Tax Law Update 2010-10-01 (1)Tax Law Update 2010-10-01 (1)

Trustee's participation determines whether trust activity is passive under IRC Section 469 — In Private Letter Ruling 201029014 (July 23, 2010), the Internal Revenue Service explained how to determine whether an activity is “passive” under Internal Revenue Code Section 469, which disallows passive activity losses for individuals, estates, trusts, closely held C corporations and personal service corporations. Under IRC Section 469(c)(1), a passive activity is an activity involving the conduct of any trade or business in which the taxpayer doesn't materially participate. Material participation requires the taxpayer to be involved in the operations of the activity on a basis that's regular, continuous and substantial, which means day-to-day involvement. While temporary regulations under IRC Section 469(h) have been enacted that govern individuals, there are no such regulations applicable to trusts. The ruling clarifies that until such regulations are passed, the statutory test of IRC Section 469(h) will apply to trusts. And relying on legislative history and analogizing to the corporate context, the ruling explains that the trustee's actions are the focus of IRC Section 469 as it applies to trusts. Therefore, according to the ruling, to determine whether a trust's activity is passive, the sole means for a trust to establish that it's materially participating in an activity is to show that the trustee's (not the beneficiaries') involvement in the activity is regular, continuous and substantial.

Disclaimer of interest in trust passing to private foundation meets qualified disclaimer rules and is eligible for charitable deduction — In PLR 201032010 (Aug. 13, 2010), a taxpayer disclaimed her interest in a sub-trust (Trust A) created under a joint revocable trust established by her parents. Trust A was to be funded by the surviving parent's share of the couple's community property and the survivor's separate property. When the surviving parent died, the taxpayer (that is, the daughter) proposed disclaiming all of her interest in Trust A within nine months of the date of the surviving parent's death without receiving any consideration in exchange for the disclaimer. The taxpayer was then serving as the sole trustee of Trust A.

The trust agreement governing the trust provided that assets disclaimed by the taxpayer would be distributed to a private foundation (PF) of which the taxpayer was a director. The PF bylaws provided that assets received as a result of a qualified disclaimer were to be segregated and maintained in a separate account and the officer or director who disclaimed the assets would have no power or authority to determine how those assets or the income from such assets would be distributed.

Under IRC Section 2518(a), if a person makes a qualified disclaimer, the transfer of property made due to the disclaimer is treated as being made by the original transferor, rather than the disclaimant. As a result, the disclaimant isn't treated as making a taxable gift of the disclaimed property. A disclaimer is a “qualified disclaimer” only if it's (1) irrevocable, and (2) made in writing within nine months after the later of (a) the date on which the transfer creating the interest in such person is made, or (b) the day on which the disclaimant attains age 21. In addition, the disclaimant may not have accepted the interest or any of its benefits and the disclaimed property must pass, without any direction on the part of the disclaimant, to either the spouse of the decedent or a person other than the person making the disclaimer. Treasury Regulations Section 25.2518-2(d)(2) also provides that if the disclaimant is a fiduciary with respect to the property to be disclaimed, the exercise of fiduciary powers to preserve or maintain the disclaimed property will not be treated as an acceptance of such property or any of its benefits. However, a fiduciary can't retain discretionary powers to direct the enjoyment of the disclaimed property.

At issue were whether the taxpayer's proposed disclaimer would be a qualified disclaimer and whether the estate would be able to claim a charitable deduction for the property passing to the PF as a result of the disclaimer.

First, the IRS ruled that the taxpayer's timely disclaimer of all her interest in Trust A would be qualified because her actions in her capacity as the sole trustee of Trust A wouldn't constitute acceptance of the assets held in Trust A. In addition, even though the disclaimed property would be transferred to a PF of which the taxpayer was a director, she retained no powers over the disclaimed property because of the restrictions in the PF's bylaws.

Second, the IRS ruled that the payment to the PF as a result of the disclaimer qualified for the estate tax deduction under IRC Section 2055. Treas. Regs. Section 20.2055-1(a) provides that a deduction is allowed under IRC Section 2055(a) from the gross estate for the value of property included in the decedent's gross estate and transferred by the decedent during his lifetime or at death for charitable purposes. Treas. Regs. Section 20.2055-2(c)(1)(i) provides that in the case of a decedent dying after Dec. 31, 1976, IRC Section 2055 allows a deduction for property that falls into a bequest, devise or transfer due to a qualified disclaimer under IRC Section 2518.

Since the PF had received a letter from the IRS determining that it was a charitable tax-exempt organization described in IRC Section 501(c)(3), the IRS ruled that assuming the proposed disclaimer was a qualified disclaimer, property passing to the PF as a result of the disclaimer would qualify for the estate tax charitable deduction under IRC Section 2055(a).

U.S. District Court for Massachusetts holds estate's claim for refund was untimely — In Estate of Dickow v. United States, 106 A.F.T.R.2d 2010-xxxx (Aug. 19, 2010), the executor of Margaret Dickow's estate filed an IRS Form 4768 (Application for Extension of Time to File a Return and/or Pay U.S. Estate Taxes) on Oct. 10, 2003, five days before the estate tax return was due. The executor requested an automatic six-month extension and enclosed an estimated estate tax payment of $945,000. The executor received the extension until April 15, 2004 to file the estate tax return.

On March 23, 2004, the executor filed a second IRS Form 4768 requesting a second extension of time (an additional six months) to file the estate tax return. Form 4768 calls for the executor to check one of several boxes indicating the ground for extension. Since none of the options were applicable, the executor simply wrote “Request for Second Extension” on the top of the Form 4768 and attached an explanation that he needed a second extension to file because “despite due diligence on his part, he had not received an appraisal of a real estate asset which constitutes a large portion of the Estate,” which prevented him from accurately calculating the estate tax due.

The IRS denied the second request but failed to inform the executor of the denial. After April 15, 2004 came and went without the executor having filed an estate tax return, the IRS sent two delinquency notices to the executor, who denied having received them. On Sept. 30, 2004, the executor filed an estate tax return and requested a refund of over $330,000, which the IRS paid. Just under three years later, on Sept. 10, 2007, the executor filed an amended estate tax return requesting an additional refund of over $237,000. The IRS denied the refund request and the executor filed a complaint with the Tax Court for a refund pursuant to IRC Section 6511.

At issue was whether the executor's suit for a refund claim met the requirement of IRC Section 6511, which sets out the timeliness requirements for tax credits and refunds. IRC Section 6511(a) provides a “filing deadline” that requires the taxpayer to file a refund claim by the later of (a) three years from the time the return was filed, or (b) two years from the time the tax was paid. Second, IRC Section 6511(b)(2)(A) limits the refund to the amount of tax paid within a certain “look-back” period, which is defined as the three years immediately preceding the filing of the claim plus any extension of time for filing the return.

The executor's claim for the second refund occurred within three years of the date the return was filed, so it met the timeliness requirements of IRC Section 6511(a). But the court held that the tax payment was outside the look-back period so that no refund could be made. The court explained that the IRS had correctly denied the executor's request for a second extension due to a lack of authority. Therefore, the look-back period was the three years and six months (for the automatic extension) immediately preceding the filing of the claim for the second refund on Sept. 10, 2007. This meant that the look-back period extended to March 10, 2004. Since the estate tax payment on Oct. 10, 2003 wasn't made within the look-back period, the executor's claim didn't meet the requirements of IRC Section 6511, and the court granted summary judgment to the IRS.

The executor also claimed the IRS was estopped from denying his refund claim because the IRS had not notified him that his request for a second extension was denied. However, the court held that the doctrine of equitable estoppel can't create exceptions to statute of limitations periods and that in any case, there was no affirmative misconduct by the IRS which would justify equitable estoppel.

Office of Chief Counsel prevents IRS from collecting time-barred gift tax based on equitable remedies — In Chief Counsel Advice 201033030 (Aug. 10, 2010), the Office of Chief Counsel ruled against the IRS' attempt to collect gift taxes for which the statute of limitations had passed. The IRS examined the taxpayer's estate tax return and discovered that the estate had underreported the value of the “adjusted taxable gifts” entered on line 4 of the Form 706. The IRS traced the error to an underreporting on a prior gift tax return that had failed to account for gifts made in prior years, with respect to which the statute of limitations had run. The IRS ultimately assessed a deficiency in estate tax and then requested the Office of Chief Counsel to rule as to whether the IRS, under various equitable theories, could collect the gift taxes that were never paid but were included in calculating both the gross estate and deduction for “gift tax paid or payable” (taken on line 7 of the Form 706).

The IRS first attempted to apply the doctrine of equitable recoupment. The chief counsel had previously issued an unfavorable Field Service Advisory, FSA 200118002, based on similar facts. However, in 2006, by amending IRC Section 6214, Congress granted the Tax Court the authority to apply equitable recoupment to the extent it would be available in civil tax cases and the IRS was hoping that this congressional action would alter the chief counsel's determination.

Equitable recoupment requires that (1) the refund or deficiency for which recoupment is sought by way of offset is barred by time; (2) the time-barred offset arises out of the same transaction, item or taxable event as the overpayment or deficiency; (3) the transaction, item or taxable event has been inconsistently subject to two taxes; and (4) if the subject transaction, item or taxable event involves two or more taxpayers, there's sufficient identity of interest between the taxpayers subject to the two taxes so that the taxpayers should be treated as one. The chief counsel emphasized that a taxpayer or the IRS may use equitable recoupment only defensively, meaning that it allows a taxpayer or the IRS to assert an otherwise time-barred claim that arises out of a transaction already in controversy as a defense or credit against additional tax. The IRS, however, was proposing to use the doctrine offensively in Tax Court — it wasn't asserting the collection of the gift taxes as a defense to a claim for refund by the estate. The chief counsel held that the amendment to IRC Section 6214 didn't affect its prior conclusion because the equitable recoupment doctrine simply didn't apply to the situation at hand.

The chief counsel also advised the IRS regarding the doctrine of consistency, which prohibits a taxpayer from changing a prior representation, upon which the IRS has relied, after the statute of limitations has expired. The doctrine of consistency also wasn't applicable in this case because the taxpayer wasn't inconsistent or attempting to change a prior representation. Instead, it was the IRS that was trying to change the taxpayer's gift tax reporting, to which it had already acquiesced. Lastly, the chief counsel ruled that the doctrine of equitable estoppel was inapplicable as well.

Tax Court holds for estate on discount for built-in capital gains — In Estate of Jensen v. Commissioner, T.C. Memo 2010-182 (Aug. 10, 2010), the Tax Court held that the discount for tax on built-in capital gains likely to be recognized in the future should be calculated by taking into account both future appreciation on property and a present value discount for the projected capital gains tax. The estate of Marie Jensen owned an 82 percent interest in Wa-Klo, a closely held C corporation, the principal asset of which was a 94-acre waterfront parcel of real estate that had appreciated significantly. The estate's appraiser calculated the tax on the gain that would be recognized currently to be $965,000. The appraiser then subtracted the built-in capital gains tax (a dollar-for-dollar discount) from the net asset value. The estate's interest was equal to 82 percent of the reduced net asset value (a pro rata share), subject to a further discount for lack of marketability. The estate later adjusted its estimate for the tax on the built-in gain upwards to $1,133,283, but the reason for the adjustment is not explained in the opinion.