Tax, Trusts & Estates Law Monitor : Estate Planning Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Gift Tax & Trust Issues

Sometimes a client owns life insurance and borrows against the policy in order to pay premiums.  After many years of this, it is not unusual for the loans against the policy to exceed the owner’s basis in the policy.  If the policy is then terminated (ie, the client surrenders the policy or just stops paying the premiums), the client often is surprised to learn that the termination triggers income tax on the difference between the amount of the outstanding loan and the basis in the policy.
 
The seminal case on this issue is Atwood v Comm’r (TC Memo 1999-61).  In Atwood, the Tax Court found that when the policy is disposed of (surrender, lapse or life settlement), the relief of the outstanding liability is tantamount to a cash distribution and is therefore taxable to the extent it exceeds basis. 

In a recent appellate level decision, the 10th Circuit affirmed a Tax Court decision on the same issue.  McGowen v Comm’r, 108 AFTR 2d 2011-6063 (10th Cir 2011), aff’g TC Memo 2009-285.  In this case, the taxpayer purchased a single premium life insurance policy in 1986.  By 2004, the loan on the policy exceeded its cash value.  The insurance company notified the taxpayer that she needed to make a minimum payment on the loan in order to keep the policy in force.  The taxpayer failed to make any payment, and the insurance company cancelled the policy and sent a 1099 reflecting over $500,000 of taxable income.  The taxpayer claimed that the income was cancellation of indebtedness (“COD”) income and excludible because she was insolvent at the time.  But the Tax Court disagreed, finding that the debt was not discharged but rather was repaid in effect by transferring an appreciated asset (the built-up cash value of the policy).  The 10th Circuit affirmed, finding that the taxpayer was not insolvent at the time the policy was terminated.

These cases usually involve inadvertent terminations of the life insurance policy, and this was the case in McGowen where the taxpayer likely ignored the insurance company’s notices about the consequences of a policy termination.  If a client is aware of this issue, there may be viable alternatives to prevent such an adverse result, such as keeping the policy in force until death but significantly reducing the death benefit so that the premiums are significantly reduced. 

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One of the most basic reasons to have a Will is to name an executor.  The executor gathers and manages assets, administers the estate, pays bills, pays taxes, and ultimately distributes the estate assets to the decedent’s beneficiaries.  The “paying taxes” part of the job can be difficult.  People don’t like to pay taxes.  Also, if there are substantial non-probate assets, or different beneficiaries sharing disproportionately in the estate, the allocation of taxes among the beneficiaries can be a very significant issue.  The executor also is responsible for dealing with tax authorities, not always a desirable job.

These types of issues came to a head in the recent Tax Court case of Gudie v Comm’r.  Decedent, a California resident, held her assets in a living trust (ie, non-probate asset) with her two nieces as successor co-trustees.  During her lifetime, decedent entered into an unusual private annuity transaction, selling her assets to her nieces in exchange for their promise to pay her an annuity.  Although no payments related to the transaction ever were made, decedent’s estate tax return reported that the decedent’s $8 million liability from the private annuity transaction exceeded the decedent’s $7 million in assets, so no estate tax was due.  Perhaps not surprisingly, the IRS challenged this position, and sent a deficiency notice to one of the nieces.

The niece raised the “wrong taxpayer” defense, arguing that, even though she had signed the estate tax return, she was only a co-trustee and had never been formally appointed as the executor of the decedent’s probate estate, so she was not the proper party to be notified of the deficiency.  Again unsurprisingly, the Tax Court rejected this argument, and denied the niece’s motion to dismiss the case.  The court found that the niece was a “statutory executor” under the tax rules and was the proper person to receive the deficiency notice. 

This case highlights some of the risks faced by fiduciaries of trusts or estates.  The successor trustee in this case attempted a weak argument to try to avoid the alleged tax deficiency, and lost.  The estate administration process is often complicated and needs to be attended to carefully.

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As estate planning attorneys, it is not uncommon for us to be confronted with clients who, for whatever reason, make the decision to disinherit a family member.  While a spouse is not legally permitted to completely disinherit a surviving spouse due to elective share statutes, there is no legal restriction from disinheriting children.

Here is a link to an article in last week’s New York Times, which discusses disinheritance from a child’s point of view.  We thought it was interesting and worthwhile to share.

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On October 20, 2011, the IRS released Revenue Procedure 2011-52, which announced inflation adjustments to the applicable exclusion amount beginning in 2012. For an estate of any decedent dying during calendar year 2012, the applicable exclusion is increased from $5 million to $5.12 million.  This change increases not only the applicable exclusion amount available at death, but also a taxpayer’s lifetime gift applicable exclusion amount and generation skipping transfer exclusion amount.

The $13,000 gift annual exclusion has not been increased.

Note that the present tax law provides that if there is no change in the law prior to December 31, 2012, the applicable exclusion will be reduced to $1 million, subject to inflationary adjustment.  Due to this potential decrease in the lifetime gift exclusion, now is the time to seriously consider gifting options before they are limited.

Other items of note that also are subject to inflationary adjustment in 2012 include the social security wage base, which increases from $106,800 in 2011 to $110,100 in 2012, and the maximum amount that can be deferred into a 401(k) from $16,500 to $17,00

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This post should provide fodder for all the tax reformers out there who want to simplify the tax code.  Employers, employees take note:  the IRS has simplified the recordkeeping requirements for employer-provided cell phones!  Uh, sort of.

Let us explain:  the Internal Revenue Code defines gross income as all income from whatever source derived.  Gross income of course includes things like compensation for services, but it also includes fringe benefits received by employees from their employers, such as car services, nonqualified moving expenses, etc.

There are exceptions to the fringe benefit rule.  For example, Code §132(a)(3) provides that gross income does not include any fringe benefit which qualifies as a “working condition fringe,” that is, a work-related benefit that would be deductible if the employee had to pay for it.  Code §132(a)(4) provides that gross income does not include any fringe benefit which qualifies as a “de minimis fringe,” that is, property or a service so small as to make accounting for it unreasonable or administratively impracticable.  There are substantiation requirements for these fringe benefits.  In addition, there are “heightened substantiation rules” for property specifically listed by Congress because it is subject to “abuse.” 

Prior to the Small Business Jobs Act of 2010 (the “Act”), employer-provided cell phones were listed property and subject to the aforementioned heightened substantiation rules.  But the Act, among other things, removed employer-provided cell phones from the heightened substantiation list. 

The IRS has now come out with its own guidance, clarifying its position on whether employer-provided cell phones are taxable fringe benefits.  The IRS takes the following position:  although an employee’s use of an employer-provided cell phone is a fringe benefit and generally includible in income, if the employee’s use of the phone is for business purposes such that it would be deductible by the employer, then the business use of the cell phone qualifies as a working condition fringe and is excludible from the employee’s income.  Furthermore, if an employer provides a cell phone to an employee for business reasons (the “business reason cell phone”), then the employee’s use of the cell phone for personal calls is a de minimis fringe and also is excludible from income.  Notice 2011-72.  Employers no longer have to record which of the employees’ calls are business and which are personal.  Employees no longer have to report the cost of those personal calls (paid by the employer) as income. 

On the other hand, if the employer provides the cell phone to the employee only to promote morale or goodwill (the “non-business reason cell phone”), then the value of the phone and service is a taxable fringe benefit. 

So, are the rules simplified, still overly complex, or both?  Is the IRS’ position on employer-provided cell phones sound tax policy that gets to the core principle of taxing income in any form, or does it represent everything that is wrong with America today (is this really what Congress does)?  We leave these questions for our readers to answer.

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The New York Department of Taxation and Finance recently announced that it will follow the IRS and eliminate the two year time limit for innocent spouse equitable relief claims. 

For federal tax law purposes, a taxpayer can request innocent spouse relief by any of three methods:  (1) making a timely election within two years from the date the IRS has begun collection activities (and meeting other requirements), (2) electing to allocate a tax deficiency in proportion to each spouse’s contribution to the deficiency, or (3) by petitioning the IRS for “equitable relief” when relief is not available under the first two alternatives if it would be inequitable under the circumstances to hold the spouse liable. 

Pursuant to 2002 regulations, an innocent spouse equitable relief claim (the third method above) had to be made within two years of the date that the IRS began collection activities.  But in July, 2011, the IRS repealed this requirement.  Notice 2011-70. 

New York has similar innocent spouse rules.  New York Tax Law §654.  On September 27, 2011, New York announced that it will follow the IRS’ lead and also will eliminate the two year time limit on innocent spouse equitable relief claims.  TSB-M-11(11)I.  This change may apply to pending and past innocent spouse claims as well.

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Estate planners frequently prepare both life insurance trusts and family limited partnerships.  These planning tools are similar in that the client has ongoing administrative and management jobs after the legal work has been completed.  With life insurance trusts, clients typically have to manage a new bank account for the trust, prepare and send proper Crummey notices, keep trust records, etc.  With family limited partnerships, clients have to make investment and distribution decisions, and manage the partnership as a legitimate business.  Lawyers always are concerned about whether a client will properly administer the planning after the legal work has been completed.

In Estate of Turner, a recent Tax Court case (TC Memo 2011-209), the IRS asserted two arguments – (1) that the decedent had not managed his family limited partnership as a legitimate business, and therefore all of the partnership assets were includible in his estate under Code §2036, and (2) that the decedent’s faulty annual exclusion gifts to his insurance trust failed to qualify for the $13,000 per person per year annual exclusion. 

The court found for the IRS on the Code §2036 claim, finding that there was no bargaining among the family members in creating the family partnership, that the decedent commingled personal and partnership funds when he used partnership funds to make gifts, pay premiums on life insurance policies and pay legal fees, that the partnership was not funded for at least eight months following the formation of the entity, and that the decedent treated the partnership as his own at-will investment account. 

However, the court found for the estate on the issue of annual exclusion gifts.  Even though the decedent had paid the insurance premiums from his own funds rather than gifting funds to the trust (which the trustee could then use to pay premiums), and even though no Crummey notices had been sent to the trust beneficiaries, the court found that the premium payments were indirect gifts that qualified as “present interest” gifts for purposes of the annual gift tax exclusion. 

Clients who have struggled to follow the administrative requirements of an insurance trust to the letter (and their advisors who have explained it to them) can take heart from the second part of the Tax Court’s opinion in this case.  Like the Crummey and Cristofani cases before it, Turner represents another taxpayer victory on the issue of present interest gifts to insurance trusts.
 

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On September 21, 2011 the IRS announced a new program to permit taxpayers to voluntarily reclassify workers as employees rather than independent contractors for employment tax purposes with minimal tax consequences for prior years.  The new program is called the Voluntary Classification Settlement Program (“VCSP”) and permits employers to make the change with minimal federal tax consequences.  To be eligible, an applicant must meet the following criteria:

• Consistently have treated the workers in the past as non-employees.
• Have filed all required Forms 1099 for the workers for the previous 3 years.
• Not currently be under audit or investigation by the IRS, the Department of Labor or any State agency concerning the classification of these workers.

In exchange for prospectively treating the workers as employees for future tax periods, the taxpayer will only have to pay an amount equal to 10% of the employment taxes that may have been due related to compensation paid to the workers for the most recent tax year.  This typically equals just over 1% of compensation. No interest or penalties will be due on the liability and the taxpayer will not be subject to an employment tax audit with respect to the worker classification issue for prior years.  Taxpayers participating in the VCSP must agree to extend the period of limitations on assessment of employment taxes for 3 years for the first, second and third calendar years beginning after the date on which the taxpayer has agreed to begin treating the workers as employees. 

Before participating in the program other issues need to be considered including, without limitation employee benefits, retirement plans, wage and hour and state tax considerations.

You should consult a qualified professional with respect to these issues.
 

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The IRS recently released the Applicable Federal Rate, or “AFR,” for October, 2011.  The AFR is a key interest rate used in connection with a number of the more sophisticated estate planning techniques, such as grantor retained annuity trusts (“GRATs”), sales to intentionally defective grantor trusts, and qualified personal residence interest trusts (“QPRITs”).

The mid-term AFR for October is 1.4%, which is historically low.  This means that GRATs, sales to grantor trusts, and intra-family loans are even more attractive in October because the amount that is required to be paid back to the donor under these techniques is relatively lower due to the extremely low interest rate. 

On the other hand, techniques in which the value of the gift is dependent upon the value of the income interest retained by the grantor, such as QPRITs or charitable remainder annuity trusts (“CRATs”), are not as attractive.  For these techniques, the low interest rate leads to a lower value for the retained interest and a higher value for the remainder interest, thereby resulting in a larger taxable gift when the technique is implemented.

With the increased lifetime gift exclusion ($5 million in 2011 and 2012) and the possibility that the use of GRATs may be restricted in the future, now may be the time to explore some of the estate planning approaches that have been enhanced by historically low interest rates.

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