Tax Law Update 2010-08-01 (1)Tax Law Update 2010-08-01 (1)

Internal Revenue Service ignores trust amendment designed to create designated beneficiary — Private Letter Ruling 201021038 (May 28, 2010) shows the importance of careful drafting for a trust designated as the beneficiary of a retirement plan. This ruling involved an individual retirement account owned by a surviving spouse. The surviving spouse named a bypass trust created under his wife's revocable trust as the IRA's beneficiary. The bypass trust provided that upon the husband's death, certain specific bequests would be made from the property held in the bypass trust, and the remaining property would be divided between two protective trusts for the benefit of each of the surviving spouse's daughters. The terms of the protective trusts authorized the trustees to distribute income and principal for the daughters' (and their descendants') health, maintenance, support and education. Each daughter had a lifetime and testamentary power of appointment over her trust, both of which included charities as permissible appointees.

The trust agreement included a general savings provision that provided that the settlor intended the trustees to make appropriate elections to defer the payments from retirement plans payable to the trusts and use the minimum distribution rules to structure payments according to the “stretch IRA” rules.

Under Internal Revenue Code Section 401(a)(9)(B), when the owner of an IRA dies after reaching his required beginning date, the payments are calculated using the life expectancy of the deceased IRA owner (the surviving spouse in this case). However, if the IRA has a designated beneficiary, payments from the IRA may be made over the life expectancy of the beneficiary. Therefore, if a designated beneficiary is younger than the IRA owner, the payments will be made over a longer period of time.

However, Treasury Regulations Section 1.401(a)(9)-4 provides that only individuals who are beneficiaries as of the date of death may be designated beneficiaries. In addition, designated beneficiaries must be individuals, which means that trusts aren't designated beneficiaries. However, one can “look through” a trust and consider its beneficiaries as designated beneficiaries if the trust is valid and irrevocable, the beneficiaries are identifiable and the proper documentation has been provided to the plan administrator.

To stretch out the IRA distributions, all of the beneficiaries (including contingent beneficiaries and remaindermen) must be individuals, and the oldest beneficiary's life expectancy is used for the payment schedule. However, if the trust requires that all IRA distributions be currently paid out to the beneficiaries (a conduit trust), then only those beneficiaries are considered for this purpose; remaindermen and objects of powers of appointment aren't considered beneficiaries. In this case, the trust wasn't a conduit trust because it allowed the trustee to receive distributions from the IRA and accumulate them in the trust. Any accumulated distributions would be subject to the daughters' powers of appointment, which were exercisable in favor of charities. Therefore, since IRA distributions to the trust could ultimately be appointed to non-individuals, the IRA didn't have designated beneficiaries.

Because of this problem, after the surviving spouse died, the two daughters obtained a local court order to amend the trust. The amendment was clearly intended to provide the IRA with a designated beneficiary: It required the trustees to pay out all amounts received from the IRA to the beneficiaries and removed charities as potential appointees.

The IRS, however, ruled that it wouldn't respect the post-death court-ordered amendment for tax purposes. Citing a recent Tax Court case, the IRS explained that while it will look to local law to determine the nature of interests in a trust, it will not give effect to a local court order that modifies the dispositive provisions of a trust agreement after the IRS has the right to tax revenues from the trust property.

Because the amendment was ineffective for tax purposes, charities, as non-individuals, were considered beneficiaries of the IRA due to the potential for accumulation of plan distributions and the powers of appointment. Accordingly, the IRS ruled that the plan didn't have a designated beneficiary. Without a designated beneficiary, the distributions from the plan would be calculated using the surviving spouse's life expectancy based on his age at death.

Strict privity requirement relaxed in New York: Personal representative of estate may sue estate-planning attorney for negligence — In Estate of Schneider v. Finmann, 2010 NY Slip Op. 05281 (June 17, 2010), the Court of Appeals of New York relaxed its doctrine of strict privity, which holds that neither an estate nor its beneficiaries may maintain an action for malpractice against an attorney who advised a decedent regarding his estate plan.

In 2000, Saul Schneider purchased a $1 million life insurance policy on his life. Over several years, he transferred the policy to entities of which he was the principal owner. In 2005, he transferred the policy back to himself, individually. When Saul died in 2006, the insurance policy proceeds were included in his taxable estate. The personal representative of Saul's estate sued Saul's estate-planning attorney for malpractice, alleging that the attorney hadn't properly advised Saul of the estate-tax ramifications of both transferring and owning the policy. Both lower courts granted the attorney's motion to dismiss, holding that sufficient privity didn't exist to allow the estate to maintain its action against the attorney. In New York, an attorney generally isn't liable to third parties who aren't in privity with an attorney for harm caused by professional negligence.

However, the Court of Appeals held that there was sufficient privity between the personal representative of an estate and the deceased person's estate-planning attorney to maintain a malpractice action. The court noted that most states no longer adhere to the doctrine of strict privity and commented on the unfairness of a doctrine that left an estate without recourse against a negligent estate-planning attorney. It didn't relax the privity requirement to the extent necessary to allow beneficiaries or other third-party individuals to sue for malpractice without evidence of fraud or collusion or other special circumstances. To do so, the court explained, would produce uncertainty and limitless liability.

U.S. stock owned by British citizen residing in Belgium included in taxable estate, but penalties abated — In an interesting case before the U.S. Court of Appeals for the First Circuit, the estate of Noordin Charania appealed the IRS' determination that all of Noordin's Citigroup stock was includible in his estate and the IRS' refusal to abate an additional penalty assessed during audit. (Estate of Noordin M. Charania v. Commissioner, No. 09-2430 (June 17, 2010)).

Noordin Charania and his wife were born in Uganda while the country was a British colony and therefore they were both British citizens. They fled the country during Idi Amin's rule and settled in Belgium, where they lived for 30 years until Noordin's death. While in Belgium, Noordin purchased stock in Citicorp, which eventually became Citigroup. At Noordin's death on Jan. 31, 2002, the value of the Citigroup stock was almost $12 million.

On the due date for the federal estate tax returns, Noordin's estate filed a request for an extension of time to file its estate tax return, but didn't make any payment. The IRS approved the filing extension but not the failure to pay. Two weeks after the estate tax return was due, the estate paid over $1 million to the IRS, without filing a return. Almost a year after the extended due date for the estate tax return, the estate finally filed its return. On its return, the estate included only one-half of the Citicorp stock purchased by Noordin, claiming that Noordin only owned one-half of the stock due to the community property laws of Belgium.

After receiving the return, the IRS initially assessed over $1 million in unpaid taxes along with a late filing penalty of approximately $289,000 and a late payment penalty of $7,100 under IRC Section 6651. Then, after examining the return, the IRS included all of the Citicorp stock in Noordin's taxable estate and issued a further notice of deficiency for $2,070,000 and a further late filing penalty of almost $512,000.

The estate sought a waiver of the initial penalties, explaining that its failure to file and pay was based on reasonable cause and didn't reflect willful neglect. The IRS granted the waiver for the initial penalties but not the additional penalties assessed after examination. The estate then appealed the inclusion of the Citicorp stock and the IRS' refusal to abate all of the penalties. The Tax Court held for the IRS and the estate appealed to the First Circuit.

IRC Sections 2103 and 2104(a) include the value of stock owned in U.S. corporations in the gross estate of a person who is neither a resident nor a citizen of the United States. Both the estate and the IRS agreed to the facts of the case and further agreed that the ownership of the Citicorp stock, as intangible personal property, was controlled by the law of the Noordin's domicile, Belgium. The conflict-of-law rules of Belgium would apply the law of the spouses' common nationality, England. However, the estate argued that English law would apply the marital property law of Belgium, which allows for community property, and therefore only half of the Citicorp shares were owned by Noordin and includible in his gross estate. The IRS argued that English law would apply its own marital property law, and as a separate property jurisdiction, all of the shares would be includible.

The Court of Appeals determined that under the only English case on point (dating to 1900), marital property is governed by the property law of the jurisdiction in which the spouses were domiciled at the time of their marriage. Noordin and his wife were married in Uganda (while it was a member of the British Commonwealth) as British citizens. England is a separate property jurisdiction, requiring a determination that all of the stock was owned by Noordin and thus includible in his gross estate.

The Court of Appeals didn't agree with the estate's reading of the English case and wasn't convinced by the estate's public policy arguments that English law should hold that marital property is governed by the property law of the jurisdiction in which the spouses resided when the property was acquired. Furthermore, it noted that Noordin hadn't exercised his option to ensure that their property would be held as community property by executing a postnuptial contract or by the Belgian statutory process that allows residents to switch the marital property law applicable to their property.

Regarding the penalties, the Court of Appeals sided with the estate and held that if the IRS abated the initial penalties on the grounds that the tardy filing and payment were due to reasonable cause, it should abate all of the penalties. IRC Section 6651 imposes a penalty for late filing of an estate tax return unless the taxpayer can show that the failure was due to reasonable cause and not willful neglect. IRC Section 6651 fixes the mandatory penalty as a set percentage of the estate tax due, not to exceed 25 percent. Reasoning that the penalty was a single penalty, even if assessed in two stages, the Court of Appeals held that if there was reasonable cause for the delayed filing and payment, it should apply to all penalties assessed for the late filing and payment.

Supreme Court finds hedging process ineligible for patent — In Bilski v. Kappos, 561 U.S. ___ (2010), the U.S. Supreme Court ruled that a hedging process developed for buyers and sellers of commodities in the energy market wasn't eligible for a patent. The petitioners who sought the patent argued that the hedging technique was a “process” eligible for a patent under Section 101 of the Patent Act (35 U.S.C. 101), which provides that a patent may be obtained for any “new and useful process, machine, manufacture or composition of matter, or any new and useful improvement thereof.”

An eligible “process” is defined in 35 U.S.C. 100(b) as a “process, art or method, and includes a new use of a known process, machine, manufacture, composition of matter, or material.” Of course, meeting this definition is only the first step in determining patent eligibility. Over time the common law has established several exceptions to what may be patented under the statute. For example, pursuant to case law, laws of nature, physical phenomena and abstract ideas may not be patented.

In the lower court decision, the Court of Appeals for the Federal Circuit held that a process must be tied to a machine or transformation to be eligible for a patent. In reading Section 100(b), the court interpreted the words “machine, manufacture, composition of matter or material” to limit and define the type of process eligible for a patent. As a result, it held that the “machine or transformation test” was the sole test governing what is patentable under Section 101.

The Supreme Court wholly rejected this attempt to restrict the scope of patent-eligible processes to only those that are related to a machine or transformation. It held that the machine or transformation test is a helpful guide in determining what is patentable, but isn't an exclusive test. In furtherance of its broad view of what developments may be patentable, the majority also held that business methods aren't per se ineligible for patents. However, a lengthy concurrence by Justice John Paul Stevens disagreed with this point and reasoned that, given the history of patent law and its purposes, legislative history and Congressional intent, business methods should be outside the scope of patentable processes.

The majority ultimately refused to define the boundaries of a patentable process or establish any new gloss on the definition of “process.” Instead, the majority relied on other grounds to determine that the hedging process at issue wasn't a patentable process: It held that the process was an attempt to patent an abstract idea, which is prohibited by the case law. For example, a fundamental truth, such as a law of nature, mathematical equation or theory, can't be patented because it is considered an abstract idea. The majority reasoned that the concept of “hedging” presented by the petitioners, which was reduced to a mathematical formula in the patent claims, was a fundamental economic concept. And limiting application of the formula to commodities and energy markets didn't, under existing case law, make the abstract idea a patentable process. Justice Stevens' concurrence instead rejected the claim for a patent based on the grounds that it was an ineligible business method.

Under Bilski, the potential for patenting tax-planning strategies remains uncertain because the case hasn't limited the definition of a patentable process or resolved to what extent business methods may be patentable.