bobrow et ux. v. Commissioner, No. 7022-11, T.C. Memo. 2014-21 (Jan. 28, 2014): Tax Court Interprets One Rollover Per Year Differently Than IRS Publication 590 and Temporary RegulationsThe following article is reproduced by kind permission of Leimberg Information Services, Inc. (LISI), originally published Mar. 14, 2014 on http://www.leimbergservices.com/ as: Steve Leimberg's Employee Benefits and Retirement Planning Email Newsletter - Archive Message #632

Subject: Mike Jones, Bob Keebler & Michelle Ward: Steamrolling Over Rollovers-the Tax Court's Ruling in Bobrow at Odds with IRS Publication 590

“In Bobrow, the Tax Court overturned IRS Publication 590’s long-standing application of the one-IRA-rollover-per-twelve-months rule to each of several separate IRAs. Instead, Bobrow held that the rule applies to all IRAs of a taxpayer. Nowhere in the opinion is any mention made of Publication 590. The holding potentially affects many taxpayers who relied on Publication 590, creating disastrous tax consequences.

The burning question for taxpayers who relied on Publication 590 will be: am I in trouble? Many taxpayers have relied on the guidance in Publication 590 to support their position that the one-rollover-per-year rule applied to each IRA independently.

Following the Court’s decision in Bobrow, the Internal Revenue Service issued Announcement 2014-15 stating Treasury’s intention to promulgate regulations consistent with Bobrow, regardless of the ultimate resolution of that case. However, the announcement also states the IRS will not apply the Bobrow interpretation of the one-IRA-rollover-per-twelve-months rule to any rollover that involves an IRA distribution occurring before January 1, 2015.

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Importantly, the IRS acknowledged that a direct transfer between IRAs is not a rollover and so does not toll the 12-month period.”

LISI has provided members with significant commentary on the Tax Court’s decision in Bobrow as well as Announcement 2014-15:

In Employee Benefits & Retirement Planning Newsletter #631, Bruce Steiner provided members with a first look at the Bobrow decision and Announcement 2014-15

In a 60 Second Planner, Andy DeMaio reported on IRS Announcement 2014-15 which advises that the IRS will not apply the Tax Court's Bobrow decision, limiting taxpayers to one 60-day IRA rollover per year, to any rollover occurring prior to January 1, 2015.

Now, Mike Jones, Bob Keebler and Michelle Ward weigh-in with their thoughts on Bobrow and Announcement 2014-15.

Here is their commentary:

EXECUTIVE SUMMARY:

In Alvan L. Bobrow, et ux v. Comm’r., No. 7022-11, T.C. Memo. 2014-21 (Jan. 28, 2014), the Tax Court overturned IRS Publication 590’s long-standing application of the one-IRA-rollover-per-twelve-months rule to each of several separate IRAs. Instead, Bobrow held that the rule applies to all IRAs of a taxpayer. Nowhere in the opinion is any mention made of Publication 590. The holding potentially affects many taxpayers who relied on Publication 590, creating disastrous tax consequences.

Following the Court’s decision in Bobrow, the Internal Revenue Service issued Announcement 2014-15 stating Treasury’s intention to promulgate regulations consistent with Bobrow, regardless of the ultimate resolution of that case. However, the announcement also states the IRS will not apply the Bobrow interpretation of the one-IRA-rollover-per-twelve-months rule to any rollover that involves an IRA distribution occurring before January 1, 2015. Importantly, the IRS acknowledged that a direct transfer between IRAs is not a rollover and so does not toll the 12-month period.

FACTS:

IRC § 408(d)(3)(B) provides that the tax-free treatment of an IRA rollover does not apply to any amount received by an individual from an IRA “if at any time during the 1-year period ending on the day of such receipt such individual received any other amount described in that subparagraph from an [IRA] which was not includible in his gross income because of the application of this paragraph.” This one-year period is measured as a twelve-month period from the date when an IRA distribution is made (not from the date the rollover of that distribution is completed), rather than a calendar year.

In Bobrow, it was held that the one-rollover-in-12-months rule applies to all IRAs of one spouse, thereby causing a failed IRA rollover. An attempted rollover by the other spouse failed because it wasn’t timely, triggering the 10 percent tax on pre-age 59 ½ withdrawals. Furthermore, the 20 percent accuracy-related penalty was imposed. In consequence of the

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holding, the failed rollovers will result in excess contributions, an issue the case doesn’t raise.

Alvan Bobrow had two IRAs: an IRA that received his regular IRA contributions, which the Court called the “Traditional IRA”, and an IRA that received a rollover from a qualified plan account, which the Court called the “Rollover IRA.”

Alvan withdrew two distributions totaling $65,064 from his Traditional IRA on April 14, 2008. The Court treated this as a single distribution, saying in a footnote that treating that IRA as having made two distributions in the same day would be reading the twelve-month rule too narrowly.

Alvan timely deposited $65,064 in his Traditional IRA on June 10, 2008, thus qualifying as a rollover of the April 14 distribution. Accordingly, the April 14 distribution wasn’t taxable. The funds apparently came from Alvan’s Rollover IRA on June 6, 2008.

But when Elisa, Alvin’s wife withdrew $65,064, which Alvan apparently used to replenish (within 60 days of June 6, 2008) his distribution from the Rollover IRA, the IRS cried “foul,” and the Court agreed. Alisa made her distribution on July 28, 2008.

The opinion holds:

[t]he plain language of section 408(d)(3)(B) limits the frequency with which a taxpayer may elect to make a nontaxable rollover contribution. By its terms, the one-year limitation laid out in section 408(d)(3)(B) is not specific to any single IRA maintained by an individual but instead applies to all IRAs maintained by a taxpayer.

To make matters worse for Elisa, her own later rollover attempt failed because the deposit was made on Sept. 30, 2008, the 61st day after she made the July 28, 2008 IRA withdrawal. There was no indication that she relied on erroneous advice or that a delay occurred on the part of her IRA custodian in making the deposit. That meant she didn’t qualify for an extension of the 60-day rollover period under IRC § 408(d)(3)(I) and Revenue Procedure 2003-16. And because Elisa was under age 59 ½, she was subject to the ten percent early withdrawal tax of IRC § 72(t).

The IRS had alternatively argued that Elisa’s Sept. 30 rollover attempt was invalid because Elisa’s IRA distribution funds were placed in a joint account and subsequently deposited in Alvan’s rollover IRA, rendering her distribution no longer available for making a rollover. The Taxpayers countered that Elisa could nevertheless make a valid rollover because money is fungible. The Court agreed, saying, “the use of funds distributed from an IRA during the 60-day period is irrelevant to the determination of whether the distribution is a nontaxable rollover contribution.”

In its opinion, the Court reminds us that there’s no rule similar to the IRA one-rollover-in-12-months rule for rollovers from non-IRA plans, such as a § 401 profit sharing plan (includes § 401(k) plans), a § 403(b) annuity, or a § 457 governmental plan).

The IRS also sought and was awarded the 20 percent accuracy-related penalty.

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On the heels of Bobrow, the IRS published Notice 2014-15, stating its future intentions:

The IRS anticipates that it will follow the interpretation of § 408(d)(3)(B) in Bobrow and, accordingly, intends to withdraw [] proposed regulation [§ 1.408-4(b)(4)(ii)] and revise Publication 590 to the extent needed to follow that interpretation. These actions by the IRS will not affect the ability of an IRA owner to transfer funds from one IRA trustee directly to another, because such a transfer is not a rollover and, therefore, is not subject to the one- rollover-per-year limitation of § 408(d)(3)(B). See Rev. Rul. 78-406, 1978-2 C.B. 157.

COMMENT:

Practical Effects of Bobrow’s Fact Pattern

It’s worth noting that, if the Court had sided with the taxpayers on all three distributions, the couple would have had the use of IRA money from April 14, 2008 through September 30, a period of 169 days. This seems a close cousin to check-kiting.

The nontax “penalty” that such a move costs an IRA owner is being out of the investment markets during the rollover period. That can damage pretax investment performance (positive investment returns accumulate tax-free in Traditional and Roth IRAs).

Excess Contributions Result from Failed Rollovers The other shoe will drop when the IRS, based on the Court’s holding, claims that the disallowed rollovers of Alvan and Elisa constitute excess contributions and assess the 6 percent excise tax on excess contributions. The Tax Court has so held before and was sustained by the Court of Appeals for the Fifth Circuit in Martin v. Commissioner (1994).

How Does Bobrow Apply When Various Types of IRAs Are Present? The question was not addressed, and the facts of the case did not raise, the question of whether different types of IRAs are aggregated for purposes of the one-rollover-in-12-months rule. IRC § 408 creates the following IRA types:

· Individual Retirement Accounts

· Individual Retirement Annuities

· Accounts established by employers and certain associations of employees as part of a trust

· SEP IRA accounts

· SEP IRA annuities

· Deemed accounts

· Deemed IRA annuities

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In addition, under IRC § 408A(a) and (b), except as otherwise provided in § 408A, a Roth IRA must “be treated for purposes of this title in the same manner as an individual retirement plan” within the meaning of § 7701(a)(37). An individual retirement plan is:

(A) an individual retirement account described in § 408(a), and

(B) an individual retirement annuity described in § 408(b).

Thus, if all IRAs are aggregated for purposes of the one-rollover-per-12-months rule, it may be that Roth IRAs are included in that aggregation, except for Roth IRA conversions which are specifically excluded from the definition of a rollover under Treas. Reg. § 1.408A-4, Q&A-7(c).

What Makes This Case Difficult To Swallow Is IRS Publication 590. The IRS website (www.IRS.gov), maintains versions of Publication 590, “Individual Retirement Arrangements (IRAs)”, as far back as tax year 1994. Every year’s version of Publication 590 beginning with 1994 contains the following guidance regarding the rule that only one rollover of an IRA distribution is allowable within any twelve-month period:

Waiting period between rollovers. Generally, if you make a tax-free rollover of any part of a distribution from a traditional IRA, you cannot, within a 1-year period, make a tax-free rollover of any later distribution from that same IRA. You also cannot make a tax-free rollover of any amount distributed, within the same 1-year period, from the IRA into which you made the tax-free rollover.

The 1-year period begins on the date you receive the IRA distribution, not on the date you roll it over into an IRA.

Example. You have two traditional IRAs, IRA-1 and IRA-2. You make a tax-free rollover of a distribution from IRA-1 into a new traditional IRA (IRA-3). You cannot, within 1 year of the distribution from IRA-1, make a tax-free rollover of any distribution from either IRA-1 or IRA-3 into another traditional IRA.

However, the rollover from IRA-1 into IRA-3 does not prevent you from making a tax-free rollover from IRA-2 into any other traditional IRA. This is because you have not, within the last year, rolled over, tax-free, any distribution from IRA-2 or made a tax-free rollover into IRA-2.

It’s disappointing that the IRS would litigate a case that appears to be in clear conflict with its own long-standing published guidance.

Some May Be In Trouble The burning question for taxpayers who relied on Publication 590 will be: am I in trouble? Many taxpayers have relied on the guidance in Publication 590 to support their position that the one-rollover-per-12-months-rule applied to each IRA independently.

The IRS appears to have answered this question in Announcement 2014-15, saying that it “will not apply the Bobrow interpretation of § 408(d)(3)(B) [i.e., the one-rollover-per-12-months rule] to any rollover that involves an IRA distribution occurring before January 1, 2015.”

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Where’s The Time Cutoff For Multiple Distributions From A Single IRA?Although the Court allowed distributions occurring on the same day to be treated as a single distribution, there’s no clear indication where the line is drawn. Would two distributions on two days still qualify as one? How about three or four days? How about within a week? To avoid such questions, the better practice would be to raise sufficient cash within an IRA for a planned distribution before making the distribution request.

Accuracy-Related Penalty Exceptions The accuracy-related penalty has exceptions. The Court said that a Tax Advice Memorandum couldn’t be used to shield the taxpayer from the penalty. But Treas. Regs. § 1.6662-4(d)(3)(iii) provides a list of authorities that may constitute substantial authority that can shield a taxpayer from the penalty. These include not only primary authority (code, regs., court cases), but also:

… private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin.

Transfer Instead of Rolling Over Bottom line: when it comes to moving IRA funds, it’s best to make a direct, trustee-to-trustee transfer described and authorized in Rev. Rul. 78-406, 1978-2 C.B. 157. Taxpayers who maintain more than one IRA may make multiple direct trustee-to-trustee transfers from the trustee of one IRA to the trustee of another IRA without triggering the one-rollover-in-12-months limitation. Transferring funds directly between trustees does not result in a “distribution” within the meaning of IRC Sec. 408(d)(3)(A) and are not considered to be “rollover contributions."

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Mike JonesBob KeeblerMichelle Ward

TECHNICAL EDITOR: BARRY PICKER

CITE AS:

LISI Employee Benefits and Retirement Newsletter #632, March 24, 2014, at http://www.LeimbergServices.com Copyright © 2014 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Written Permission.

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CITES:

Alvan L. Bobrow, et ux v. Comm’r., No. 7022-11, T.C. Memo. 2014-21 (Jan. 28, 2014); Announcement 2014-15; IRC § 408; Rev. Rul. 78-406, 1978-2 C.B. 157; IRS Publication 590; IRC § 6662; Treas. Regs. § 1.6662-4(d)(3)(iii); Martin v. Commissioner, T.C. Memo. 1992-331, (Jun. 8, 1992), aff’d 9th Cir., No. 92-5102 (Feb. 22, 1993) (regarding one-rollover-in-12-months rule); Martin v. Commissioner, T.C. Memo 7762-92 (Aug. 30, 1993) and T.C. Memo 1994-213 (May 12, 1994), aff’d 5th Cir., No. 93-5349 (Mar. 30, 1994) (regarding excess contribution resulting from violation of one-rollover-in-12-months rule)

Copyright © 2014 Leimberg Information Services Inc.

IRS Announcement 2014-15; 2014-16 I.R.B. 973 (Mar. 20, 2014): IRS Will Apply Bobrow Prospectively, Beginning Jan.1,2015In response to Alvan L. Bobrow, et ux v. Comm’r, supra, the IRS announced it would withdraw its former interpretation that the one-rollover-per-year limitation is applied on an IRA-by-IRA basis found in Proposed Regulation § 1.408-4(b)(4)(ii) and IRS Publication 590. However, the IRS said it would not enforce the Bobrow interpretation “to any rollover that involves an IRA distribution occurring before January 1, 2015.”

REG-209459-78; 79 F.R. 40031-40032: IRS Withdraws Proposed Regulation At Variance with BobrowThe IRS has withdrawn proposed regulations containing its former interpretation that the one-rollover-per-year limitation is applied on an IRA-by-IRA basis found in Proposed Regulation § 1.408-4(b)(4)(ii). The IRS said, in part:

Based on the language in section 408(d)(3)(B), a recent Tax Court opinion, Bobrow v. Commissioner, T.C. Memo. 2014-21, held that the limitation applies on an aggregate basis. Thus, under Bobrow, an individual cannot make an IRA-to-IRA rollover if the individual has made an IRA-to-IRA rollover involving any of the individual's IRAs in the preceding 1-year period. The IRS intends to follow the opinion in Bobrow and, accordingly, is withdrawing paragraph (b)(4)(ii) of § 1.408-4 of the proposed regulations and will revise Publication 590. This interpretation of the rollover rules under section 408(d)(1)(B) does not affect the ability of an IRA owner to transfer funds from one IRA trustee or custodian directly to another, because such a transfer is not a rollover and, therefore, is not subject to the one-rollover-per-year limitation of section 408(d)(3)(B). See Rev. Rul. 78-406, 1978-2 C.B. 157.

Thus, the IRS confirmed that direct trustee-to-trustee transfers described in Rev. Rul. 78-406 are not rollovers subject to the one-rollover-per-year rule.

Announcement 2014-32, 2014-48 IRB 1 (Nov. 10, 2014): Application of One-Per-Year Limit on IRA RolloversThe IRS has clarified that no rollover that occurs before January 1, 2015 will be given regard in applying the one-rollover-per-year rule to IRA or Roth IRA distributions occurring on or after that date. But the one-rollover-per-year limitation must nevertheless be applied on an IRA-by-IRA basis. The IRS also stated that the one-rollover-per-year rule will apply to

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distributions from any type of “traditional IRA” under IRC § 408 (including a simplified employee pension described in § 408(k) and a SIMPLE IRA described in § 408(p)), as well as any type of Roth IRA. However, a Roth IRA conversion is not a rollover, and so can’t cause a one-year rollover blackout period to commence. Further, IRA rollovers to or from retirement plans other than traditional IRS or Roth IRAs lie outside the rule limiting IRA rollovers to once per year.

Direct transfers are preferable to rollovers. See Rev. Rul. 78-406, 1978-2 C.B. 157. In that regard, the Notice helpfully states:

IRA trustees are encouraged to offer IRA owners requesting a distribution for rollover the option of a trustee-to-trustee transfer from one IRA to another IRA. IRA trustees can accomplish a trustee-to-trustee transfer by transferring amounts directly from one IRA to another or by providing the IRA owner with a check made payable to the receiving IRA trustee.

Haury v. Commissioner, No. 13-1780, 8th Cir. (May 12, 2014), rev’g in part T.C. Memo. 2012-215 (2012): 60-day IRA rollover was validWhen it came to income tax matters for 2007, Harry Robert Haury got off on the wrong foot: he filed no income tax return. The IRS, acting on information reporting, prepared a substitute return for him. Based on $149,216 of taxable salary income and $434,964 of taxable IRA withdrawals, a grand total of $584,180, an assessment of more than $250,000 of taxes, penalties and interest soon followed.

Harry responded by preparing a 2007 income tax return and filed a petition with the Tax Court, representing himself before the Court (pro se). Harry claimed a $120,000 IRA rollover and a $413,156 worthless business debt deduction to corporations in which he owned stock.

During 2007, Harry made the following IRA withdrawals and attempted rollover contribution:

(Withdrawal)

Attempted Rollover

Contribution

February 15, 2007($120,000.00

)

April 9, 2007($168,000.00

)April 30, 2007 $120,000.00

May 14, 2007 - ($100,000.00

)July 6, 2007 - ($46,933.06)October 25, 2007 - ($31.32)

Total for 2007($434,964.38

) $120,000.00

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The Tax Court denied both the rollover and the bad debt deduction.

Harry hired an attorney and appealed to the Eight Circuit.

The rollover wasn’t allowed because, according to the Tax Court, the $120,000 contribution on April 30 was an attempt to roll over the February 15 withdrawal of the same amount on the basis that the rollover occurred more than 60 days after the withdrawal.

The Court of Appeals reversed and allowed rollover treatment of $120,000 of the April 9 withdrawal, admonishing the Tax Court for succumbing to arguments of the government. The Court said:

Proceeding pro se, Haury explained at trial that his April 30 $120,000 contribution came as the result of repayment by the companies of a prior loan funded by his IRA account. Seizing on the fact that the $120,000 April 30 contribution matched a $120,000 February 15 withdrawal, the Commissioner argued that it was not a qualifying rollover contribution because it was not made within the 60-day time limit in § 408(d)(3)(A)(i). The Tax Court agreed and included the $120,000 in determining the amount of Haury's taxable income from IRA distributions that year.

On appeal, now represented by counsel, Haury argues that the $120,000 IRA contribution on April 30 was a qualifying partial rollover of the $168,000 IRA distribution made on April 9, less than 60 days before the contribution. That the 60-day limit in § 408(d)(3)(A)(i) was satisfied is clearly correct, as government counsel reluctantly acknowledged at oral argument. The government nonetheless asserts two feeble defenses to this contention. First, it argues that the partial rollover issue was forfeited because Haury failed to argue it to the Tax Court. Frankly, we are appalled by the unfairness of this contention. At trial, the pro se Haury simply explained the facts, as the presiding Tax Court judge directed him to do. It was the Commissioner's attorneys who matched up the two $120,000 transactions and, ignoring the obviously applicable partial rollover provision in § 408(d)(3)(D), asserted that the rollover contribution was untimely. The issue before the Tax Court was whether this was a qualifying rollover contribution under I.R.C. § 408(d)(3). The Tax Court was obligated to fairly apply that statute to the facts presented, particularly for a taxpayer who is pro se. See Transp. Labor Contract/Leasing, Inc. v. Commissioner, 461 F.3d 1030, 1034 (8th Cir. 2006). Though we generally do not consider issues not raised below, as the Supreme Court said in a tax case many years ago, we should “where injustice might otherwise result.” Hormel v. Helvering, 312 U.S. 552, 557 (1941). We conclude this is such a case.

Second, the Commissioner argues that we cannot grant relief on the basis of a qualifying partial rollover because Haury failed to prove that he had not made a prior rollover contribution within one year of April 30, 2007. This contention is factually without merit, if not downright silly. As government counsel conceded at oral argument, the IRS had access to the transactions in Haury's IRA account during the year prior to April 30, 2007. Had there been a prior rollover contribution, it would have been a complete defense to Haury's rollover contention, because the one-year limitation in § 408(d)(3)(B) applies to all rollover contribution claims,

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whether complete or partial. Had the IRS's exhaustive review of the transactions in Haury's IRA account revealed a disqualifying prior rollover contribution during the prior year, the Commissioner would have asserted this defense before the Tax Court, making the 60-day limit the Commissioner in fact asserted unnecessary. As the Commissioner did not raise the one-year issue, Haury had no need to address it at trial.

The Court held that the rollover was valid and reversed the tax court.

But, the appeals court upheld the Tax Court regarding the bad debt loss because it found no clear error in the lower court’s opinion. The Tax Court had found that loans underlying the bad debt loss were predominantly made in order to protect his investments, rather than to protect his salary from employment.

Estate of Kessel v. Comm’r., T.C. Memo. 2014-97 (May 21, 2014): No summary judgment for Government in valuing decedent’s personal pension plan invested in Madoff Ponzi SchemeAt the time of Bernard Kessel’s death his personal pension held an account that invested in Bernard L. Madoff Investment Securities, LLC (Madoff Investments) ostensibly worth over $4.8 million. The executor filed an estate tax return reporting that amount and paying the full amount of estate tax on that value. Soon after that, the executor filed a supplemental estate tax return claiming a refund based on the estate’s revised date-of-death value of zero.

The Tax Court summarized the Governments motions:

Respondent asks us to decide two issues. Respondent first asks us to identify the Madoff account -- as opposed to the Madoff account's purported holdings -- as the property subject to [*3] Federal estate tax. We will deny respondent's motion on this point. Respondent next asks us to hold that a hypothetical willing buyer and willing seller of the Madoff account would not reasonably know or foresee that Mr. Madoff was operating a Ponzi scheme at the time Decedent died. We will likewise deny respondent's motion on this point.

Regarding the issue of whether the Madoff account and not the account’s purported investments could be the subject of a summary judgment, the Court said:

The creation of legal interests in property is generally governed by State law, while Federal law determines what interests so created shall be taxed. Personal property under New York law includes everything that may be owned, except real property. Certainly, the owner of the Madoff account had what appear to be property-like rights in his agreement with Madoff Investments concerning the Madoff account; e.g., he had the restricted right to transfer the account. We cannot say on the record before us, however, whether that agreement constituted a property interest includible in Decedent's gross estate separate from, or exclusive of, any interest Decedent had in what purported to be the assets held in the Madoff account. This question is best answered after the parties have had the opportunity to develop the relevant facts at trial. We will therefore deny respondent's motion on this point. (Citations and footnote omitted.)

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Regarding the issue of whether the existence of the Ponzi scheme could be taken into account, the Court said material issues of fact must be considered. The inquiry of valuation is a question of fair market value. The Court said:

Value in this context is defined as fair market value -- what a willing buyer would pay to a willing seller, both having reasonable knowledge of the relevant facts. Sec. 20.2031-1(b), Estate Tax Regs. Accordingly, later occurring events affecting the value of the property transferred are relevant to the determination of fair market value only if they were reasonably foreseeable at the time of transfer. Estate of Gilford v. Commissioner, 88 T.C. 38, 52-54 (1987). But later occurring events not affecting value may be relevant to the determination of fair market value regardless of their foreseeability at the time of transfer. Estate of Jung v. Commissioner, 101 T.C. 412, 431 (1993).

Respondent argues that a Ponzi scheme, by its very nature, is not reasonably knowable or foreseeable until it is discovered or it collapses. Respondent notes Mr. Madoff's particular skill and that his Ponzi scheme was not disclosed until it collapsed in December 2008. Respondent then reasons that Mr. Madoff's Ponzi scheme was knowable or foreseeable only at the point when it collapsed -- when the amount of money flowing out of Madoff Investments was greater than the amount flowing in. For purposes of this motion, at least, we disagree.

Some people had suspected years before Mr. Madoff's arrest that Madoff Investments' record of consistently high returns was simply too good to be true. See, e.g., Comm. on Fin. Servs., 111th Cong., Meeting on Assessing the Madoff Ponzi Scheme and the Need for Regulatory Reform 48-49 (Comm. Print 2009); Oversight of Securities and Exchange Commission's Failure to Identify the Bernard L. Madoff Ponzi Scheme & How to Improve SEC Performance: Hearing Before the Comm. on Banking, Hous., & Urban Affairs, 111th Cong. 2-3 (2009). Whether a hypothetical willing buyer and willing seller would have access to this information and to what degree this information would affect the fair market value of the Madoff account or the assets purportedly held in the Madoff account on the date Decedent died are disputed material facts. See Rule 121(b); Elec. Arts, Inc. v. Commissioner, 118 T.C. at 238. Thus, we will deny respondent's motion on this point as well. (Footnote omitted.)

Clark v. Ramaker, 573 U. S. ____ (Jun. 12, 2014): Supreme Court Holds Inherited IRA Doesn’t Qualify for Exclusion from Bankruptcy EstateThe U.S. Supreme Court has held that an Inherited IRA is not exempt from inclusion in a bankruptcy estate. As a result, naming a trust that has creditor protection features may become more commonplace.

Heidi Heffron-Clark inherited an Individual Retirement Account from her mother, Ruth Hefron in 2001. Heidi and her husband filed for bankruptcy protection in Wisconsin during 2010. Heidi sought to exclude her Inherited IRA from her bankruptcy estate.

11 U. S. C. § 522 exempts “retirement funds” from the estate of a bankrupt debtor. § 522(b) provides the exemption where a bankruptcy proceeds under federal law, while § 522((3)(C) provides the exemption where, as in this case, a bankruptcy proceeds under state law.

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The Court found that, lacking specific statutory definitions, the plain meaning of “retirement funds” means sums of money (plain meaning of “funds”) set aside for the day an individual stops working (plain meaning of “retirement”).

The Court further found that “retirement funds” has meaning aside from IRC sections referenced later in the same sentence because no term in the same statute should be rendered superfluous. Accordingly, to qualify for the exemption, both of two tests must be met: the Inherited IRA must constitute “retirement funds” and also must be a type of account described in one of 26 U.S.C. (Internal Revenue Code) sections 401, 403, 408, 408A, 414, 457, or 501(a).

The Court found Heidi’s Inherited IRA failed to constitute “retirement funds”, based on its legal characteristics, for each of three reasons.

First, Heidi’s Inherited IRA didn’t (and couldn’t) hold retirement funds with respect to Heidi because the holder of an inherited IRA may never invest additional money in the account. Thus, none of Heidi’s own funds were (or could be) saved.

Second, Heidi couldn’t (and didn’t) wait until she reached retirement to make withdrawals, as she was compelled by federal tax law to take required minimum distributions before reaching any “retirement age”.

Finally, because IRC § 72(t)’s ten percent excise tax on IRA withdrawals before reaching age 70½ excludes Inherited IRAs from its reach, Heidi can withdraw any amount (up to all) for any purpose, at any time (e.g., before retiring). Based on its reading of the statute and its finding that Heidi’s Inherited IRA fell outside the definition of “retirement funds”, the Court concluded that Heidi’s could not be excluded from her bankruptcy estate.

Spousal Rollover AccountsClark has left planners wondering: in what position is a surviving spouse of a decedent who accumulated a retirement account that would have qualified for the bankruptcy exemption for retirement funds?

A surviving spouse who inherits any of the types of accounts falling within the Bankruptcy Code’s definition of “retirement funds” has two options: treat the inherited retirement account as the account of the deceased spouse, or roll over any or all of the account’s proceeds to a rollover IRA. A rollover may be accomplished by direct transfer from the decedent’s retirement account to an IRA of the surviving spouse. Alternatively, and somewhat more risky, the surviving spouse may take possession of the proceeds and make a rollover within 60 days.

Once a spousal rollover is made, the surviving spouse is allowed to make contributions, unless the surviving spouse is past the surviving spouse’s own required beginning date. Note that a Roth IRA of the surviving spouse (as opposed to an Inherited Roth IRA) has no required beginning date until after the death of the surviving spouse.

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A spousal rollover account will be subject to § 72(t)’s 10% early (pre-age 59½) withdrawal tax.

Required minimum distributions with respect to a spousal rollover account begins with reference to when the surviving spouse attains age 70½. Clark does not say whether all three of its tests (whose funds are saved, presence of legal impediment to withdrawal before attaining retirement age, distributions not required prior to retirement) must be met. On the other hand, courts have frequently viewed spouses as a single economic unit, which could form the basis for granting exemption to a surviving spouse, even without a rollover.

ERISA Protection§ 206(d)(1) of the Employee Retirement Income Security Act of 1976 (ERISA) and the IRC require qualified retirement plans to prohibit assignment or alienation of benefits. Thus, for ERISA-covered plans sponsored by an employer, protection is available aside from the Bankruptcy Code. But ERISA protection can end soon after a covered employee’s death for non-spouse beneficiaries when the plan forces a distribution of all benefits soon after death.

In Patterson v. Shumate, 504 U.S. 753 (1992), the Supreme Court held that an employee- participant’s interest in ERISA-covered plan benefits is exempt from creditor claims in bankruptcy proceedings.

ERISA’s anti-alienation clause was found to be “A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law” within the meaning of Bankruptcy Code § 541(a)(1).

Note that ERISA’s exemption is not limited to the Bankruptcy exclusion (generally $1 million, plus cost of living increases).

ERISA protection extends to beneficiaries of plan death benefits. See, for example, Kennedy v. Plan Admr for DuPont Sav. & Inv. Plan, 555 U.S. 285 (U.S. 2009). In Kennedy, a marital settlement agreement to which a deceased ERISA-covered plan participant was a party was held not effective to override the decedent’s beneficiary designation of plan account death benefits in favor his of ex-spouse.

Because many retirement plans pay out benefits in a single lump sum shortly after a plan participant’s death, creditor protection for death benefits under the terms of the governing plan document and ERISA may be of little consequence to the death beneficiary.

LTR 201423043 (Feb. 15, 2014): Surviving spouse may roll over both of decedent’s two Roth IRAs, even though trust was named beneficiaryTwo Roth IRAs of a decedent named a trust as beneficiary. Following the decedent’s death his surviving spouse was the trustee of the trust. The trust divided into a marital trust and a family trust. The trust granted the trustee the ability to choose which assets were allocated to each of the marital and family trusts. The marital trust was to receive property equal in value to the minimum amount of the estate tax marital deduction necessary to reduce federal estate taxes to zero.

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As to how the Marital Trust was to be funded, the trust provided that the trustee's decision as to the property to be allocated to the Marital Trust shall be final and conclusive and binding upon all beneficiaries, with certain exceptions the IRS deemed not relevant. Thus, the surviving spouse, in her capacity as trustee, was free to allocate the Roth IRAs to the Marital Trust, provided their combined value didn’t exceed the amount of the trust’s marital deduction bequest.

The terms of Marital Trust entitled the surviving spouse to all net income. The Marital Trust further provided that the Trustee may distribute to the surviving spouse, or use for her benefit, any portion or all of the principal of the Marital Trust as the Trustee deems desirable for her support, comfort, and welfare, in her accustomed manner of living, or "for any other purpose the Trustee believes to be for [the surviving spouse’s] best interests.” The IRS further noted that provision “further states that [the decease spouse’s] primary concern is for [the surviving spouse's well-being and happiness and the Trustee need not consider the interest of any other beneficiary in making distributions to her or for her benefit.”

The proposed transaction was for the surviving spouse to make a distribution of both Roth IRAs “to herself as beneficiary of the Marital Trust under her power to do so ‘for any purpose’ because to do so is in her ‘best interest.’”

The ruling holds:

1. Roth IRA X and Roth IRA Y will not be treated as inherited IRAs within the meaning of section 408(d) of the Code with respect to [the surviving spouse].

2. [The surviving spouse] is eligible to roll over or have transferred, by means of a trustee to trustee transfer, a distribution of the proceeds of Roth IRA X and Roth IRA Y into a Roth IRA set up and maintained in her own name, as long as the rollover of such distribution occurs no later than the 60th day from the date said distribution is made from the IRA.

LTR 201444024 (Mar. 24, 2014): Trustee’s Retitling of Decedent’s IRA in Charity’s Name Held Not To Be a Distribution: Decedent’s Trust provided that after two pecuniary bequests, the remainder would be immediately distributed to Charity. Decedent also owned an IRA with Trust as the primary beneficiary. The Estate and Trust intend to assign and transfer the IRA to Charity in accordance with the terms of the Trust. A ruling was requested that the proposed transfer would not be a transfer within the meaning of § 691(a)(2).

Section 691(a) provides that all items of income in respect of a decedent which are not properly includable in the taxable period in which falls the date of the decedent’s death shall be included in the gross income, for the taxable year when received, of (A) the estate of the decedent, (B) the person who by reason of the decedent’s death acquires the right to receive the amount or (C) the person who has received from the decedent’s estate the right to receive the amount.

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Section 691(a)(2) that if a right described in § 691(a)(1) is transferred by the estate of the decedent, the estate must include in its gross income the fair market value of such right. For purposes of this paragraph, the term “transfer” includes sale, exchange or other disposition but does not include the transmission at death to the estate of the decedent or to a person entitled to receive such amount by reason of the death of the decedent or by bequest, devise or inheritance from the decedent.

Section 1.691(a)-4(b)(2) provides that if a right to IRD is transferred by an estate to a specific or residuary legatee, only the specific or residuary legatee must include such income in gross income when received.

Rev. Rul. 92-47, 1992-1 C.B. 198, holds that a distribution to the beneficiary of a decedent's IRA that equals the amount of the balance in the IRA at the decedent's death, less any nondeductible contributions, is IRD under § 691(a)(1) that is includable in the gross income of the beneficiary for the tax year the distribution is received.

Rev. Rul. 78-406, 1978-2 C.B. 157, provides, in general, that the direct transfer of funds from one IRA trustee to another IRA trustee does not result in such funds being treated as paid or distributed to the participant and such transfer is not a rollover contribution.

Rev. Rul. 78-406 is applicable to a trustee-to-trustee transfer directed by the beneficiary of an IRA after the death of the IRA owner as long as the transferee IRA is set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary. In that situation, the transfer does not constitute a payment or distribution as those terms are used in § 408(d).

The IRS ruled that retitling the IRA in the name of the Charity will not constitute a payment or distribution out of the IRA to the Estate, Trust or Charity within the meaning of § 408(d) and further ruled that the transfer will not be a transfer within the meaning of § 691(a)(2). Charity will include the amount of IRD from the IRA in its gross income when distributions from the IRA are actually received by Charity.

LTR 201432029 (May 13, 2014): Neither taxable gift nor taxable income arose from disgorgement of inherited IRAs pursuant to settlement agreement and court orderAn IRA and a SEP IRA both passed by beneficiary designation to, apparently, a life partner of the IRAs’ creator. That beneficiary set up two Inherited IRAs to receive the proceeds of each respective account, and then made trustee-to-trustee transfers of the IRA and a SEP IRA to those accounts.

The IRA creator died before reaching the required beginning date for making required minimum distributions. The custodial agreement governing the IRAs provided that all amounts standing in the IRAs would be distributed within five years of death, unless the beneficiary elected the life expectancy method. The life expectancy method was not elected.

A personal friend and business associate of the IRAs’ creator was named as beneficiary of the surviving life partner’s Inherited IRAs. Then, the surviving life partner died.

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The life partner’s named beneficiary set up two new Inherited IRAs and made trustee-to-trustee transfers to them, thus closing the life partner’s set of Inherited IRAs. Later, the new set of Inherited IRAs were ultimately transferred to a new IRA provider.

The life partner’s estate sued to recover the IRAs from the life partner’s named beneficiary. A settlement agreement was reached allowing the surviving beneficiary to retain part of each IRA and disgorge the rest. The surviving beneficiary then divided each IRA along the lines of the settlement agreement in anticipation of carrying out its terms, resulting in four Inherited IRAs. Next, court approval of the settlement agreement had to be obtained.

But before anything else could occur, a charity named as residuary beneficiary of a trust established by the life partner sued for recovery of all (now four) Inherited IRAs. Over a year and a half of contested litigation followed, ending in a court-approved final settlement agreement. The end result was a court order providing that all of both IRAs were the property of the IRA creator’s estate and that neither IRA was ever the property of that second beneficiary.

The surviving beneficiary sought and obtained rulings that:

(1) Entering into the final settlement agreement approved by Court Order will not be treated as a section 2501 taxable gift transfer from the surviving beneficiary to the life partner’s estate and/or the trust’s charitable beneficiary;

(2) The surviving beneficiary is not subject to income tax on the series of account balance transfers from and to the succession of Inherited IRAs;

(3) The surviving beneficiary is not subject to income tax on the final distributions to the residuary beneficiary of the estate, the charity; and,

(4) The surviving beneficiary will not be subject to Code section 4973 or section 4974 excise taxes with respect to any of the IRAs listed in this ruling request.

The IRS isn’t always bound to follow a court-approved settlement agreement for tax purposes. In that regard, the ruling instructively states:

Generally, transfers pursuant to agreements in settlement of disputes between adverse parties are not subject to the gift tax. See Beveridge v. Commissioner, 10 T.C. 915 (1948); Estate of Noland v. Commissioner, T.C. Memo. 1984-209; Lampert v. Commissioner, T.C. Memo 1956-226.

In Ahmanson Found. v. United States, 674 F.2d 761 (9th Cir. 1981), the issue before the court was whether property received by the spouse pursuant to a settlement qualified for the estate tax marital deduction. Relying on Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), the court held that, in order for the settlement to be recognized for transfer tax purposes, the settlement must be made in good faith, and it must be based on the spouse's underlying enforceable right under state law properly interpreted. The court limited the amount of the marital deduction to the value of the property received with respect to which the spouse had enforceable rights, notwithstanding that the spouse received a greater amount under the good faith settlement.

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In this case, whether the final settlement agreement approved by Court Order results in a transfer subject to gift tax depends on whether the settlement is based on a valid enforceable claim asserted by the parties. See Ahmanson, 674 F.2d at 774-75. Thus, state law must be examined to ascertain the legitimacy of each party's claim. If it is determined that each party has a valid claim, the Service must determine that the distribution under the settlement reflects the result that would apply under state law. If there is a difference, it is necessary to consider whether the difference may be justified because of the uncertainty of the result if the question were litigated.

The final settlement agreement approved by Court Order is a mediated settlement and is based on arm's-length negotiations among the parties after years of litigation. Under applicable State law, if Court had sustained allegations made by Decedent C's estate and Charity D, Taxpayer A would have been precluded by State Statute 1 and State Statute 2 from inheriting IRA I1 and IRA I2. Under the terms of the final settlement agreement approved by Court Order, it was agreed, in effect, that Taxpayer A did not inherit IRA I1 and IRA I2. Thus, we conclude the terms of the final settlement agreement approved by Court Order represent (i) the resolution of a bona fide controversy regarding enforceable claims of the parties; and (ii) the parties' assessments of the relative strengths of their positions. We further conclude that the final settlement agreement approved by Court Order is within the range of reasonable outcomes under the governing instruments and applicable State law.

Therefore, based on the facts submitted and representations made, we conclude that Taxpayer A did not make a taxable gift for purposes of the federal gift tax under section 2501 by entering into the final settlement agreement approved by Court Order.

Note: “Taxpayer A” is the surviving beneficiary; “Decedent C” is the life partner; “IRA I1 and IRA I2” are the set of Inherited IRAs of the life partner; and Charity D is the charity that brought the lawsuit to recover the Inherited IRAs of the life partner.

LTR 201437029 (Jun. 5, 2014): Spouse may make direct transfer or rollover of decedent’s IRA, even though estate is IRA beneficiary by defaultA decedent’s IRA had no beneficiary named by the IRA owner during lifetime. Under the IRA’s governing instrument (here, an IRA adoption agreement), the IRA passed to the decedent’s estate. The decedent’s death occurred after attaining 70 ½

COMMENT: the ruling doesn’t say whether the decedent died on or April 1 of the year after the when age 70 ½ was attained – in other words, on after the decedent’s required beginning date. However, that distinction is of little no consequence when the surviving spouse makes a direct transfer or rollover to an IRA of the surviving spouse.

The surviving spouse was appointed as executor of the decedent’s estate. In her capacity as executor, the surviving spouse represented she would transfer the entire estate, including the rights to IRA distributions, to a trust. The facts of the ruling don’t disclose whether the trust was a testamentary trust or was a trust the decedent established during lifetime. The surviving spouse was trustee of the trust and of subtrusts created under the trust’s terms.

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The trust terms provided that, upon the decedent’s death, a pecuniary amount would be allocated to a marital trust intended to qualify for the estate tax marital deduction. The amount of the marital deduction gift was the minimum amount needed to create a federal estate tax marital deduction that would reduce the federal estate taxes to zero. Trust property equal to that amount was to be allocated to a marital trust.

The surviving spouse, as trustee of the trust will transfer the decedent’s IRA to the marital trust. Then, surviving spouse, as trustee of the Marital Trust will either make a direct transfer to an IRA set up in her own name (as individual), or else distribute the IRA to herself and then rollover the proceeds to an IRA set up in her own name.

COMMENT: The ruling is silent about what power the surviving spouse has as trustee of the marital trust to distribute trust property to herself.

COMMENT: The marital gift funding formula employs a pecuniary bequest by formula. The ruling never raises the issue that satisfaction of a pecuniary bequest triggers income recognition. But see LTR 201438014, discussed later, where the IRS held satisfaction of two pecuniary charitable bequests of stated dollar amounts did trigger income recognition. From an income recognition standpoint, income recognition shouldn’t turn on whether the pecuniary amount is a stated dollar amount versus an amount determined by formula.

The IRS held that the decedent’s IRA was not an Inherited IRA with respect to the surviving spouse. Thus, the spouse was not prohibited from making a rollover. See IRC § 408(d)(3)(C)(ii). That meant that the surviving spouse was eligible to roll over the IRA proceeds to an IRA of her own.

Accordingly, the IRS held that the decedent’s IRA could either make a 60-day rollover if the IRA is distributed or, alternatively, make a direct trustee-to-trustee transfer, to an IRA set up in the name of the surviving spouse.

The IRS also held that the surviving spouse would not recognized any income from a rollover or transfer.

COMMENT: missing is a ruling that neither the trust nor the marital trust would recognize taxable income. Note that inferences beyond stated rulings are barred under the terms of the ruling. This particular ruling states:

No opinion is expressed as to the tax treatment of the transaction described herein under the provisions of any other section of either the Code or regulations which may be applicable thereto.

LTR 201438014 (May 5, 2014): Satisfaction of Pecuniary Bequests to Charities Using IRA AssetsSatisfaction of a pecuniary gift generally means income in respect of a decedent will be recognized. This includes taxable retirement benefits. Examples are a bequest of $50,000 to a friend, as well as a formula bequest such as the least amount of a marital deduction or charitable deduction gift necessary to reduce the trustor’s estate tax to zero.

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In this ruling, a trust established by decedent was named as beneficiary of the decedent’s IRA. The trust provided for two pecuniary bequests (specified dollar-amount gifts) to charities. Because non-IRA assets weren’t sufficient to satisfy those charitable pecuniary bequests, it was necessary to use some IRA assets to complete the funding of those bequests.

The trustee sought and obtained a court order reforming the trust in an effort to establish a right in the charities to receive part of the IRA proceeds. The IRS refused to recognize the order, as it had no effect other than for tax purposes.

The ruling held that use of IRA assets to satisfy the charitable pecuniary bequests must be treated as a sale or exchange of income in respect of a decedent. It was further held that the trust would not qualify for a charitable income tax deduction because the governing instrument (i.e., the trust) did not provide that income must be used to satisfy those charitable distributions from the trust.

COMMENT: a pecuniary bequest can be stated as a formula bequest. For example, a $1 million bequest to charity could be stated as a fraction of trust property, the numerator of which is $1 million and the denominator of which is the value of all trust property as finally determined for estate tax purposes. It may be necessary or desirable to adjust the denominator, such as for expenses of administration. Examples for marital and charitable bequests can be found in estate planners’ drafting guides.

LTR 201440028 (Jul. 9, 2014): IRS Waives Rollover Requirement for 1st IRA Distribution; But Denies Waiver for 2nd DistributionAn IRA owner wished to invest IRA funds at another firm that represented itself in writing to be qualified as an IRA custodian. On March 28, 2011, a direct transfer was made from the existing IRA to the new account. On September 28, 2011, a second transfer was made from the existing IRA to the new account.

The firm holding the new account issued monthly statements in the name of "Taxpayer A -- Rollover IRA."

But the firm holding the new account wasn’t qualified to hold an IRA, something discovered by the firm during a subsequent self-audit. Accordingly two taxable distributions occurred from the IRA from which funds were transferred.

The IRA owner requested relief from the 60-day rollover rule. The IRS granted relief for the first transfer, but said it couldn’t grant relief for the second transfer because of the one rollover per year rule.

COMMENT: this case shows there’s value in doing business with well-established firms that have an IRA track record.

PLR 201444044 (Aug. 6, 2014): IRS Denies Waiver of Rollover Requirement for IRA Distribution To obtain a better investment return, in 2012 the taxpayer rolled her IRA from one financial institution to another. The second financial institution erroneously transferred the amount into a non-IRA trust account instead. Taxpayer did not discover the error until 2013, when

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her 2012 tax returns were being prepared. She asked the second financial institution to correct the mistake, and the available amount in the non-IRA account (which was less than the amount originally transferred into the account) was transferred into a new IRA. The IRS granted a waiver of the 60-day rollover requirement with respect to the amount that was transferred into the IRA, but denied the waiver for the amount the taxpayer withdrew from the non-IRA account. The taxpayer ‘s submitted documentation was insufficient to show the location and use of this amount after the distribution.

PLR 201444045 (Aug. 4, 2014): IRS Denies Waiver of Rollover Requirement for IRA DistributionTaxpayer wanted to have all her CDs with one financial institution. Upon maturity of the CD in her IRA with the first financial institution, she took a complete distribution in a cashier’s check and closed the IRA account. One week later, she gave the cashier’s check, which did not indicate that it was a distribution from an IRA, to the second financial institution and told the representative that the funds were from an IRA. She assumed the money would be invested in an IRA, but the financial institution set up a non-IRA account. She received statements and the account was not identified as an IRA.

After setting up the non-IRA account, taxpayer directed the financial institution to change the account to a joint account with her daughter, similar to other CDs she held jointly with her daughter at that financial institution.

Taxpayer took required minimum distributions from the IRA account while it was at the first financial institution, but she took no distributions from the non-IRA account at the second financial institution.

Taxpayer asserts that she was not aware that the account set up at the second financial institution was not an IRA until she received a tax notice.

The IRS found that taxpayer did not present sufficient evidence showing that the second financial institution erred in setting up the non-IRA account. She presented no evidence that she instructed the institution to set up an IRA account with the cashier’s check. Further, her actions were consistent with maintaining a non-IRA account. She received statements that did not show the account was an IRA, she did not take required minimum distributions and she converted the account to joint ownership with her daughter. Accordingly, the IRS declined to waive the 60-day rollover requirement.

§ 469: Passive Activity Losses

Frank Aragona Trust v. Commissioner, No. 15392-11, 142 T.C. No. 9 (Mar. 27, 2014): Trusts may qualify for material participation exception to passive activity classification; material participation of individual trustees attributed to trust The Tax Court has held that material participation of individual trustees acting in their capacity as employees of a limited liability company wholly owned by a trust satisfies the § 469(c)(7) material participation exception to per se classification as a passive activity of rental real estate operations under § 469(c)(2).

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Frank Aragona formed a revocable living trust during his lifetime. Following his death in 1981, his five children became beneficiaries under the trust’s terms. The five children and one independent trustee became co-trustees.

The Opinion describes the trust as “a complex residuary trust that owns rental real-estate properties and is involved in other real-estate business activities such as holding real estate and developing real estate” with its principal place of business located in Michigan.

The statement of facts details the LLC’s role in managing real estate and the LLC’s employment of three of the children:

Three of the children -- Paul V. Aragona, Frank S. Aragona, and Annette Aragona Moran -- worked full time for Holiday Enterprises, LLC, a Michigan limited liability company that is wholly owned by the trust. Holiday Enterprises, LLC, is a disregarded entity for federal income tax purposes. Holiday Enterprises, LLC, managed most of the trust's rental real-estate properties. It employed several people in addition to Paul V. Aragona, Frank S. Aragona, and Annette Aragona Moran, including a controller, leasing agents, maintenance workers, accounts payable clerks, and accounts receivable clerks. In addition to receiving a trustee fee, Paul V. Aragona, Frank S. Aragona, and Annette Aragona Moran each received wages from Holiday Enterprises, LLC.

The trust experienced net operating losses from real estate operations incurred in 2005 and 2006 and had deducted those losses as net operating loss carrybacks in tax years 2003 and 2004. The IRS examined those returns and classified the losses as passive losses, thereby denying the NOL carryback deductions.

The IRS argued that trusts can never qualify for the § 469(c)(7) material participation exception because only an individual or a corporation can so qualify, thus precluding trusts from qualifying.

The Court noted that trustees are mere holders of title to property to be managed for the benefit of trust beneficiaries.

The Court then explained the statutory rule:

In 1993 Congress enacted section 469(c)(7), which provides that section 469(c)(2) does not apply to the rental real-estate activity of any taxpayer who meets the requirements of section 469(c)(7)(B). Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103-66, sec. 13143(a) and (b), 107 Stat. at 440, 441.9 Section 469(c)(7)(B) consists of two tests. The first test is met if more than one-half of the “personal services” performed in trades or businesses by the taxpayer during the taxable year is performed in real-property trades or businesses in which the taxpayer materially participates. Sec. 469(c)(7)(B)(i). The second test is met if the taxpayer performs more than 750 hours of "services" during the year in real-property trades or businesses in which the taxpayer materially participates. Sec. 469(c)(7)(B)(ii). Both tests must be met.

Based on legislative history and the language of § 469(c)(7), and in the absence of interpretive Treasury regulations, the Court found that trusts can qualify.

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The Court went on to raise the question: how can a trustee materially participate in the active management of real estate owned by an entity, in this case, an LLC? Michigan state law provided the answer: fiduciary duties of a trustee extend to a fiduciary’s acts as employee of a corporation owned by a trust. The Court extended that rule to a fiduciary who acts as an employee of a limited liability company.

The individual trustees were thus found to satisfy the material participation requirements by reason of their duties as LLC “employees”.

COMMENTSThe Court’s opinion relies, in part, on Michigan case law holding that the fiduciary duty of a trustee governs acts of a trustee while acting as an employee of a corporation in which the trust holds an interest. State law must be analyzed to determine whether a similar rule applies in any other state.

The opinion applies to individual trustees. The question is left open whether a similar result is attained where the trustee is a corporate trustee.

Should revocable living trusts establish a separate subtrust to hold only real estate operations? That might make it easier to meet the test that more than one-half of the “personal services” performed in trades or businesses by the taxpayer during the taxable year must be performed in real-property trades or businesses in which the taxpayer materially participates.

Where § 469(c)(7) tests are met, income will not constitute taxable income for purposes of the Medicare tax. See § 1411(c)(2), providing that income from a passive activity so classified under § 469 is net investment income. Similarly, gains from property classified as a property held in a trade or business will not constitute net investment income. See further, Regs. § 1.1411-5(b), relating to treatment of passive activities).

See also, and Mattie K. Carter Trust v. U.S., 256 F. Supp. 2d 536 (N.D. Tex. 2003).

§ 1001: Determination of Amount of and Recognition of Gain or Loss

REG 15489-03 (Jan. 17, 2004): Proposed regulations regarding sale of all interests in charitable remainder trusts Proposed regulations address the perceived abuse of (1) placing appreciated assets in a charitable remainder trust, (2) selling those assets free of income taxes within the trust, and then (3) deducting basis equal to fair market value from proceeds realized when all interests in the trust are sold. Under proposed regulations the basis the sellers can deduct from the amount realized is reduced by the amount of the trust’s realized gains not yet carried out by distribution to the trust’s noncharitable beneficiaries.

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§ 1022: Election Out of Estate Tax and Into Carryover Basis of Property Acquired from a Decedent Dying During 2010

Rev. Proc. 2014-18; 2014-7 I.R.B. 513 (Jan. 27, 2014), amplifying Rev. Proc. 2014-3, 2014-1 I.R.B. 111: Automatic Extension of Time to Elect Carryover BasisCiting U. S v. Windsor, 570 U.S. 12, 133 S. Ct. 2675 (2013) striking down § 3 of the Defense of Marriage Act (DOMA), an automatic Extension of Time to Elect Carryover Basis for any estate, provided that no estate return was required to be filed, no estate tax return has been filed (for example, to elect portability of the decedent’s unused applicable exclusion amount, and the election is filed on or before Dec. 31, 2014. Other requirements are provided in the revenue procedure.

For taxpayers wishing to make a late election into carryover basis but that do not qualify for the automatic relief, the revenue procedure confirms that relief may be requested under Treas. Reg. § 301.9100-1 et seq.

LTR 201442015 (15 July 2014): Request for Extension of Time to Elect Carryover Basis DeniedThe executor of an estate timely executed Form 8939, electing carryover basis. The accounting firm that prepared Form 8939 mailed the return to the IRS Service Center. The ruling’s summary of facts states:

It is represented that Accounting Firm has a long-standing practice, with specific procedures in place, to mail by regular mail with the United States Postal Service tax returns that show little or no tax due. Accounting Firm did not advise Executor that there were other methods of mailing the Form 8939 which would have ensured timely filing.

The IRS claimed it never received Form 8939 and refused to recognize the accounting firm’s practice as proof of timely filing.

The facts of the ruling also state that an estate tax examining agent (IRS) had inquired whether an estate tax return was filed. A letter to Executor stated, that if the Executor determined that a Form 706 was not needed, then the Executor was requested to provide a detailed explanation. The Executor responded that Form 8939 had been filed, electing out of the estate tax. Based on that letter, the examining agent contacted the IRS Service Center to obtain a copy, but the return wasn’t found.

The executor then applied for an extension of time to file Form 8939. The IRS denied the request, saying:

The IRS has no record of receiving Decedent's Form 8939, which Executor claims was mailed by Accounting Firm on Date 1. Accounting Firm has provided affidavits claiming to have timely mailed the Form 8939. Affidavits, however, are not prima facie evidence that the Form 8939 was delivered to the IRS. Executor has not provided direct proof of actual delivery or proof that the Form 8939 was sent to the IRS by United States registered or certified mail, or other designated delivery service, and maintains only that the postal service lost the filing. Thus, Executor has

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failed to present prima facie evidence that the Form 8939 was delivered to the IRS. Accordingly, Decedent's estate failed to timely elect out of the estate tax and is now requesting relief to elect out of the estate tax under § 301.9100-3.

Based on the facts submitted and the representations made, we conclude that the requirements of § 301.9100-3 have not been satisfied. Executor alleges that the United States Postal Service lost the Decedent's Form 8939, claiming that this is an intervening event beyond the taxpayer's control. However, under § 7502 and the corresponding regulations, if Executor had sent the Form 8939 to the IRS by United States registered or certified mail, it would constitute prima facie evidence of delivery to the IRS on the postmark date. Because Executor could have prevented this result, intervening events beyond Executor's control did not cause Executor to fail to make the election under § 301.9100-3(b)(1)(ii).

§ 1411: Medicare Tax on Net Investment Income

T.D. 9644 (26 Nov. 2013): IRS Final Regs. on Net Investment Income Tax; 78 FR 72393-72449, Dec. 2, 2013, corrected at 79 FR 18159-18161, Apr. 1, 2014.Final regulations on the 3.8 percent Medicare tax on net investment income (“NII”) tax have been issued.

Estates and trusts, and their beneficiaries: § 1.1411-3The final regulations confirm that charitable, etc. exempt trusts aren’t subject to the tax. Grantor trusts are exempt because their deemed owners are subject to tax. Corporations that are grantors of a grantor trust will escape the tax, as corporations aren’t subject to § 1411. Other entities not subject to tax:

Electing Alaska Native Settlement Trusts subject to taxation under section 646

Cemetery Perpetual Care Funds to which section 642(i) applies.

Foreign trusts (as defined in section 7701(a)(31)(B) and § 301.7701-7(a)(2)) (but see §§ 1.1411-3(e)(3)(ii) and 1.1411-4(e)(1)(ii) for rules related to distributions from foreign trusts to United States beneficiaries).

Foreign estates (as defined in section 7701(a)(31)(A)). But distributions to U.S. beneficiaries may be subject. Determining the NII element of such a distribution may not be possible where a tax treaty doesn’t cover the subject matter of § 1411.

For trusts that are subject to the tax, the taxable amount is the lesser of the trust’s undistributed NII or the difference between adjusted gross income and the threshold amount ($12,150 for 2014). Each beneficiary’s interest in a § 685 qualified funeral trust is treated as a separate trust.

A bankruptcy estate in which the debtor is an individual is treated as a married taxpayer filing a separate return for purposes of section 1411. Thus, the threshold amount is $125,000.

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The threshold amount is not reduced for a short tax year. But if there’s a change in accounting period, that amount will be prorated.

An electing non-grantor small business trust (ESBT) may hold S corporation stock. The ESBT and non-ESBT portions are treated as a single trust for purposes of determining the amount subject to tax. That should mean only one threshold amount is available to both portions. But each portion determines its own amount of undistributed NII. § 1.1411-(c)(2) provides the method for computing the tax:

(i) Step one.The S portion and non-S portion computes each portion's undistributed net investment income as separate trusts in the manner described in paragraph (e) of this section and then combines these amounts to calculate the ESBT's undistributed net investment income.

(ii) Step two.The ESBT calculates its adjusted gross income (as defined in paragraph (a)(1)(ii)(B)(1) of this section). The ESBT's adjusted gross income is the adjusted gross income of the non-S portion, increased or decreased by the net income or net loss of the S portion, after taking into account all deductions, carryovers, and loss limitations applicable to the S portion, as a single item of ordinary income (or ordinary loss).

(iii) Step three.The ESBT pays tax on the lesser of --

(A) The ESBT's total undistributed net investment income; or

(B) The excess of the ESBT's adjusted gross income (as calculated in paragraph (c)(2)(ii) of this section) over the dollar amount at which the highest tax bracket in section 1(e) begins for the taxable year.

The regulation deals with distributions from charitable remainder trusts in a manner consistent with existing rules for subjecting distributions to income taxation under § 664. NII received by a CRT is classified according to § 664 categories of ordinary income, short-term capital gains, and long-term capital gains. NII distributed from a CRT to its noncharitable beneficiary retains its character as NII in the hands of a CRT beneficiary.

Trustee Can Distribute Net Investment Income; But What About Trustor Intent?Capital gains of a trust or an estate will be subject to Medicare taxes imposed on the trust or estate, unless shifted to beneficiaries of the trust or estate.

Treasury Regulations Section 1.643(a)-3 Capital gains and losses.

(a) In general. Except as provided in § 1.643(a)-6 and paragraph (b) of this section, gains from the sale or exchange of capital assets are ordinarily excluded from distributable net income and are not ordinarily considered as paid, credited, or required to be distributed to any beneficiary.

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(b) Capital gains included in distributable net income. Gains from the sale or exchange of capital assets are included in distributable net income to the extent they are, pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law) --

(1) Allocated to income (but if income under the state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to this subparagraph § 1.643(a)-3(b));

(2) Allocated to corpus but treated consistently by the fiduciary on the trust's books, records, and tax returns as part of a distribution to a beneficiary; or

(3) Allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.

(c) Charitable contributions included in distributable net income. If capital gains are paid, permanently set aside, or to be used for the purposes specified in section 642(c), so that a charitable deduction is allowed under that section in respect of the gains, they must be included in the computation of distributable net income.

(d) Capital losses. Losses from the sale or exchange of capital assets shall first be netted at the trust level against any gains from the sale or exchange of capital assets, except for a capital gain that is utilized under paragraph (b)(3) of this section in determining the amount that is distributed or required to be distributed to a particular beneficiary. See § 1.642(h)-1 with respect to capital loss carryovers in the year of final termination of an estate or trust.

(e) Examples. The following examples illustrate the rules of this section:

Example 1. Under the terms of Trust's governing instrument, all income is to be paid to A for life. Trustee is given discretionary powers to invade principal for A's benefit and to deem discretionary distributions to be made from capital gains realized during the year. During Trust's first taxable year, Trust has $5,000 of dividend income and $10,000 of capital gain from the sale of securities. Pursuant to the terms of the governing instrument and applicable local law, Trustee allocates the $10,000 capital gain to principal. During the year, Trustee distributes to A $5,000, representing A's right to trust income. In addition, Trustee distributes to A $12,000, pursuant to the discretionary power to distribute principal. Trustee does not exercise the discretionary power to deem the discretionary distributions of principal as being paid from capital gains realized during the year. Therefore, the capital gains realized during the year are not included in distributable net income and the $10,000 of capital gain is taxed to the trust. In future years, Trustee must treat all discretionary distributions as not being made from any realized capital gains.

Example 2. The facts are the same as in Example 1, except that Trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid first from any net capital gains realized by Trust during the year. Trustee evidences this treatment by

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including the $10,000 capital gain in distributable net income on Trust's federal income tax return so that it is taxed to A. This treatment of the capital gains is a reasonable exercise of Trustee's discretion. In future years Trustee must treat all discretionary distributions as being made first from any realized capital gains.

Example 3. The facts are the same as in Example 1, except that Trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid from any net capital gains realized by Trust during the year from the sale of certain specified assets or a particular class of investments. This treatment of capital gains is a reasonable exercise of Trustee's discretion.

Example 4. The facts are the same as in Example 1, except that pursuant to the terms of the governing instrument (in a provision not prohibited by applicable local law), capital gains realized by Trust are allocated to income. Because the capital gains are allocated to income pursuant to the terms of the governing instrument, the $10,000 capital gain is included in Trust's distributable net income for the taxable year.

Example 5. The facts are the same as in Example 1, except that Trustee decides that discretionary distributions will be made only to the extent Trust has realized capital gains during the year and thus the discretionary distribution to A is $10,000, rather than $12,000. Because Trustee will use the amount of any realized capital gain to determine the amount of the discretionary distribution to the beneficiary, the $10,000 capital gain is included in Trust's distributable net income for the taxable year.

Example 6. Trust's assets consist of Blackacre and other property. Under the terms of Trust's governing instrument, Trustee is directed to hold Blackacre for ten years and then sell it and distribute all the sales proceeds to A. Because Trustee uses the amount of the sales proceeds that includes any realized capital gain to determine the amount required to be distributed to A, any capital gain realized from the sale of Blackacre is included in Trust's distributable net income for the taxable year.

Example 7. Under the terms of Trust's governing instrument, all income is to be paid to A during the Trust's term. When A reaches 35, Trust is to terminate and all the principal is to be distributed to A. Because all the assets of the trust, including all capital gains, will be actually distributed to the beneficiary at the termination of Trust, all capital gains realized in the year of termination are included in distributable net income. See §1.641(b)-3 for the determination of the year of final termination and the taxability of capital gains realized after the terminating event and before final distribution.

Example 8. The facts are the same as Example 7, except Trustee is directed to pay B $10,000 before distributing the remainder of Trust assets to A. Because the distribution to B is a gift of a specific sum of money within the meaning of section 663(a)(1), none of Trust's distributable net income that includes all of the capital gains realized during the year of termination is allocated to B's distribution.

Example 9. The facts are the same as Example 7, except Trustee is directed to distribute one-half of the principal to A when A reaches 35 and the balance to A when A reaches 45. Trust assets consist entirely of stock in corporation M with a fair market value of $1,000,000 and an adjusted basis of $300,000. When A reaches 35, Trustee sells one-half of the stock and distributes the sales proceeds to A. All the sales proceeds, including all the

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capital gain attributable to that sale, are actually distributed to A and therefore all the capital gain is included in distributable net income.

Example 10. The facts are the same as Example 9, except when A reaches 35, Trustee sells all the stock and distributes one-half of the sales proceeds to A. If authorized by the governing instrument and applicable state statute, Trustee may determine to what extent the capital gain is distributed to A. The $500,000 distribution to A may be treated as including a minimum of $200,000 of capital gain (and all of the principal amount of $300,000) and a maximum of $500,000 of the capital gain (with no principal). Trustee evidences the treatment by including the appropriate amount of capital gain in distributable net income on Trust's federal income tax return. If Trustee is not authorized by the governing instrument and applicable state statutes to determine to what extent the capital gain is distributed to A, one-half of the capital gain attributable to the sale is included in distributable net income.

Example 11. The applicable state statute provides that a trustee may make an election to pay an income beneficiary an amount equal to four percent of the fair market value of the trust assets, as determined at the beginning of each taxable year, in full satisfaction of that beneficiary's right to income. State statute also provides that this unitrust amount shall be considered paid first from ordinary and tax-exempt income, then from net short-term capital gain, then from net long-term capital gain, and finally from return of principal. Trust's governing instrument provides that A is to receive each year income as defined under state statute. Trustee makes the unitrust election under state statute. At the beginning of the taxable year, Trust assets are valued at $500,000. During the year, Trust receives $5,000 of dividend income and realizes $80,000 of net long-term gain from the sale of capital assets. Trustee distributes to A $20,000 (4% of $500,000) in satisfaction of A's right to income. Net long-term capital gain in the amount of $15,000 is allocated to income pursuant to the ordering rule of the state statute and is included in distributable net income for the taxable year.

Example 12. The facts are the same as in Example 11, except that neither state statute nor Trust's governing instrument has an ordering rule for the character of the unitrust amount, but leaves such a decision to the discretion of Trustee. Trustee intends to follow a regular practice of treating principal, other than capital gain, as distributed to the beneficiary to the extent that the unitrust amount exceeds Trust's ordinary and tax- exempt income. Trustee evidences this treatment by not including any capital gains in distributable net income on Trust's Federal income tax return so that the entire $80,000 capital gain is taxed to Trust. This treatment of the capital gains is a reasonable exercise of Trustee's discretion. In future years Trustee must consistently follow this treatment of not allocating realized capital gains to income.

Example 13. The facts are the same as in Example 11, except that neither state statutes nor Trust's governing instrument has an ordering rule for the character of the unitrust amount, but leaves such a decision to the discretion of Trustee. Trustee intends to follow a regular practice of treating net capital gains as distributed to the beneficiary to the extent the unitrust amount exceeds Trust's ordinary and tax-exempt income. Trustee evidences this treatment by including $15,000 of the capital gain in distributable net income on Trust's Federal income tax return. This treatment of the capital gains is a reasonable exercise of Trustee's discretion. In future years Trustee must consistently treat realized capital gain, if

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any, as distributed to the beneficiary to the extent that the unitrust amount exceeds ordinary and tax-exempt income.

Example 14. Trustee is a corporate fiduciary that administers numerous trusts. State statutes provide that a trustee may make an election to distribute to an income beneficiary an amount equal to four percent of the annual fair market value of the trust assets in full satisfaction of that beneficiary's right to income. Neither state statutes nor the governing instruments of any of the trusts administered by Trustee has an ordering rule for the character of the unitrust amount, but leaves such a decision to the discretion of Trustee. With respect to some trusts, Trustee intends to follow a regular practice of treating principal, other than capital gain, as distributed to the beneficiary to the extent that the unitrust amount exceeds the trust's ordinary and tax-exempt income. Trustee will evidence this treatment by not including any capital gains in distributable net income on the Federal income tax returns for those trusts. With respect to other trusts, Trustee intends to follow a regular practice of treating any net capital gains as distributed to the beneficiary to the extent the unitrust amount exceeds the trust's ordinary and tax-exempt income. Trustee will evidence this treatment by including net capital gains in distributable net income on the Federal income tax returns filed for these trusts. Trustee's decision with respect to each trust is a reasonable exercise of Trustee's discretion and, in future years, Trustee must treat the capital gains realized by each trust consistently with the treatment by that trust in prior years.

(f) Effective date. This section applies for taxable years of trusts and estates ending after January 2, 2004.

Valuation

Estate of Helen P. Richmond et al. v. Commissioner, No. 21448-09, T.C. Memo. 2014-26 (Feb. 11, 2014): Appraisal by a non-certified appraiser was not “reasonable cause” defense against accuracy related penalty for valuation understatementA decedent’s 23.44% non-controlling interest in a C corporation taxed as a personal holding company was found to be appropriately valued based on the net asset method and not on the capitalization-of-dividends method. The Court determined valuation discounts for the PHC’s built-in gains tax and for the decedent’s non-controlling minority holding of the PHC.

The value of the PHC’s assets at date of death was $52,159,430. Its net asset value ("NAV") was $52,114,041 (non-BICG tax liabilities were $45,389).

$50,690,504 of PHC assets were invested in stocks within 10 major industries. 42.8% of that stock was concentrated in four companies. $45,576,677, or 87.5% of the total stock value consisted of unrealized appreciation. The litigants agreed that the amount of the built-in capital gains tax unrealized gain was $18,113,083.

The decedent’s estate tax return included the PHC value at $45,576,677, based on an unsigned report prepared by an accountant with valuation experience, but no valuation credentials. The valuation was based on the capitalization-of-dividends method. The net asset value method was not considered in that report.

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Upon examination, the government increased the PHC value by $9,223,658, resulting in assessment of additional tax of $2,854,729. The increase gave rise to a 40% gross valuation misstatement penalty of $1,141,892 under IRC § 6662(h).

The taxpayer’s expert argued the capitalization-of-dividends method was appropriate because the decedent had only an income right, with no ability to influence PHC investing. The Court indicated that method was more appropriate for an operating business with difficult to value assets, preferring the objectivity of the net asset method where, as in the case before it, the assets were marketable securities.

In analyzing the effect of the built-in capital gains tax, the court expressly rejected reduction of value dollar for dollar. The taxpayer’s expert offered no testimony about the time over which gains would be realized while the government’s expert did. But the government’s expert assumed the tax would be paid over 70 years, based on an assumption the PHC would continue to adhere to a policy of investing for dividends and avoid diversification. Nevertheless, that expert testified that the portfolio would be turned between 20 and 30 years.

The Court observed that willing buyer of the entire PHC would be free to adopt a different investment policy, and that such a rational actor would expect a turnover period shorter than 70 years. Based on turnover between 20 and 30 years, the Court found a $7,817,106 BICG discount “to be reasonable in this case.”

Following its finding that the value of the PHC was $44,296,935 (equal to $52,114,041 NAV, less $7,817,106) the Court applied further discounts of 7.75% for lack of control and 32.1% for lack of marketability, resulting in a final value of $6,503,804 for the decedent’s 23.44% interest.

The 20 percent accuracy-related penalty for valuation was imposed. The estate’s argument that the estate reasonably relied on a qualified professional was rejected because the accountant who prepared the valuation used in the estate tax return lacked appraiser credentials and because he used only the capitalization-of-dividends method. The Court said:

In order to be able to invoke "reasonable cause" in a case of this difficulty and magnitude, the estate needed to have the decedent's interest in PHC appraised by a certified appraiser. It did not.

William Cavallaro et ux. v. Commissioner, T.C. Memo. 2014-189, Nos. 3300-11, 3354-11 (Sept. 17, 2014): Taxable gift arose from company mergerWilliam and Patricia Cavallaro, of New Hampshire, founded Knight Tool Co. in 1979, which eventually employed all three of their sons, Ken, Paul and James. Knight was a machine shop that made tools and parts used by other companies in their manufacturing processes. As such, it was a contract manufacturer.

Upon the corporation’s inception, William owned 49 percent of Knight; Patricia owned 51 percent.

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Following a meeting with one of Knight Tool’s customers, Ken saw an opportunity for Knight to have its own product by developing a machine could be sold to other manufacturers. He set about creating a machine that could apply liquid adhesive to computer circuit boards in the production process. Ken dubbed the new product CAM/ALOT (computer assisted machine that its inventors hoped would be used “a lot”).

But the cost of developing and marketing it over many years was a financial strain on Knight, so a new company was eventually formed by the family in 1987: Camelot Systems, Inc. Ken worked for that company as its only employee, but its costs and payroll continued to be underwritten by Knight.

Ownership of CAM/ALOT was in the three sons, equally, who capitalized it with $1,000.

By 1996, Ken’s brainchild had become highly successful. As part of William’s and Patricia’s estate planning, it was decided to merge the companies. Because share ownership of Knight was different than that of Camelot, the companies were valued, so as to avoid a taxable gift when the merged company issued its stock to all five individuals. Preparatory to the merger, the value of the two companies combined was estimated by the companies’ accounting firm, Ernst & Young as being between $70 and $75 million, with Knight's portion of that value being between $13 and $15 million.

Importantly, the valuations were based on ownership of CAM/ALOT technology by Camelot Systems, Inc. (Had that technology been owned by Knight, William and Patricia would have been entitled to a greater number of shares.)

The merger proceeded on that basis. On December 31, 1995, Knight and Camelot merged in a tax-free merger with Camelot as the surviving corporation.

On July 1, 1996, the merged company was sold in entirety for $57 million in cash, plus up to $43 million based on future performance.

Ownership of the technology by Knight had been reported in tax returns of Knight in connection with claiming the research and development credit. When the estate planning attorney convinced the return preparer (Ernst & Young) otherwise, that return was amended to remove the credit and the return of Camelot was amended to claim it.

Knight's and Camelot's 1994 and 1995 income tax returns were examined. One outgrowth of that examination was that a gift tax examination was also opened, culminating in the finding that each of the parents had made a taxable gift of $23,085,000 to their sons and assessment of gift tax liability of $12,889,550 for each of Mr. and Mrs. Knight. In addition, the IRS assessed “additions to tax pursuant to section 6651(a)(1) for failure to file timely gift tax returns, as well as section 6663(a) penalties for fraud. In his answers the Commissioner asserted, for the first time, alternative section 6662 accuracy-related penalties.”

At the heart of the IRS determinations was that ownership of CAM/ALOT technology resided not in Camelot Systems, Inc., but rather in Knight Tool Co.

The Tax Court found, on the record, that ownership of CAM/ALOT technology resided in Knight Tool Co.

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Worse yet, with regard to the merger, the Court found:

There is no evidence of any arm's-length negotiations occurring between the representatives or executives of the two companies. Instead (and despite a wholesale lack of evidence as to Camelot's ownership of the technology), Knight agreed to take a less than 20% interest in the merged company, effectively valuing Camelot at four times the value of Knight. As we stated in Dauth v. Commissioner, 42 B.T.A. 1181, 1189 (1940):

Where the facts show that the parties to a sale demonstrate such a lack of interest as to the price at which one sells to another that the buyer purportedly gives a sum greatly in excess of the worth of the property, such facts indicate that what was done was not a real business transaction and "was not intended to have the usual results and significance of a bona fide business deal." Pierre S. du Pont [ v. Commissioner ], * * * [37 B.T.A. 1198] p. 1242 [(1938)]. * * *

Accordingly, we find that the merger transaction between Knight and Camelot was not engaged in at arm's length and was not in the ordinary course of business.

The Court proceeded to value the companies, leaning heavily towards the valuation opinion of the government’s expert witness, because the taxpayer had offered no valuation evidence reflecting ownership of CAM/ALOT technology by Knight Tool. Like the valuation prepared for the taxpayers, the value of the combined companies and the value of Knight were both estimated, but with the assumption that Knight owned CAM/ALOT technology.

As a result, the Court concluded “that Mr. and Mrs. Cavallaro made gifts totaling $29.6 million on December 31, 1995.”

Because the Cavallaros filed no gift tax returns, the government asserted failure-to-file additions to tax under section 6651(a)(1) in addition to accuracy-related penalties under section 6662 (the fraud penalty was conceded at trial). The Court found that neither penalty applied because the taxpayers reasonably relied in good faith on a mistaken legal opinion of a competent tax adviser. Accordingly the reasonable cause defense to both penalties defeated those assessments.

COMMENT: As a tax-free merger precludes cash payments to shareholders, it seems very likely that it will be difficult for the taxpayers to raise the cash to pay their obligation.

Estate of James A. Elkins Jr. et al. v. Commissioner, No. 13-60472, 5th Cir. (Sept. 15, 2014), aff’g. in part, rev’g. in part 140 T.C. No. 5: Fifth Circuit determines valuation of estate's art worksJames Elkins collected fine art. He made lifetime gifts to his children of fractional interests in that art. When he died, the executor of his estate obtained appraisals of the fractional interests in 64 art pieces held by James at death, taking into account fractional interest discounts. On the estate tax return, a 44.75 percent discount was applied to the decedent’s fractional interests in the art for lack of marketability and control. The basis for the

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discounts was the presence of fractional interests that were subject to an art lease and a cotenant agreement imposing restrictions on the sale of the art items. Upon examination, the IRS found that no discounts should be applied.

The Taxpayer instituted proceedings in the Tax Court and offered witnesses and testimony in support of appraisals submitted into evidence indicating various discounts applied to various artworks. The government offered no appraisals, but rather argued no discounts were available.

The Tax Court found a nominal discount of 10 percent was appropriate for all 64 works of art. The discount was based on findings that the Elkins children would be the logical buyers, who would buy (and were financially situated to buy), but that there would be some uncertainty as to their intentions.

On appeal, that court disagreed with the Tax Court’s arrival at a 10 percent discount that was unsupported by evidence before it. The Court of Appeals examined the evidence and concluded discounts based on that evidence. Here, the government was disadvantaged by having introduced no appraisals into evidence. The Tax Court’s 10 percent discount was found to be reversible error.

The Appeals Court examined the record and agreed with the Tax Court’s finding that the Taxpayer’s appraisals “considered and correctly weighed all factors and characteristics of the Elkins heirs when determining how much a hypothetical willing buyer would pay for Decedent's fractional interests and thus become a co-owner with them.” And because the government offered no appraisals, the Tax Court should have granted judgment to the Taxpayer. The Court admonished:

While continuing to advocate the willing buyer/willing seller test that controls this case, the Tax Court inexplicably veers off course, focusing almost exclusively on its perception of the role of "the Elkins children" as owners of the remaining fractional interests in the works of art and giving short shrift to the time and expense that a successful willing buyer would face in litigating the restraints on alienation and possession and otherwise outwaiting those particular co-owners. Moreover, the Elkins heirs are neither hypothetical willing buyers nor hypothetical willing sellers, any more than the Estate is deemed to be the hypothetical willing seller.

The Court ultimately held that the value of the artworks was correctly stated by the Taxpayer at trial and that the estate is therefore entitled to a refund in the amount of $14,359,508.21, plus statutory interest.

§ 2010: Unified credit against estate tax

Rev. Proc. 2014-18, 2014-7 IRB 1 (Jan. 27, 2014): IRS Provides Simplified Method to Obtain Portability Election Extension for Certain EstatesAn executor of a decedent’s estate has not timely filed an estate tax return and wasn’t required to file one might now be able to claim deceased spousal unused exclusion amount by filing a late return.

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The criteria qualifying an executor for the relief are:

(1) The taxpayer is the executor (see § 20.2010-2T(6)) of the estate of a decedent who:

(a) has a surviving spouse;

(b) died after December 31, 2010, and on or before December 31, 2013; and

(c) was a citizen or resident of the United States on the date of death.

(2) The taxpayer is not required to file an estate tax return under § 6018(a) (as determined based on the value of the gross estate and adjusted taxable gifts, without regard to § 20.2010-2T(a)(1));

(3) The taxpayer did not file an estate tax return within the time prescribed by § 20.2010-2T(a)(1) for filing an estate tax return required to elect portability; and

(4) All requirements of section 4 of this revenue procedure are satisfied.

The procedure is the only route to relief until January 1, 2015, as the IRS will not accept private letter ruling requests under Reg. 301.9100-1 through 3.

The procedural requirements of section 4 are:

1) A person permitted to make the election on behalf of a decedent, pursuant to § 20.2010-2T(a)(6), must file a complete and properly-prepared Form 706 on or before December 31, 2014. The Form 706 will be considered complete and properly prepared if it is prepared in accordance with § 20.2010-2T(a)(7).

(2) The person filing the Form 706 on behalf of the decedent's estate must state at the top of the Form 706 that the return is "FILED PURSUANT TO REV. PROC. 2014-18 TO ELECT PORTABILITY UNDER § 2010(c)(5)(A)."

The Rev. Proc. notes:

[I]f an executor is not required by § 6018(a) to file an estate tax return and the executor files or may file an estate tax return to elect portability, the due date for electing portability is prescribed by § 20.2010-2T(a), and not by statute. Therefore, in such a case, the executor may seek an extension of time under § 301.9100-3 to elect portability under § 2010(c)(5)(A).

COMMENT: as 9100 relief is available only where the time for requesting that relief is not set by statute but is set by regulation, Rev. Proc. 2014-18 appears to acknowledge that the portability election due date is set by regulation.

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§ 2041: Powers of Appointment

LTR 201444002(Jul. 14, 2014): POA Over Trust Property Won't Trigger Estate Tax Inclusion (See also PLRs 201444003, 201444004, 201444005, 201444006, 201444007, 201446001, 201446002, 201446003 and 201446004.)

In two series of apparently companion rulings with identical facts, the IRS found that a grandchild’s testamentary power of appointment over trust principal and accumulated income was not a general power of appointment and would not trigger estate tax inclusion.

Under the Settlor’s will, a trust created for the grandchild provided discretionary payments of income and principal to or for the benefit of grandchild and grandchild’s issue. Upon the death of the grandchild, the principal and any accumulated or undistributed income, was to be paid over "to such among [Settlor's] issue" as Grandchild shall validly appoint in Grandchild's last will. Any balance of Trust remaining and not effectively appointed by Grandchild in Grandchild's last will is disposed of pursuant to paragraphs 2 and 3 of Article 10C of Settlor's last will.”

Section 2041(a)(2) provides that the value of the gross estate includes the value of all property with respect to which the decedent has at the time of his death a general power of appointment created after October 21, 1942.

Section 2041(b)(1) provides, with exceptions not relevant here, that the term "general power of appointment" means a power that is exercisable in favor of the decedent, his estate, his creditors, or the creditors of his estate.

The regulations further go on to provide in Section 20.2041-1(c)(1)(a) that a power of appointment is not a general power if by its terms it is exercisable only in favor of one or more designated persons or classes other than the decedent or his creditors, or the decedent's estate or the creditors of his estate.

In this case, the grandchild may only appoint by will to the class consisting of the settlor’s issue. Because the power is testamentary, grandchild may not appoint any part of Trust to himself or his creditors during his lifetime. In addition, the reference to “such among [Settlor’s] issue” as a permissible class of appointees of grandchild’s power is properly viewed as not including the grandchild’s estate or the creditors of the grandchild’s estate after the grandchild’s death.

Accordingly, the IRS ruled that grandchild’s testamentary power of appointment did not constitute a general power of appointment within the meaning of Section 2041(a) and (b), and the existence, exercise, failure to exercise, or partial or complete release of the power will not cause the property of the trust to be included in the grandchild’s estate under Section 2041(a).

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§ 2044: Marital Deduction Property Included in Taxable Estate of Surviving Spouse

Estate of Olsen v. Comm’r., No. 1981-12, T.C. Memo. 2014-58 (Apr. 2, 2014): Court decides allocation of expenses, in absence of subtrust fundingElwood H. Olsen was preceded in death by his wife, Grace Olsen. Each of them had established a revocable living trust. When Grace died in 1998, her trust became irrevocable and Elwood became successor trustee. Although Grace’s trust required that her trust estate be divided into three subtrusts, and although Elwood’s attorney advised him in writing to carry out the subtrust funding, Elwood never did so.

The three subtrusts consisted of a Family Trust, and two Marital Trusts meant to qualify for the estate tax marital deduction election for qualified terminable interest property. One Marital trust was intended to be exempt from generation-skipping transfer taxes, the other not. The Family Trust gift was a pecuniary formula bequest, with the residue passing to the Marital Trusts.

Elwood filed an estate tax return making the elections to claim the marital deduction and to allocate GST exemption.

Elwood withdrew a total of $1,080,802 from the trust and contributed those funds to Morningside College, where he had been employed. He also withdrew $393,978 from the trust, which he used for personal purposes.

The government argued that all funds withdrawn must be charged to the Family Trust, while the taxpayer argued that all funds withdrawn must be charged to the Marital Trusts.

The Tax Court analyzed the trust document, finding that the Family Trust should be charged with $1,080,802 because the terms of the trust granted Elwood a power to appoint Family Trust property to qualifying charities. The Court further found that the Marital Trusts should be charged with $393,978 because the Marital Trusts provided that distributions could be made to Elwood for his benefit so much of the principal of the Marital Trusts as Elwood, as trustee, determined to be advisable to provide for the health, education, support, and maintenance of that surviving spouse.

COMMENTS: This case underscores the importance of funding subtrusts within a reasonable time after the death of a decedent. Where, as in this case, a pecuniary bypass gift isn’t funded, estate tax savings of post-death appreciation that might have escaped estate tax is lost. In California, statutory interest is required to be paid on pecuniary bequest after one year.

But when is a reasonable time? For example, is it reasonable to wait until the estate tax is finally determined?

COMMENT: Had Elwood made charitable contributions from his own assets, his own taxable estate would have been reduced while, at the same time, his children would have received the Family Trust undiminished by the withdrawals.

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§ 2053: Expenses, Indebtedness, And Taxes

Estate of Gertrude H. Saunders et al. v. Commissioner, 9th Circ., No. 12-70323 (Mar. 12, 2014), aff’g 136 T.C. No. 18 (April 28, 2011): Tax Court’s denial of estate’s $30 million deduction for claims against estate and allowance of amount actually paid upheld

Tax Court OpinionThe Tax Court, based on Treas. Reg. § 20.2053-1(b)(3) prior to amendment, held that a claim against an estate may not be deducted in the amount of $30 million, as determined by valuation because the amount of the claim was not ascertainable with reasonable certainty as of the date of the decedent’s death.

The Court also held that: “Different standards apply to including a claim in favor of an estate in the gross estate and deducting a claim against an estate for estate tax purposes.” However, the estate could claim a deduction for the amount actually paid, apparently $250,000.

The opinion notes that some litigation claims can be valued with reasonable certainty, but goes on to say:

We agree with the comment of the District Court in Marshall Naify Revocable Trust v. United States, (citation omitted) that

[I]t cannot be that simply because one can assign a probability to any event and calculate a value accordingly, any and all claims are reasonably certain and susceptible to deduction. To so hold would read the regulatory restriction [section 20.2053-1, Estate Tax Regs.] out of existence. * * * The regulation * * * explicitly contemplates that some claims will be simply too uncertain to be taken as a deduction, regardless of the fact that it is always possible to come up with some estimate of a claim's value. [Fn. ref. omitted.]

The finding that the amount of the claim was not ascertainable with reasonable certainty was based on the estate's and the Commissioner’s expert reports, standing alone. The range of possible values the Court fixed upon was $1 to $90 million. Even allowing for estimated probabilities of various outcomes, the range was still great enough to indicate to this tribunal that that amount was too uncertain to be taken as a deduction.

Comment: Treasury and the IRS have since promulgated regulations interpreting IRC § 2053 further tightening deductions for claims against a decedent’s estate.

Ninth Circuit Court of Appeals OpinionThe Ninth Circuit reviewed “the tax court's legal conclusions, including its interpretation of the Internal Revenue Code and Treasury Regulations, de novo.”

The Court concluded:

The Claim at issue in this case was disputed at the date of the decedent's death, and its estimated value as of that date was not ascertainable with reasonable certainty.

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Under these circumstances, the tax court properly disallowed the Estate's $30 million deduction, but correctly allowed a deduction in the amount paid to settle the Claim after the decedent's death. We therefore affirm the decision of the tax court.

The Court said claims against an estate must be classified “as either ‘certain and enforceable,’ on the one hand, or ‘disputed or contingent,’ on the other.” The lower court failed to so classify the claims, but that failure was found “inconsequential.” Here, the Court found that, while the claim wasn’t contingent (because assertion before death occurred), it was nevertheless disputed.

The Court was not persuaded that the claim against the estate, even if uncertain, was reasonably ascertainable, based on the wide practice of relying on routine valuation of pending claims held by estates. The Court observed, “… the Estate confuses the valuation of assets held by an estate with the deduction allowable for claims pending against an estate.”

§ 2056: Bequests, Etc. to Surviving Spouse

PLR 201447008 (Jul. 22, 2014): IRS Grants Extension to Sever QTIP TrustDecedent died on Date 3, survived by Spouse. His revocable trust provides that if Spouse survives Decedent, the entire residue of the trust estate is to be held, administered and distributed in accordance with the provisions of Article 8 (Marital Trust).

Article 8 provides, in relevant part, that the trustee is to distribute all of the net income of Marital Trust to or for the benefit of Spouse, in convenient intervals, but not less often than monthly, during Spouse's lifetime. The trustee may also distribute to Spouse or for her benefit so much of the principal of Marital Trust for her health, maintenance and support in reasonable comfort. Article 8 further provided that it was Decedent’s intention for the Marital Trust to qualify for the federal estate tax marital deduction and that the trustee may elect to have all or a portion of the Marital Trust treated as qualified terminable interest property.

The trustee was also given the ability to divide the Marital Trust into subtrusts with identical dispositive and administrative provisions and to make different tax elections, including the allocation of GST exemption, with respect to those trusts.

Spouse and Accountant 1 were co-executors and co-trustees. Spouse hired the accounting firm of Accountant 1 to prepare Decedent’s Form 706. Spouse and Accountant 1 represented that they relied upon Accountant 2 with the firm for estate planning expertise. Form 706 was timely filed on behalf of the estate. The Form 706 did not evidence any intent to divide Marital Trust into two separate trusts, a Qualified Share (QTIP Trust) and a non-Qualified Share (Non-QTIP Trust). On Schedule M, Accountant 2 mistakenly listed Marital Trust as property not subject to the QTIP election. Thus, no QTIP election was made with respect to Marital Trust. Also, Schedule R was not completed for Form 706. It was represented that Decedent had not allocated any of his GST exemption to lifetime transfers.

The Estate requested relief under § 301.9100-3. Requests for relief under section 301.9100-3 will be granted when the taxpayer provides the evidence to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the government. Section 301.9100-3(b)(1)(v) provides that a taxpayer is deemed to have acted reasonably and in good faith if the

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taxpayer reasonably relied on a qualified tax professional, including a tax professional employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make, the election.

The IRS determined that the requirements of § 301.9100-3 had been met. Accordingly Decedent's estate was granted an extension of time to file a supplemental Form 706 to sever the QTIP Trust into a GST Exempt QTIP Trust and a Non GST-Exempt QTIP Trust; to make a reverse QTIP election with respect to the GST Exempt Marital Trust; and allocate Decedent's available GST exemption to the GST Exempt QTIP Trust and to the Non-QTIP Trust portion of Marital Trust. The GSTT allocation was effective as of Decedent's date of death.

§ 2511: Transfers by Gift in general

LTR 201440007 (Jun. 17, 2014): Disclaimer of Trust Distributions Won't Trigger Gift Tax

An individual proposed to make a disclaimer of entitlement to distributions from a trust that was established irrevocably before January 1, 1977. Because the individual seeking to make the disclaimer had never received any trust distributions and because that individual was under age 18, the IRS held that the proposed disclaimer could be a qualified disclaimer. The ruling was based in part on an analysis of state disclaimer laws.

The ruling discusses federal tax rules for disclaiming interests in property created before 1977:

Section 25.2511-1(c)(2) of the Gift Tax Regulations provides that, in the case of transfers that create an interest in the person disclaiming made before January 1, 1977, where the law governing the administration of the decedent's estate gives a beneficiary a right completely and unqualifiedly to refuse to accept ownership of property transferred from a decedent, a refusal to accept ownership does not constitute the making of a gift if the refusal: (1) is made within a reasonable time after knowledge of the existence of the transfer; (2) is unequivocal; (3) is effective under local law; and (4) is made before the disclaimant has accepted the property. Compare with § 2518 and §§ 25.2518-1 through 25.2518-3 (providing rules for determining whether a disclaimer is a qualified disclaimer effective for estate and gift tax purposes, in the case of the disclaimer of an interest in property that is created in the beneficiary disclaiming a transfer made after December 31, 1976).

As noted above, under § 25.2511-1(c), if the interest to be disclaimed was created before January 1, 1977, the disclaimant must disclaim the interest in the property within a reasonable time after knowledge of the existence of the transfer that created the interest to be disclaimed. In the case of a disclaimer of an interest in trust, in general, the transfer occurs when the trust is established rather than when the interest actually vests in the disclaimant, if the transferor has not reserved any power over the trust. See Jewett v. Commissioner, 455 U.S. 305 (1982). However, the time limitation for making the disclaimer does not begin to run until the disclaimant has attained the age of majority and is no longer under a legal disability to disclaim. Jewitt at 318. See also § 2518(b)(2)(B) and § 25.2518-2(c)(1)(ii).

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§2652: Other definitions; Special Election For Qualified Terminable Interest Property

LTR 201447014 (Aug. 7, 2014): IRS Allows Marital Trust to Be Treated As Two Separate TrustsDecedent and Spouse established Family Trust. Decedent died, survived by Spouse, three children, and two grandchildren. Thereafter, one of the children died, leaving two issue surviving and three great-grandchildren were born.

Family Trust provided that on Decedent's death, Family Trust was divided into three trusts, Survivor's Trust, Marital Trust, and Bypass Trust. Survivor's Trust contains Spouse's separate property and Spouse's share of the community property. Of the remaining property, the amount of Decedent's unused applicable exclusion amount was placed in the Bypass Trust and the rest was placed in the Marital Trust. Within nine months of Date Decedent’s death, Spouse executed a qualified disclaimer and disclaimed her interest in the Bypass Trust. Spouse is still alive.

Family Trust provides that after the death of Decedent, the trustee is to pay to Spouse the entire net income of Marital Trust in quarterly or other convenient installments but in no event less often than annually. The trustee is to also distribute to Spouse such amounts from the principal of Marital Trust as the trustee, in its discretion, deems necessary or advisable to provide for Spouse's maintenance and support. Upon Spouse's death, the assets of Marital Trust are distributable, in part, to trusts for the grandchildren and, in part, to trusts that benefit the children and/or the issue of a deceased child.

Spouse, in her role as executor of Decedent's estate, hired Attorney to prepare Form 706, Attorney elected to treat Marital Trust as qualified terminable interest property (QTIP) so that Marital Trust qualified for the marital deduction under § 2056(b)(7). In addition, Attorney made a special election under § 2652(a)(3) to treat the assets of Marital Trust, for generation-skipping transfer (GST) tax purposes, as if the election under § 2056(b)(7) had not been made (a "reverse" QTIP election). Attorney allocated a portion of Decedent's GST exemption to Bypass Trust, but did not allocate Decedent's remaining GST exemption. For GST tax purposes, Decedent was considered the transferor for the entire Marital Trust. Therefore the Decedent’s remaining GST exemption was automatically allocated to Marital Trust by operation of § 2632(e). Spouse timely filed the return (with extensions) prior to December 27, 1995.

Subsequent to the filing of Decedent's Form 706, § 26.2652-2(c) was issued. This regulation provides a transitional rule that allows certain trusts subject to a "reverse" QTIP election, to which GST exemption had been allocated, to be treated as two separate trusts, so that only a portion of the trust would be treated as subject to the "reverse" QTIP election, and that portion would be treated as having a zero inclusion ratio. The deadline for making the election set forth in the transitional rule was June 24, 1996.

In Year, Spouse resigned as trustee of Family Trust and all subtrusts created thereunder, including Marital Trust. During Spouse's term as trustee, Attorney never advised Spouse of the election under § 26.2652-2(c). Upon the appointment of New Trustee, New Trustee obtained advice from a law firm regarding administration of Marital Trust and New Trustee became aware of the election under § 26.2652-2(c).

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Relief was sough under Section 301.9100-3. Section 301.9100-3 (a) provides, in part, that requests for relief subject to § 301.9100-3 will be granted when the taxpayer provides the evidence to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the government.

Section 301.9100-3(b)(1)(v) provides that a taxpayer is deemed to have acted reasonably and in good faith if the taxpayer reasonably relied on a qualified tax professional, including a tax professional employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make, the election.

The IRS determined that the requirements of § 301.9100-3 were met. Accordingly an extension of time to make the election under § 26.2652-2(c) to treat Marital Trust as two separate trusts, one of which has a zero inclusion ratio by reason of Decedent's GST exemption that was automatically allocated to Marital Trust, was granted. The "reverse" QTIP election will be treated as applying only to the trust with the zero inclusion ratio.

§ 2702: Special valuation rules in case of transfers of interests in trusts – Exception for Grantor Retained Annuity Trust

LTR 201442042 (Jun. 18, 2014): Trust modification to correct scrivener’s error retroactively approved by IRSAn individual created two grantor retained annuity trusts. GRAT 1 paid annuity payments to the grantor for four years; GRAT 2 was similar, but paid for 15 years. Upon each GRAT’s final annuity payment, the trust terminated and distributed all remaining property to a trust for the benefit of the grantor’s children and their descendants (“Childrens’ Trust”). But the Childrens’ Trust was revocable by the grantor, thus disqualifying the GRAT.

The grantor’s gift tax return preparer, an accountant, noticed the defect and questioned it. But, according to the statement of facts in the private letter ruling, the drafting attorney (“Attorney 1”) “insisted that his drafting of Children's Trust was proper and noted that Accountant, not being an attorney, did not understand the State law governing the trust.” The accountant prepared notes for his file and prepared the gift tax return according to the attorney’s advice.

Several years later, the grantor began working with a financial planner who reviewed the documents and also raised concerns about whether the GRATs qualified. Upon review by second attorney (“Attorney 2”), it was determined that, for the GRATs to qualify as such, the grantor should not have retained a power to revoke.

The grantor then hired the attorney to reform the trust, effective as of the date when the GRATs were executed (ab initio) to correct a scrivener’s error, as permitted under applicable state law. The court granted the petition, contingent upon favorable private letter rulings from IRS.

The IRS granted the requested rulings on the basis of state law, saying:

It is well settled under State law that the mistake of a scrivener in preparing a deed or other writing may be established by parol evidence, and the instrument reformed

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accordingly. Citation 1. However, the evidence required to reform a written instrument must be clear, precise, convincing, and of the most satisfactory character. Citation 2.

In Year 4, State adopted Uniform Trust Code § 415, which allows the reformation of the terms of a trust to correct mistakes. The statute provides:

The court may reform a trust instrument, even if unambiguous, to conform to the settlor's probable intention if it is proved by clear and convincing evidence that the settlor's intent as expressed in the trust instrument was affected by a mistake of fact or law, whether in expression or inducement. The court may provide that the modification have retroactive effect.

Statute 1. State also enacted Statute 2[,] which provides:

The court may modify a trust instrument in a manner that is not contrary to the settlor's probable intention in order to achieve the settlor's tax objectives. The court may provide that the modification have retroactive effect.

In Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), the [U.S. Supreme] Court considered whether a state trial court's characterization of property rights conclusively binds a federal court or agency in a federal estate tax controversy. The Court concluded that the decision of a state trial court as to an underlying issue of state law should not be controlling when applied to a federal statute. Rather, the highest court of the state is the best authority on the underlying substantive rule of state law to be applied in the federal matter. If there is no decision by that court, then the federal authority must apply what it finds to be state law after giving "proper regard" to the state trial court's determination and to relevant rulings of other courts of the state. In this respect, the federal agency may be said, in effect, to be sitting as a state court.

In this case, affidavits made by the Grantor, Attorney 1, Accountant, Financial Planner, and Attorney 2, together with contemporaneous correspondence, memoranda, and emails provide clear and convincing evidence that the provision in Children's Trust of Grantor's power to revoke Children's Trust does not conform to the Grantor's intention. The correspondence from Attorney 1 indicates that the transfers to GRAT 1 and GRAT 2 were intended to be completed gifts. In reforming Children's Trust, State Court found that there was clear and convincing evidence of scrivener's errors, the reformation of Children's Trust was necessary and appropriate to achieve Grantor's tax objectives, and the reformation was not contrary to Grantor's intentions.

§ 4941: Taxes on Self-Dealing

LTR 201445017 (Aug. 14, 2014): Redemption of Decedent's Interest in Family Corporation Is Not Self-DealingThis ruling involved a highly complex family structure of partnerships, corporations, trusts and a family foundation and the use of promissory notes during the settlement of an estate. It provides a roadmap to the avoidance of self-dealing with a private foundation in the

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settlement of estates and trusts in such an environment. (This private letter ruling request was submitted prior to the IRS announcing a no-rule position with regard to self-dealing issues involving the issuance of a promissory note by a disqualified person during the administration of an estate or trust.)

See also PLR 201446024 (Aug. 21, 2014), where the IRS ruled that distributions of LLC units from an estate to a private foundation were not self-dealing and that the Foundation's ownership of non-voting units in LLC will not constitute a violation of the prohibition against ownership of excess business holdings under § 4943.

§6324: Special Liens For Estate And Gift Taxes

United States v. Elaine T. Marshall et al., No. 12-20804 (Nov. 10, 2014): Fifth Circuit Affirms Gift Tax Donee LiabilityIn 1995, J. Howard Marshall, II (“J. Howard”) sold his stock in Marshall Petroleum, Inc. (“MPI”) back to the company. Because he sold the stock back for a price below its fair market value, this sale increased the value of the stock of the remaining stockholders. At the time of the sale, there were five other individuals and trusts that held MPI stock, including E. Pierce Marshall, Elaine Marshall, the Preston Marshall Trust, and the E. Pierce Marshall, Jr. Trust. The fifth stockholder of MPI stock at the time was a Grantor Retained Income Trust ("GRIT"), which paid income to Eleanor Pierce (Marshall) Stevens (“Stevens”), J. Howard’s ex-wife. The GRIT was designed to pay income to Stevens for ten years and then terminate, with E. Pierce as the remainder beneficiary.

The IRS audited J. Howard's 1992 through 1995 gift taxes. The IRS determined that J. Howard had made an indirect gift to the MPI shareholders when he sold his stock back for below market value and sent notice of deficiency. J. Howard's Estate challenged the deficiencies. After years of back-and-forth negotiation, in 2002 J. Howard's Estate and the IRS entered into a stipulation ("the Stipulation") regarding J. Howard's Estate's tax liability. The Stipulation provided that, in 1995, J. Howard made indirect gifts to the following people in the following amounts: (1) E. Pierce -- $43,768,091, (2) Stevens -- $35,939,316, (3) Elaine -- $1,104,165, (4) the Preston Trust -- $1,104,165, and (5) the E. Pierce Jr. Trust -- $1,104,165. In 2008, the United States Tax Court issued decisions finding deficiencies in J. Howard's 1995 gift taxes.

J. Howard’s estate never paid the assessed taxes. In 2008, the IRS assessed gift tax liability for the unpaid donor gift tax against the donees pursuant to I.R.C. § 6324(b). In May and June 2010, E. Pierce's Estate paid the IRS an amount equal to the value of the gift received for E. Pierce, Elaine, the E. Pierce Jr. Trust, and the Preston Trust.

Stevens died in 2007. E. Pierce Jr. became the executor of her estate, and Hilliard was the trustee for the Living Trust. E. Pierce Jr. and Finley L. Hilliard were both aware that Stevens's Estate and the Living Trust could be held liable for the unpaid gift tax. E. Pierce Jr. distributed the personal property of the Estate. Hilliard paid legal and accounting expenses for several charities and set aside $1.1 million for charity. Stevens’ Estate has paid nothing for Stevens’ share of the gift tax liabilities.

The Government filed a motion for partial summary judgment for donee liability against Elaine in her individual capacity, as executrix of E. Pierce's Estate, as trustee of the Preston

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Trust, and as trustee of the E. Pierce Jr. Trust. The Government argued that it could "charge interest pursuant to I.R.C. §§ 6601 and 6621 on the unpaid donee liability created by § 6324(b)." The Government claimed that there were two separate obligations: the obligation of the donor and the obligation of the donee. Section 6324(b), according to the Government, only limited the obligation of the donor, and so the donee's liability for the unpaid gift tax was not capped under § 6324(b). Elaine filed a cross-motion for summary judgment, arguing that the plain language of § 6324(b) capped all donee liability at the value of the gift received, and so the donees could not incur unlimited interest on any separate donee liability.

The district court agreed with the Government and found that (1) the donees had an independent liability under § 6324(b) that was not capped at the value of the gift and (2) this independent liability was subject to interest under § 6601.

Finally, the Government moved for summary judgment against E. Pierce Jr. and Hilliard for violations of 31 U.S.C. § 3713, the Federal Priority Statute, and against E. Pierce Jr. for breach of state law fiduciary duties. The court granted the motion and found E. Pierce Jr. and Hilliard (1) individually liable for money they had distributed from Stevens's Estate and the Living Trust, respectively, in violation of 31 U.S.C. § 3713 and (2) jointly liable for money they set aside for charitable purposes in violation of the government's priority under § 3713.

The Fifth Circuit affirmed all of the district court’s rulings, with one exception. The ruling that E. Pierce Jr. had breached state law fiduciary duties was reversed, finding that under Texas law he did not have a fiduciary duty to the Estate’s creditors.

§ 6662: Accuracy Related Penalty

AD Investment 2000 Fund LLC et al. v. Commissioner, 142 T.C. No. 13, Nos. 9177-08, 9178-08 (Apr. 16, 2014): Attorney-Client Privilege Lost Because Reasonable Cause Defense to Penalty InvokedSo-called son of BOSS partnership tax-shelter transactions were reported on partnership income tax returns of two LLC partners in 2000. A law firm had provided an opinion letter saying it was more likely than not that the taxpayer would prevail if challenged. When the IRS asserted accuracy-related penalties due to substantial understatement of income tax, gross misevaluation understatement and negligence or disregard of rules and regulations, the taxpayers claimed the defense that “[a]ny underpayment of tax was due to reasonable cause and with respect to which the Partnership and its partners acted in good faith.”

The IRS sought production of the legal opinion. The taxpayers refused to comply on the grounds of attorney-client privilege. But the IRS said the privilege was waived under the common law doctrine of implied waiver of the attorney-client privilege when the client places otherwise privileged matters in controversy. The IRS argued the opinions were placed into controversy by relying on affirmative defenses to the penalties that turn on the partnerships' beliefs or state of mind.

The Court found irrelevant assertions by the taxpayers that they chose not to rely on the legal opinion when preparing their income tax returns. Because the state of mind of the taxpayers was central to the defenses they asserted, the Court found that, “by placing the

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partnerships' legal knowledge and understanding into issue in an attempt to establish the partnerships' reasonable legal beliefs in good faith arrived at (a good-faith and state-of-mind defense), petitioners forfeit the partnerships' privilege protecting attorney-client communications relevant to the content and the formation of their legal knowledge, understanding, and beliefs.”

Production of the legal opinion was ordered by the Court.

§ 6651: Failure to file tax return or to pay tax

Estate of Liftin v. U.S., Fed. Cir. (Jun. 11, 2014), aff’g No. 10-589, Fed. Cl. (2013): Penalty on failing to file estate tax return upheld, despite timely payment of the estate taxIRC § 6651(a) generally imposes a penalty on filing an estate tax return after its due date, including extensions of time to file. But the penalty won’t apply if reasonable cause is shown. The penalty is five percent per month, up to a maximum of 25 percent.

Delay of filing a decedent’s estate tax return led to imposition of penalties because reasonable cause could not be shown continuously through the date when the return was finally filed.

Reasonable cause was found to exist for a time period beginning with the return’s extended due date. The executor’s attorney advised that the return could be filed late because the estate tax marital deduction depended on grant of U.S. citizenship to the decedent’s surviving spouse and because of a financial dispute with the decedent’s former spouse. But after the surviving spouse was granted citizenship and also after the dispute was settled with the former spouse, the attorney’s further advice that filing the return could be filed even later did not constitute reasonable cause. The Federal Circuit Court of Appeals upheld the maximum 25 percent penalty and determined the amount of the penalty.

The facts of the case reveal that the estate tax was paid in full by the extended due date of the return, which was the same date as the extended due date for paying the tax. The Majority opinion states:

… there was no issue regarding timeliness of payment. In January 2004 -- which was before the extended June 2004 payment and filing deadline, but after the original, un-extended December 2003 filing deadline -- the executor had made an estimated payment to the IRS of $877,300, an amount sufficient to cover the taxes due even if the estate could not claim the marital deduction. … [T]he executor timely sought a six-month extension both to file and to pay, and the IRS granted the extension … .

Unfortunately, according to dissenting Circuit Judge Newman, the majority failed to read further than Code section 6651(a)(1). Had the majority read further, according to the dissenting judge, the penalty’s amount would have been zero. That’s because the late filing penalty is a percentage of the amount of tax due net of timely-paid estimated tax payments. IRC § 6651(b)(1) provides:

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For purposes of subsection (a)(1), the amount of tax required to be shown on the return shall be reduced by the amount of any part of the tax which is paid on or before the date prescribed for payment of the tax and by the amount of any credit against the tax which may be claimed on the return.

COMMENT: the amount of the penalty appears to turn on whether the tax was “paid on or before the date prescribed for payment of the tax”. Here, the time for payment had been extended and the payment made within the extended due date for payment. IRC § 6161 provides that the “Secretary may, for reasonable cause, extend the time for payment of” the estate tax.

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Michael J. Jones, CPA

Mike is a partner of Thompson Jones LLP. His tax consulting practice focuses on sophisticated wealth transfer strategy, trust and probate matters (both administration and controversy resolution), and family business transitions. He is a noted authority on estate planning for IRA and retirement plan benefits, and chairs Trusts & Estates magazine’s Retirement Benefits Committee.

Mike is the author of Inheriting an IRA (available through www.inheritinganira.com); Guide to Electing Out of the 2010 Estate Tax (And Into Modified Carryover Basis); and Final Regulations Governing Minimum Required Distributions, a Special Supplement to the Pension Answer Book. He has written over 100 articles appearing in Trusts & Estates, Leimberg Information Services, Inc., Estate Planning, Tax Notes, CCH Federal Tax Weekly, California Trusts and Estates Quarterly, Ed Slott’s IRA Newsletter, and others. He has been quoted in Natalie Choate’s Life and Death Planning for Retirement Benefits, Keith Schiller’s Estate Planning at the Movies, Art of the Estate Tax Return, New York Times, Forbes Magazine, The Wall Street Journal, Bloomberg Financial Report and others.

Mike has served as adjunct faculty at Santa Clara University School of Law and University of St. Thomas Center for Family Enterprise. He has been a featured lecturer at: Jerry A. Kasner Estate Planning Symposium, Santa Clara University; Southern California Tax & Estate Planning Forum, AICPA Advanced Estate Planning Conference; Hawaii Tax Institute; AICPA Conference on Tax Strategies for the High-Income Individual; CEB Estate Planning and Administration Annual Updates, UCLA-CEB Estate Planning Institute; The Federal Institute on Taxation, NYU; NYU Family Wealth Institute (co-founder and co-Chair with Thompson Jones LLP’s DeeAnn L. Thompson); The Summer Institute In Taxation, Introduction to Estates and Trusts, NYU (Chair); Notre Dame Institute on Estate Planning, and many others. He has been a course developer and lecturer for California CPA Education Foundation.

Mike is an avid prone paddleboarder and surfer. He has completed the 32-mile Catalina Classic paddleboard race to Manhattan Beach. His (mostly) paddleboarding blog is located at: www.mikejones-whatsup.blogspot.com/

CITE AS: 

LISI Estate Planning Newsletter #2267 (January 6, 2015) at http://www.leimbergservices.com  Copyright 2015 Michael J. Jones and DeeAnn L. Thompson. All rights reserved in all media. Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission. 

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