Tax Law Update 2012-03-01Tax Law Update 2012-03-01

IRS seeks comments on tax consequences of decanting — In Notice 2011-101, the Internal Revenue Service requested comments regarding the income, gift, estate and generation-skipping transfer (GST) tax issues and consequences arising from trust decanting. Decanting is a distribution from one irrevocable trust to another, usually pursuant to state law. Decanting may change the beneficial interest of a beneficiary of the original trust or could create a beneficial interest in the new trust for a new beneficiary. The IRS isn't issuing private letter rulings with respect to decantings that change beneficial interests.

The request for comments highlights different circumstances that may need to be considered, which include how the beneficial interests and powers of appointment change, the grantor trust status of the two trusts, the situs and governing law of the two trusts, whether the consent of the attorney general or the beneficiaries is required, the effect of state law, the potential change in the identity of the donor and the GST status of the trust.

District Court approves IRS “John Doe” summons — In In Re Tax Liabilities of John Does, WL 6302284 (Dec. 15, 2011), the U.S. District Court for the Eastern District of California granted the government's petition to serve a “John Doe” summons on California's Board of Equalization. The government filed the petition to gain access to records disclosing intra-family transfers of real estate in which no consideration was paid, for use as evidence of unreported gifts.

The district court had previously denied the government's petition but in its resubmission, the government adequately addressed the district court's concerns. When the IRS power to summons under Internal Revenue Code Section 7609(f) pertains to unknown taxpayers, and the information requested is in the hands of a third party, the government must show that its investigation relates to an ascertainable class of persons, a reasonable basis exists for the belief that these unknown taxpayers may have failed to comply with tax laws and that it can't obtain the information from another readily available source.

The district court held that the class, defined as California residents who were involved in real property transfers from parents to children or grandparents to grandchildren for little or no consideration between 2005 and 2010, was particular enough to be considered an ascertainable class. The court also held that the IRS survey results showing that between 50 percent and 90 percent of individuals within the identified class failed to file a Form 709 were sufficient to support a reasonable belief that the taxpayers failed to comply with tax laws. The government had failed to substantiate the third requirement in its original petition. But, the court held that the resubmitted petition established that the government couldn't obtain the records from all of the 58 counties if it contacted each county directly for the records, because some counties didn't have the requested files. Therefore, the summons on the California Board of Equalization was necessary.

The government also satisfied the court that a state is a “person” that may be served with a summons, a state's sovereign immunity doesn't preclude the issuance of a “John Doe” summons, the United States had exhausted all administrative remedies and it wasn't required to pursue any remedies in state court.

PLR determines income tax consequences of sale in exchange for termination of annuity obligation — In PLR 201149005 (Dec. 9, 2011), a grantor established two trusts, each of which was for the sole benefit of a different beneficiary. Each trust purchased stock in a corporation from the grantor and, in exchange, entered into an annuity contract under which the trustees agreed to pay fixed annual annuity payments to the grantor for his life.

At a later date and after various reinvestments, the trusts owned interests in a partnership. The grantor assigned his rights to the annuity payments under the contract to a new trust. Each of the original trusts then sold its partnership interests to the new trust in exchange for the termination of the annuity contract and cash. The fair market value (FMV) of the partnership interest sold by each trust was equal to the present value of the future annuity payments (calculated using the IRC Section 7520 rate as of the closing date of the transaction and the grantor's age) due under the annuity contract plus the cash amount.

The IRS ruled that a transfer of the partnership interest in exchange for the termination of the annuity contract is treated as an annuity payment in an amount equal to the present value of the future annuity payments under the contract. Because the termination of the annuity contract ends the deferral treatment, each trust will recognize any remaining gain.

The gain or loss recognized is equal to the difference between each trust's adjusted basis in its partnership interest and the sum of: (1) the value of the annuity; (2) the cash payment; and (3) the trust's allocable share of the partnership's liabilities immediately prior to the sale.

Estate can't enforce IRS agent's promise to discharge lien — In Adamowicz v. United States, 108 A.F.T.R.2d 2011-7271 (Nov. 21, 2011), the executors of the estate of Mary Adamowicz elected under IRC Section 6166 to defer payment of the estate's taxes relating to an interest in real property located in Peconic, N.Y. (the Peconic Property). The IRS audited the estate and, during the course of the audit, the executors contracted to sell the Peconic Property. However, pursuant to IRC Section 6324(a), there was an automatic lien imposed for unpaid estate taxes on all the assets of the estate.

The executors applied under IRC 6325(c) for a certificate of discharge of the lien on the Peconic Property. IRC Section 6325(c) provides that the Secretary may issue a certificate of discharge of any or all of the property subject to any lien imposed by IRC Section 6324 if the Secretary finds that the liability secured by such lien has been fully satisfied or provided for. Allegedly, the IRS examiner informed the executors' counsel that the application would be granted if the estate paid the portion of estate taxes attributable to the Peconic Property. The executors alleged that the IRS' Northeast Territory Manager, one or more officers in the IRS' National Office and one or more officers in the IRS' Office of Chief Counsel approved this promise. However, the IRS refused to grant the application, and the executors filed a one-count complaint for breach of contract against the United States.

The U.S. Court of Federal Claims denied the executors' complaint, holding that the IRS agent didn't have actual authority to enter into such a contract. IRC Sections 7121 and 7122 allow the IRS to enter closing agreements and compromises, respectively, if certain procedures outlined in the Treasury regulations are followed. The court held that the agreement was within the scope of IRC Sections 7121 and 7122, but didn't meet their requirements. And, no other statute or regulation creates authority in an IRS employee to agree to discharge property under IRC Section 6325(c). Therefore, there was no actual authority for the agreement. Furthermore, the executors couldn't show there was implied authority or ratification of the promise. The court, therefore, granted the government's motion for summary judgment.

Charitable deduction denied for bargain sale gift due to incomplete acknowledgement — In Cohan v. Commissioner, T.C. Memo. 2012-8 (Jan. 10, 2012), the Tax Court denied the taxpayers' charitable deduction, because the taxpayers hadn't obtained a contemporaneous written acknowledgement that fully described the consideration provided by the charity to the taxpayers.

The taxpayers were members of the Cohan family that had formed HCAC, a Massachusetts limited liability company. The Cohan family owned a large and unique parcel of farmland on Martha's Vineyard in Massachusetts. In 1969, they sold the property to the Wallace family, but retained certain neighboring parcels. As part of the sale, the parties entered into an agreement that limited the development of the farm property and granted both parties certain rights of first refusal if either party attempted to sell its property before Jan. 1, 2010. The price set by the agreement for the rights of first refusal was significantly less than the value of the land, so the rights of first refusal effectively foreclosed a sale to a third party. The Wallace family eventually decided that they wanted to develop the property as a residential subdivision and filed a lawsuit seeking to invalidate the 1969 agreement, but the Massachusetts Superior Court upheld it. Meanwhile, the Cohan family transferred their rights under the agreement to HCAC and considered how they could continue to enforce the 1969 agreement or purchase the farm back from the Wallace family before 2010 to ensure that it wasn't developed.

TNC, an international conservation organization that acquires land to preserve biological diversity, became interested in purchasing the farm from the Wallace family. TNC planned to impose conservation and development restrictions on the farm. To arrange the purchase, TNC had to negotiate with the Cohan family to deal with its rights of first refusal. After significant negotiations, HCAC reached a tentative agreement with TNC and agreed to sell its rights of first refusal to TNC in exchange for certain portions of the farm, leases for certain other portions of the farm, reimbursement for taxes incurred by the members of HCAC and tax indemnifications. TNC was also negotiating with the Wallace family regarding the purchase of the farm and, after extensive negotiations involving several other interested parties, a final agreement was reached, but due to certain terms, it required TNC to renegotiate the deal with HCAC.

In the final deal, HCAC agreed to make a bargain sale gift to TNC of the appraised FMV of its rights under the 1969 agreement in excess of the cash and real estate conveyances by TNC to HCAC. The agreement by TNC to reimburse HCAC for the income tax related to the sale was a critical part of the deal. The parties negotiated a complicated agreement involving several stakeholders. After the closing, TNC sent HCAC a letter related to the transaction, which stated that the difference between the value of the rights of first refusal and the consideration received represented the bargain sale. It listed four properties, cash payments, beach access rights and the release of the rights of first refusal as the consideration received by HCAC and valued the benefits at $11,931,755. It noted that “no other goods or services were provided by TNC to HCAC in connection with this transaction,” but didn't list other benefits received by HCAC, which included two leases, an easement, an option to buy a certain parcel, a closure and relocation of a road and several other beach access rights. HCAC issued the Cohan family members a K-1 reflecting the transaction, and the family members reported the respective income attributable to sale as long-term capital gain and claimed charitable contribution deductions that collectively exceeded $2 million on their income tax returns.

Under IRC Section 170(f)(8)(A), a taxpayer may not deduct any charitable contribution of $250 or more unless the contribution is substantiated with a contemporaneous written acknowledgement which must include: (1) the amount of cash paid and a description (but not the value) of any property other than cash contributed; (2) whether the donee organization provided any goods or services in consideration for the cash or property contributed; and (3) a description and good faith estimate of the value of any goods or services provided by the done organization.

The court held that the TNC letter didn't constitute a contemporaneous written acknowledgement, because it omitted several items of consideration received by HCAC. It reasoned that the failure to disclose the consideration benefited both the taxpayers and the charity, because any tax savings resulting from a charitable contribution deduction for HCAC would ultimately benefit TNC by reducing the tax reimbursements it owed to HCAC. It found that the negotiations illustrated the parties' intent to minimize the taxes that TNC agreed to pay. It wasn't convinced by the parties' counsels' testimony that the items of consideration in question were left out of the letter inadvertently due to the complexity of the negotiations. Instead, it found that the parties specifically negotiated the disclosure of consideration and what to include in the letter. The court further held that the taxpayers didn't reasonably rely on the gift letter because they knew or should have known that certain items were omitted in calculating the bargain sale gift amount. Lastly, it held that the doctrine of substantial compliance was inapplicable, because there wasn't enough information in the letter to allow the IRS to determine the amounts of the charitable contributions. As a result, the court affirmed the IRS' disallowance of the charitable deductions.

The court also addressed the valuation of the various property interests and held for the taxpayer that the amount realized from HCAC's sale of the property rights under the 1969 agreement was long-term capital gain, rather than ordinary income, but affirmed certain negligence penalties under IRC Section 6662.