Tax Law Update 2011-06-01 (1)Tax Law Update 2011-06-01 (1)

Proposed regulations regarding discharge of indebtedness income exclusions applicable to grantor trusts and disregarded entities — The Internal Revenue Service has issued Proposed Regulations Section 1.108-9 under Internal Revenue Code Section 108(a), relating to the exclusion of discharge of indebtedness income of a grantor trust or a disregarded entity (that is, a business entity that's separate from its owner but that's disregarded for federal tax purposes).

Under IRC Sections 108(a)(1)(A) and (B), discharge of indebtedness income isn't included in a taxpayer's gross income if the discharge occurs in a Title 11 bankruptcy case or when the taxpayer is insolvent. The proposed regulations provide that grantor trusts and disregarded entities themselves won't be considered the “taxpayer” under Section 108; instead, the owner of the grantor trust or the disregarded entity is considered the taxpayer. Therefore, the exceptions under Sections 108(a)(1)(A) and (B) are available only to the extent the owner of the grantor trust or the disregarded entity is insolvent or subject to the bankruptcy court's jurisdiction.

In addition, with respect to partnerships, the rules apply directly to partners to whom the discharge of indebtedness income is allocable. The preamble to the proposed regulations provides that if a partnership holds an interest in a grantor trust or disregarded entity, Section 108(a) is applied by looking through to the partners to whom the income is allocable, and if any partner is itself a grantor trust or disregarded entity, looking through to the owner of such trust or entity.

Of course, a cancellation of indebtedness solely between a taxpayer and a trust that's a grantor trust as to the taxpayer would be outside the scope of these proposed regulations. For example, if a grantor trust owes a debt to the grantor evidenced by a promissory note, cancellation of the promissory note by the grantor still shouldn't result in discharge of indebtedness income even if the grantor himself isn't bankrupt or insolvent under these proposed regulations. That's because the debt is disregarded for income tax purposes (that is, treated as a loan to oneself). See Revenue Ruling 85-13.

IRS extends interim guidance on IRC Section 67 deductions for bundled fiduciary fees — On Jan. 16, 2008, the U.S. Supreme Court issued its decision in Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner, 128 S.Ct. 782 (2008), holding that costs paid to an investment advisor by a non-grantor trust or estate generally are subject to the 2 percent floor for miscellaneous itemized deductions under IRC Section 67(a). In the absence of final regulations consistent with the Knight decision, the IRS issued interim guidance in Notice 2008-32 to address the treatment of a bundled fiduciary fee.

Notice 2008-32 allowed taxpayers to deduct the full amount of the bundled fiduciary fee without regard to the 2 percent floor and didn't require them to determine the portion of a bundled fiduciary fee that was subject to the 2 percent floor. However, payments by the fiduciary to third parties for expenses subject to the 2 percent floor that were readily identifiable had to be treated separately from the otherwise bundled fiduciary fee. In Notice 2011-37 issued this past April, the IRS extended these rules to apply to any year beginning before the date that the final regulations are published in the Federal Register.

Tax Court rules that the termination of an insurance policy, which applied cash value to satisfy policy loans, results in gross income to taxpayer — In Brown v. Comm'r, TC Memo 2011-83 (April 12, 2011), the Tax Court upheld the IRS' notice of deficiency for income tax and penalties. Bruce Brown purchased a life insurance contract from Northwestern Mutual Life Insurance Company (Northwestern) in 1982. Over the years, he used various methods to pay the premiums: direct payment by check, application of dividends and loans from the cash value. In 2005, Northwestern terminated the policy because the policy debt incurred to pay premiums exceeded the cash value. On termination, Northwestern applied the cash value to satisfy the debt owed by Bruce. There were no cash payments to Bruce on termination.

Northwestern sent Bruce a Form 1099-R, which showed a gross distribution of $37,365.06 and a taxable amount of $29,093.30. Bruce and his wife believed that Northwestern had mistakenly issued the Form 1099-R based on the theory that the Browns, as debtors, recognized a taxable gain when Northwestern, as creditor, cancelled a debt. The Browns didn't report any income from the termination on their income tax return, and the IRS determined a deficiency and assessed penalties.

The Tax Court agreed with the IRS and held that the cancellation of the debt was a payment to the Browns under a life insurance contract that's taxed under IRC Section 72. Under IRC Section 72(e)(5), the amount received under a life insurance contract is included in gross income but only to the extent it exceeds investment in the contract. IRC Section 72(e)(6) defines investment in the contract as the aggregate amount of premiums paid for the contract, reduced by the aggregate amounts received under the contract, to the extent that such amounts were excludable from gross income. The gross distribution reduced by the investment in the contract resulted in taxable income of $29,093.30, as shown on the Form 1099-R.

The Tax Court also upheld accuracy-related penalties imposed by the IRS under IRC Section 6662, holding that the Browns (1) didn't provide substantial authority for their position, and (2) didn't qualify for the reasonable cause and good faith exception under IRC Section 6664(c) because they didn't exert enough effort to determine the proper tax liability.

Tax Court denies discounts for hazards of litigation — In Estate of Ellen D. Foster, TC Memo 2011-95 (April 28, 2011), the Tax Court assessed the value and deductibility of claims pending against and held by the estate of Ellen Foster. Her husband, Thomas Foster, founded Foster & Gallagher, Inc. (F&G) a mail-order horticulture business. In 1991, Thomas and F&G entered into a stock restriction agreement that required F&G to purchase all of the Fosters' stock upon their deaths and to maintain life insurance on their lives to fund the purchase. In 1995, Thomas and others decided to sell the majority of their stock to an employee stock option ownership plan (ESOP). F&G borrowed $70 million, unsecured, to finance the ESOP's purchase.