Tax Strategies, 2003
The Rules of Engagement are Changing
by Robert L. Moshman
he IRS is doing fewer and fewer audits of tax returns.1 Two tax professors recently argued that as many as 43,000 estate tax returns are already irrelevant, such as returns filed where there is no estate tax due to the marital deduction.2 And the estate tax is already on borrowed time. In fact, efforts to make the repeal of the estate tax permanent have the President's support.3
Connecting the dots, it might be reasonable to assume that the IRS would not want to devote much of its limited manpower to a pile of "irrelevant" estate tax returns reporting zero taxes owed for a tax that will soon be history. So is the IRS backing off? Has the IRS been tamed by taxpayer protections and crippled by its limited resources?
Not a chance. The IRS hasn't conceded any issue; the field of battle has simply shifted. To counter the many taxpayer protections that it finds troublesome, the IRS has brought back a horror that taxpayers thought had finally been laid to rest, the dreaded random tax audit. The Service is also contemplating the use of collection agencies — apparently hoping that if collection efforts are farmed out to contractors who can work with fewer restrictions, the taxpayers will be more likely to pay up.4
Proposed Regulations
On four separate occasions during 2002, the IRS proposed regulations which reflect recent laws to protect taxpayers.5 These releases included the following developments:6
Individuals will be able to sue the United States for a wrongful tax levy that results from reckless, intentional, or negligent disregard of the IRS Code by IRS personnel.
A prevailing party may be awarded reasonable administrative costs in an administrative proceeding brought in connection with the collection of any tax.
Proposed Reg. §301.6331-4 prevents a tax levy while a taxpayer's proposal of a compromise or an installment agreement is pending with the IRS, for 30 days after a rejection of such a proposal, while an installment agreement is in effect, or 30 days after termination of an installment agreement by the IRS. No levy could be made during legal appeals of a rejection or termination decision. A levy could only apply if (1) the taxpayer waives the restriction on levy in writing; (2) the IRS determines that the proposed installment agreement was submitted solely to delay collection; or (3) the IRS determines that the collection of the tax is in jeopardy.
Proposed criteria for compromising tax liabilities: (1) doubt as to liability; (2) doubt as to collectibility; (3) economic hardship of the taxpayer; or (4) compelling public policy or equity considerations. The proposed regs define terms such as "economic hardship."
One proposal would impose a $150 fee for processing offers to compromise tax liabilities. This fee would not apply to offers based on doubt as to liability, offers made by certain low income taxpayers, offers accepted to promote effective tax administration, and offers accepted based on doubt as to collectibility
Hanging Tough
In fact, the IRS has been steadfast and even aggressive on many fronts over the past year. Thus, you have the IRS raining on the parade of FLP victories by successfully amending its complaint in Strangi getting a second chance. The IRS also took a hard stand in Sheppard where the FLP was funded before the decedent's heirs signed the partnership agreement.7 Here are several recent examples of the IRS in action.
The Lottery: Husband died soon after winning $35.3 million in the Texas lottery. Since annual of payments of $1,768,000 would be paid in the future, the estate wanted to pay the estate tax in installments over ten years due to the estate's limited liquid assets. The Tax Court found that the IRS denial of this request was not an abuse of discretion. The estate could easily have borrowed against the future lottery payments that were anticipated.8
Adjustment Clause: A partnership sales agreement contained an adjustment clause that governed how much of the partnership would be sold. But the IRS found this to be an invalid "savings clause" that was merely intended to discourage the IRS from challenging the transaction.9
Spousal Consistency: Despite "innocent spouse" protections, the IRS invoked the "duty of consistency" doctrine for spouses. A taxpayer may not take inconsistent positions and a husband and wife, having a privity relationship, may not take inconsistent positions from each other.10
Case History: O'Neal
Here is a case that epitomizes the determination of the IRS. Seven years before she died, Elizabeth O'Neal (and her husband) gave shares of a closely held corporation to their children. Although the IRS was time barred from imposing gift or generation skipping transfer taxes on Mrs. O'Neal's estate, it assessed a deficiency of $9.4 million against the donees of the stock. An Alabama Probate Court ordered the estate to reimburse the donees.
The 11th Circuit Court of Appeals ruled that the donees' claim against the estate was to be valued as of the date of death without regard to post-death events. Upon remand, it was determined that a $5.3 million claim against the estate could be enforceable, so the estate was entitled to an estate tax deduction of $5.3 million.
Attorney Fees: The IRS was found to have been substantially unjustified in pursuing the action from the time it was remanded. Attorney fees of $250 per hour were permitted in this case because there were complex and novel issues involved and those were the prevailing rates in the community for the level of assistance required.11
The Battle Continues
The IRS may find the estate tax battleground disappearing beneath its feet, but it is clear the IRS will continue fighting every issue in every case. It is safe to say the IRS must never be taken for granted.
Recent Decisions
COLAs Confirmed: In Revenue Procedure 2002-70, the IRS has confirmed the cost-of-living adjustments projected by experts and publishers last fall but with one correction regarding gifts to noncitizen spouses. Here is the correct noncitizen spouse figure along with other key COLA figures for 2003 affecting trusts and estates:
Gifts to Noncitizen Spouses-§§2503, 2523(i)(2): The amount of gifts to a noncitizen spouse which are not included in the donor's annual amount of taxable gifts rises from $110, 000 in 2002 to $112,000 in 2003 (not $120,000 as estimated by a leading publisher).
Installment Payments, Estate Tax Interest-§6166: The dollar amount used for calculating interest under §6601(j) regarding the two-percent portion of the estate tax payable in installments rises from $1,100,000 to $1,120,000.
Annual gift tax exemption -§2503(b): Remains at $11,000.
Generation-Skipping Tax Exemption-§2631: Up from $1,100,000 to $1,120,000.
Special Use Valuation-§2032A: Up from $820,000 in 2002 to $840,000.
Attorneys Fees-§7430: Awards remain capped at $150 per hour.
Expatriation Presumptions: Tax avoidance is presumed for expatriates with average annual net income tax liability for the five-year period before the loss of citizenship of $122,000 in 2003 (up from $120,000 in 2002); or net worth exceeded $608,000 (up from $599,000 in 2002).
Disclaimer Did Not Trigger Taxable Gift
Donor created a trust in 1955. Upon a designated termination date, the corpus would be distributed to Donor's surviving descendants, per stirpes. Donor's great-granddaughter, B, has received lifetime discretionary payments from the trust. But can B now disclaim her rights as a potential distributee of the trust corpus? Can a remainder interest be disclaimed as a separate interest by someone who is receiving lifetime benefits from the same trust?
Yes, says the IRS in a private letter ruling. A disclaimer of pre-1977 trusts is governed by Reg. §25.2511-1(c)(2). The disclaimer was valid because B executed it within nine months of attaining majority age, did not control the direction of the disclaimed interest, met all state laws, and did not accept benefits of the property interest disclaimed. Letter Ruling 200238039.
The Sale of the Seventh Trust
After Husband's death, the residue of his estate was gathering into a QTIP trust for Wife during her lifetime with the remainder to seven descendants. To avoid disagreements, the QTIP was divided into seven separate trusts. Wife then sold her income interest in the seventh trust to the designated remainder beneficiary. This sale resulted in gift tax consequences for which the trustees agreed to pay. But would the sale also trigger gift tax consequences in the other six trusts? After all, they had been part of one single QTIP trust.
No, responded the IRS in a private letter ruling. The other six trusts continue and no gift tax is triggered. After the seventh trust is terminated, the wife's income interest in the remaining six trusts was not valued at zero under IRC §2702. Income from the sale of the seventh trust was treated as long-term capital gain. Letter Ruling 200230017.
Lawsuit Valued for Estate Tax Purposes
A stroke victim's trusted friends took $1.6 million of her property and had a law firm draft a will. When the stroke victim died, her
beneficiaries discovered the misappropriation and sued the stroke victim's lawyers. The probate court ordered the firm to return $247,500 in fees it had received from the estate. The firm then settled all claims (including the $247,500) for a total of $750,000. But what was the value of the stroke victim's interest in the malpractice claim?
The Court found that the valuation should not include the $247,500 since those were fees incurred by the estate after the decedent's death. The court then reduced the remaining $502,500 by legal costs anticipated in a malpractice action and calculated the present value of the decedent's interest at $130,962. Estate of Glover v. Comm'r., TC Memo. 2002-186, 84 TCM 120 (Aug., 2002). TC Memo. 2002-186, 84 TCM 120 (Aug., 2002).
Change in Title of Stock Is Not Taxable Gift
A divorce decree allocated a portion of closely held shares to Wife. Six years later, the wife brought a lawsuit to require the shares to be titled in her name rather than her ex-husband's. Despite the timing, the re-titling of the stock was part of the divorce decree and was deemed to be for adequate consideration. The wife had received all of the economic benefits of the stock. There were valid business reasons for not re-titling the stock sooner, i.e., maintaining investor confidence. Therefore the re-titling did not result in a gift tax. Letter Ruling 200221021.
Stock Transfers Were Not Taxable Gifts
Intra-family transfers of the bare legal title in family-owned, closely held corporations (car dealerships) did not trigger gift tax. The IRS argued that transfers between Husband, Wife, and three children were subject to gift tax. The Tax Court disagreed because no beneficial interest had been transferred. Husband supplied all the funding, ran daily operations, prepared all corporate documents and was the exclusive agent with third parties. Having complete control, Husband remained the sole beneficial owner of the corporations. Cordes v. Comm'r., TC Memo. 2002-124, 83 TCM 1673 (2002).
TECHNICAL REFERENCES
1 In 1995 the IRS audited 1.7 million returns. This number dropped to 1.1 million in 1999 and then dramatically dropped nearly 50% to 618,000 audits the following year. This decline was only partially attributed to the lack of staff, which is a complaint of long standing. The real reason was the impact of the Taxpayer Bill of Rights 2 (P.L. 104-168) and the IRS Restructuring and Reform Act of 1998 (P.L. 105-206). This legislation requires the cessation of tax collection efforts when an offer of settlement is made.
2 Why file an estate tax return that is irrelevant? Two tax law professors, Jay Soled of Rutgers and Richard Schmalbeck of Duke, say that preparing a 44-page estate tax return can cost as much as $15,000, yet 43,000 of the estate tax returns filed each year serve no purpose. "Congress can eliminate the source of this annoyance easily and at little cost," they say. Schmalbeck and Soled, Many Unhappy Returns: Estate Tax Returns of Married Decedents, 21 Va. Tax Rev. 373 (2002); Schmalbeck and Soled, Unnecessary Estate Tax Returns: Removing the Residue of the Widow's Tax, 94 Tax Notes 235 (Jan.14, 2002).
3 The House supported a permanent repeal resolution by a vote of 242 to 158 on September 19, 2002 but the vote fell six votes short in the Senate on June 12, 2002.
4 Several states have already shifted tax collection efforts to the private sector. At the Federal level, the suggestion is being opposed by unionized IRS staff and criticized as a means of bypassing the taxpayer protections that have been enacted in recent years. The approach taken by the IRS would not involve the entire Federal backlog of over $200 billion of uncollected taxes. Only $50 billion of outstanding taxes would be assigned to collection agents. The IRS is also increasing its own collection efforts. In 2002 it conducted 712,000 audits (up from 618,000). Congress increased the IRS budget from $8.3 billion to $8.9 billion.
5 The Taxpayer Bill of Rights 2 (P.L. 104-168) and the IRS Restructuring and Reform Act of 1998 (P.L. 105-206).
6 Proposed Regulation, NPRM REG-107366-00 (published in the Federal Register on March 5,
7 Estate of Strangi, CA-5, 2002-2; Estate of Shepherd, 115 TC 376, affirmed (CA-11, 2002-1); Moshman, How NOT to FLP, The Estate Analyst (July, 2002); Moshman, An Achilles' Heel for FLPs, The Estate Analyst (Oct., 2001);
8 Estate of Doster v. Comm'r., 83 TCM 1044, TC Memo. 2002-2 (Jan., 2002).
9 Technical Advice Memorandum 200245053 (July, 2002).
10 Technical Advice Memorandum 200244002.
11 The O'Neal estate was entitled to an estate tax deduction based on the restitution claims made by the descendants who had transferee liability. Estate of O'Neal v. United States, US Dist. Ct., 2002-2 (Dec., 2002); Estate of O'Neal v. United States, N.D. Ala., CV-97-J-2189-S. (July, 2002); Estate of O'Neal v. United States, 258 F.3d 1265 (11th Cir. 2001), affirming in part, vacating in part, and remanding; Estate of O'Neal v. U.S., 81 F. Supp. 2d 1205 (N.D. Ala. 1999).
© MMIII.1 R. Moshman
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