MORE GUIDANCE ON ELECTING OUT OF ESTATE TAX FOR 2010 DECEDENTS

The IRS has issued detailed guidance regarding estates of 2010 decedents that elect out of federal estate tax. The guidance has lots of details, and should be reviewed by any persons involved with the estates of decedents that died in 2010.

While not intended as a comprehensive analysis of the new guidance, some highlights and interesting points follow:

1. Form 8939 will be used to opt-out of estate tax (the Section 1022 election), and to allocate available basis step-up among eligible assets.

2. Form 8939 is due no later than November 15, 2011. Since the form is not out yet, estates should start gathering information now. The are only limited circumstances for an extension or a later amendment.

3. A conditional Form 8939 (one that is effective only if assets exceed the remaining unified credit amount of the decedent) is not allowed.

4. If the Section 1022 election is made, the decedent’s GST exemption is allocated by attaching Schedule R to the Form 8939. For decedents that made a 2010 inter vivos gift, the Form 8939 is not used to elect out of the automatic allocation of GST exemption. If the gift was made before December 17, 2010, the time for filing a Form 709 with the election out is extended to September 19, 2011. If the gift was on or after December 17, the regular 2010 Form 709 filing dates apply.

5. Note that the Form 8939 must report ALL of the decedent’s assets, not just those for which a basis step-up allocation applies (except for cash and IRD items, and noncitizens who are nonresidents only report U.S. assets). The form must also report property that was required to be included on another donor’s Form 709 if gifted to the decedent within 3 years of his or her death.

6. The executor must provide a statement to each recipient of property acquired from the decedent within 30 days of the filing of the Form 8939.

7. If the decedent creates separate interests in an item of property (such as a life estate and remainder), the basis interest must be allocated to all such separate interests if an allocation to any portion is desired.

If the opt-out election is not filed, the estate must file a Form 706, unless the assets of the decedent total less than the decedent’s available unified credit amount. Those estates that do not file a Form 706 because the value of its assets do not require one and for which an opt-out election does not make sense should NOT file a Form 8939 since this could act to reduce the available amount available to step-up the basis in the decedent’s assets.

Notice 2011-66  and Revenue Procedure 2011-41

ANOTHER ATTACK ON DEFINED VALUE CLAUSES FAILS

In the previous posting on June 23, 2011, we discussed the use of charitable lid/defined value clause planning, and how it had recently been upheld in by the Tax Court in Hendrix. Such planning has now successfully weathered another attack – this time in the 9th Circuit Court of Appeals in Petter. This time, the IRS dropped its public policy objections and focused on denial of the gift tax charitable deduction for additional amounts passing to charity by reason of a revaluation of gifted or sold property under regulations prohibiting a condition precedent to a deductible charitable gift.

In Petter,  the taxpayer transferred UPS stock to a family LLC. She then gifted LLC units to two trusts and a charitable organization. The gift was accomplished via a transfer of a fixed number of LLC units. A formula was employed to allocate the transferred units between the two trusts and the charitable organization. The amount allocable to the trusts was intended to equal the value of the taxpayer's unused unified tax exemption. More specifically, the allocation clause allocated to each trust a portion of the LLC units equal to "one-half the [maximum] dollar amount that can pass free of federal gift tax by reason of Transferor's applicable exclusion amount allowed by Code Section 2010(c). Transferor currently understands her unused applicable exclusion amount to be $907,820, so that the amount of this gift should be $453,910." To the extent the value of the transferred LLC units exceeded this allocation to the trusts, such remaining LLC units from the transfer were allocated to the charitable organization. The transfer documents also provided that  if the value of the units was finally determined for federal gift tax purposes to be different than as originally computed, the trusts and charitable organization would reallocate those units amongst themselves in accordance with that final determination. Subsequent to the gift, a sale of additional LLC units to the two trusts was undertaken on an installment basis. The sold units were allocated to the two trusts and another charitable organization in a similar manner.

The LLC interests were eventually revalued higher than the value used on the Form 709. This triggered additional units passing to the charitable organizations.

Generally, gifts to charities are not subject to gift tax pursuant to the gift tax charitable deduction under Code Section 2522(a). However, no charitable deduction is allowed "[i]f, as of the date of the gift, a transfer for charitable purposes is dependent upon the performance of some act or of the happening of a precedent event in order that [the transfer] might become effective" (emphasis added). Treas. Reg. Section 25.2522(c)-3(b)(1). The IRS argued that the transfer of the additional LLC units to the charities is subject to a condition precedent within the meaning of that regulation. The condition precedent is the IRS audit that ultimately determines that the reported value of the LLC units is too low and triggers the additional transfer.

The IRS further bolstered its argument by citing Code Section 2001(f)(2).  That provision provides that a value as finally determined for gift tax purposes means the value shown on the taxpayer's return unless the IRS audits and challenges the value. The IRS thus argued that under the taxpayer's formula, the value, and thus the amount passing to charity, was fixed by the value reported on the gift tax return. Any IRS action to change that value was a subsequent action, and thus a necessary precedent event, to increase what passes to the charity - thus that increase would be a prohibited precedent event to the transfer at the time of the gift.

The appellate court found that there was no condition precedent -  the Taxpayer's transfers became effective immediately upon the execution of the transfer documents and delivery of the units. The only post-transfer open question was the value of the units transferred, not the transfers themselves. The court stated the "clauses merely enforce the foundations' rights to receive a pre-defined number of units...Thus, the IRS's determination...in no way grants the foundations rights to receive additional units." Similarly, the court noted "that value was a constant, which means that both before and after the IRS audit, the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the Taxpayer's transfer was dependent upon an IRS audit." If the charities did not agree with the reported value, they could have brought suit to determine the proper value applying the gift tax definition and thus did not need an IRS audit to get all they needed (although the court notes this was unlikely to occur).

The appellate court overcame the IRS' argument that Code Section 2001(f)(2) set the value as finally determined for gift tax purposes at the returned value, by noting that Code Section 2001(f)(2) applies to set the value as finally determined for purposes of gift only for purposes of applying Code Section 2001(f)(1) which relates to determination of values only after the period for assessment of tax has expired. Code Section 2001(f)(2) does not apply to set that value for other Chapter 12 gift tax purposes.

The decision is important for several reasons. It applies a well-reasoned and supported appellate court defeat to the IRS' condition precedent argument. Also, it may signal IRS surrender on the public policy arguments it has been asserting, per its withdrawal of those arguments from the appeal issues. Lastly, another Circuit Court of Appeal is voicing its approval of the formula clauses.

The appellate court invites the IRS to seek a change in the law if it is troubled by these clauses. One hopes that Capital Hill would resist such changes. While the clauses can be subject to abuse, for the majority of taxpayers they provide a mechanism to allow them to make full use of available transfer tax exemptions without being subject to the risk of taxes arising from challenges to a good faith valuation.

Petter v. Commissioner (9th Cir. 2011)

SECTION 197 AMORTIZATION APPLIED TO NONCOMPETE COVENANT IN SMALLER STOCK ACQUISITION

Noncompetition covenants are common when interests in businesses are sold. The buyer typically would like to amortize (deduct) the cost of the covenant as quickly as possible, so as to get the tax savings from the deduction sooner rather than later. Absent any special statutory treatment, the cost of the covenant is usually written off over the number of years that the covenant applies.

However, if Code Section 197 applies to the covenant, the buyer must amortize it slowly, over a 15 year term. In a recent case, the First Circuit Court of Appeals held that Section 197 applies to a one-year covenant not to compete when it was issued in conjunction with a redemption of a 23% corporate shareholder.

The case turned on whether Code Section 197(d)(1)(E) characterizes such a covenant as a section 197 intangible. That section includes as a section 197 intangible “any covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof.”

The taxpayer argued that the term "thereof" at the end of this provision requires that the interest sold any trade or business must be substantial, and that the 23% sold here is not substantial. Thus, the covenant would not be a section 197 intangible.

The IRS argued that the term "thereof" does not not modify the term "interest" but instead modifies the term "trade or business." Applying the IRS' interpretation, there are thus two circumstances that will treat the covenant as a section 197 intangible. The first is the purchase of an INTEREST in a trade or business, such as stock, no matter how small that interest is. The second is the purchase of assets of the trade or business (that is, the purchase of the trade or business itself), in which case the sale must be at least of a substantial portion of the total assets to trigger section 197 treatment.

At first, the IRS interpretation appears strange, if not outright ridiculous. However, if you look at it long enough, it does appear to be more reasonable, and if you keep looking at the clause, you soon have no idea what it really means.

The Tax Court accepted the IRS’ interpretation. It based this in part on the policy of Code Section 197 to discourage over allocation of purchase price to a covenant by a buyer. However, this is probably not a fair basis on which to base the interpretation, since in a stock sale there is a natural tension between the buyer and seller that limits the ability of the buyer to over allocate purchase price to a covenant not to compete. This is because the covenant not to compete will be ordinary income to the seller, while the allocation of sale proceeds to the asset being sold would generate only capital gain. The buyer will thus be bargaining for a lower allocation of proceeds to the covenant not to compete.

Nonetheless, with this case the IRS' interpretation of Code Section 197(d)(1)(E) must be given due consideration in regard to any sales of interests in business entities that are accompanied by a covenant not to compete, no matter how small the percentage interest that is being sold.

Recovery Group, Inc., 108 AFTR 2d ¶ 2011-5114 (CA 1 7/26/2011)