Mid-Year Review, 2006

he financial planning world is experiencing a transitional period of extended duration. Yes, it is a cliffhanger of sorts: Will the estate tax stay repealed after 2010? Yet, ironically, this period of protracted uncertainty is, in its own way, one of the most enduring periods of the tax code.

During the 1980s and 1990s, a succession of tax reforms kept arriving. It was like taking a bullet train across Europe and stopping in a different nation, with a brand new set of rules, every year.

By comparison, we are now in the middle of a decade-long trek…more like going coast to coast across the United States by bicycle. Congress continues making modest tax code adjustments, but we are still heading to the same destination, i.e., estate tax repeal in 2010.

In any event, analogies are to SAT exams, as tax changes are to financial planning-they may not make sense, but we live within the rules. So let us review the relevant changes of the first half of 2006.

The Tax Cut Package

Over the years, Congress has mastered a trick worthy of Harry Houdini, the disappearing tax cut. There have been numerous tax cuts in recent years and each is greeted with great jubilation. You would think there would be no taxes left to cut. Yet tax cuts expire and/or other taxes must somehow grow back because we soon find taxes just as high as before.

Here is a recap of where we stand after the latest tax cut, the Tax Increase Prevention and Reconciliation Act (TIPRA), which President Bush signed on May 17, 2006. The recent package signed by the President represents a tax reduction of $70 billion and extends previous tax cuts which would have expired.

ECONOMIC CONTEXT: The justification for this law is the economic growth that resulted from the tax cut enacted in 2003, during the President's first term in office. At the moment, the United States economy for the first quarter of 2006 was a robust 5.3% while that of Europe has struggled to reach 1%. Perhaps it is not a coincidence that average tax rates in the United States are 30% compared to 50% in Europe.

CAPITAL GAINS: The 15% rate for dividends and long-term capital gains has been extended for an additional two years. It will now expire in 2010 rather than 2008. Left unchanged is the 5% rate on most long-term gains that applies to individuals in the 10% and 15% federal income tax brackets.

Planning Note: The 5% rate will continue through 2007 and then drop to 0% for 2008 through 2010. That window of zero capital gains for those tax brackets sets up opportunities for advance planning. Those are the years one needs to be in those brackets and to liquidate certain appreciated holdings.

ALTERNATIVE MINIMUM TAX: TIPRA has provided another one-year extension to alleviate the impact of the AMT on middle-income taxpayers increases the exemption. For married couples filing joint returns, the exemption goes from $58,000 in 2005 to $62,550 for 2006. This change has been referred to as a one-year "band-aid."

KIDDIE TAX EXPANDED: The tax on unearned income of minors previously applied to dependent children under age 14, i.e., children who did not turn 14 by the end of the year. Under TIPRA, the new age limit is 18. Taxes kick in for unearned income in excess of $1,700. The new rules apply retroactively to the entire 2006 tax year.

ROTH IRA CONVERSION: Rules will be relaxed, allowing higher income taxpayers to convert regular IRAs to Roth IRAs in 2010…unless rules are modified before then.

Estate Tax Repeal Updates

Conspicuously absent from TIPRA was any mention of the estate tax. Efforts to make the repeal of the tax permanent stalled last September in the wake of hurricane Katrina. Since then, the President's approval ratings dropped, forecasts arrived for a slower economy, and the housing market passed its peak. It does not help matters that projections show the nation's annual and long-time budget deficits reaching critical proportions by 2010.

Those are all variables that support a reinstated federal estate tax of some kind. It doesn't prove that the estate tax repeal won't become permanent, but it certainly supports that conclusion.

Note, however, that dozens of proposals continue to be offered in Congress. These fall into two categories-laws that would make the repeal of the federal estate tax permanent, and laws that would preserve the estate tax with a higher exemption amount and/or lower tax rates. Since the current exemption is $2 million and the current top estate tax rate is 46%, any compromise would be somewhere between those thresholds and total repeal.

Limited Partnerships

An implied agreement caused a limited partnership to be included in the estate of the decedent and resulted an assessment of a $1.1-million estate tax deficiency. Estate of Edna Korby et al. v. Commissioner T.C. Memo. 2005-102.

Charitable Giving

About 100 major charitable organizations have now joined together to support tax reforms designed to encourage charitable giving along the same lines as the CARE Act and the Charitable Giving Act in the 108th Congress.

The joint letter to congressional leaders states, "The reforms, as amended by the staff of the Senate Finance Committee and Joint Committee on Taxation, will strengthen the work of our sector by deterring and punishing abuses by individuals who exploit charitable organizations for their personal gain. * * * Moreover, the proposed reforms strike the right balance between legitimate government oversight and protecting the independence that charitable organizations need to remain innovative and effective."

Signatories include the AARP, American Cancer Society, American Heart Association, Girl Scouts of the USA, Habitat for Humanity International, Independent Sector, Land Trust Alliance, March of Dimes, The National 4-H Council, and the Salvation Army. Note: Senate Bill 2688 was recently introduced. This legislation would encourage charitable giving by private donors by allowing personal philanthropy accounts to be set up.

Use of IRA for Charitable Bequest

What are the tax consequences when an IRA is used to partially satisfy a charitable bequest? In, Letter Ruling 200617020, the Service determined that such an assignment to a residuary beneficiary which was a charity was not a transfer under section 691(a)(2), and income in respect of a decedent in the IRA would only be included in gross income by the charity.

Generation-Skipping Transfer Tax

Does the replacement of fiduciaries cause a trust to lose its GST tax-exempt status or cause a taxable gift? No, ruled the IRS in Letter Ruling 200620021. A proposed resignation of advisors would result in the appointment of successor advisors to a trust.

Retirement Plan Distributions

A taxpayer had reached age 70.5 prior to his death. During his lifetime, he had established a trust that was the beneficiary of his IRA. A sub-trust named decedent's two daughters as beneficiaries. Regarding the sub-trust, the IRS has ruled that decedent had created a qualified see-through trust under section 401(a)(9). Minimum required distributions could be based on the life expectancy of the decedent's eldest daughter. Letter Ruling 200620026.

Immigration Reform

An immigration reform bill focused on border security and citizenship also has tax-oriented provisions including the payment of all back taxes. The version of the bill passed by the Senate on May 25, 2006, included amendments that restricted the ability of aliens to use earned income tax credits, required payment of all back taxes (and not just three of the past five years), and would bar aliens paying back taxes from receiving any refunds.

The latter provision was criticized as a double standard by Senator John McCain, R-Ariz.: "What's next, we're going to say legalized workers have to ride in the back of the bus?"

Expatriation

The House of Lords has decided that persons from outside the United Kingdom who make sponsorship revenues based on their activities within the United Kingdom are subject to taxation-even if the sponsors have no presence in the United Kingdom.

This was $51,000 of bad news for tennis player Andre Agassi, who was the subject of the appeal, but the ruling also affects other foreign athletes and performers and, had it gone the other way, would have affected other celebrities and resulted in tax refunds of 500 million pounds. Agassi had received income from Nike, Inc., and Head Sports AG, which do not have a U.K. tax presence.

Intentional Expatriation

Should an expatriate be presumed to have a principal purpose of tax avoidance under section 877(a)(2)? No, ruled the IRS in Letter Ruling 200547001. In that scenario, the taxpayer was born in Country C, surrendered his green card, and will again be subject to Country C's tax laws on his worldwide income.

Under section 877, a citizen who loses U.S. citizenship or a U.S. long-term resident who ceases to be taxed as a lawful permanent resident (individuals who "expatriate") within the 10-year period immediately preceding the close of the taxable year will be subject to the special rules of section 877(d) for such taxable year, unless such loss did not have for one of its principal purposes the avoidance of U.S. taxes.

Such a tax avoidance purpose is presumed if the individual's net worth on the date of expatriation exceeds certain thresholds for income, gift, and estate tax purposes under under sections 877(a)(2), 2107(a)(2)(A), and 2501(a)(3)(B), respectively.

However, under Notice 98-34, a former long-term resident whose net worth or average tax liability exceeds the applicable thresholds will not be presumed to have a principal purpose of tax avoidance if that former resident is described within certain categories and submits a complete and good-faith request for a ruling as to whether such loss had for one of its principal purposes the avoidance of U.S. taxes.

However, under Notice 98-34, a former long-term resident whose net worth or average tax liability exceeds the applicable thresholds will not be presumed to have a principal purpose of tax avoidance if that former resident is described within certain categories and submits a complete and good-faith request for a ruling as to whether such loss had for one of its principal purposes the avoidance of U.S. taxes.

Here, because the taxpayer complied, the IRS agreed not to presume a tax avoidance motive. However, without sufficient information provided, the IRS also did not establish conclusively that the motive was NOT tax avoidance either.

Extension Granted for QTIP Election

An estate was granted an extension to make an election under section 2056(b)(7) regarding qualified terminable interest property (QTIP). In, Letter Ruling 200618018, the IRS approved the extension based on sections 301.9100-1 and -3 of the Procedure and Administration Regulations.

Section 301.9100-1(c) provides that the Commissioner has discretion to grant a reasonable extension of time up to six months (unless the taxpayer is abroad). Section 301.9100-3(b)(1)(ii) provides that a taxpayer is deemed to have acted reasonably and in good faith if the taxpayer failed to make the election because of intervening events beyond the taxpayer's control.

New Guidance on QTIP Elections

The IRS has released new Revenue Ruling 2006-26 pertaining to QTIP elections when a marital trust is the beneficiary of a decedent's IRA.

Catherine Hughes, an attorney with the Treasury's Office of Tax Policy, provided an overview of the new Revenue Ruling. The ruling focuses on the definition of income in three types of states: those which have adopted laws authorizing adjustments and certain provisions of section 409(c) and (d) of the Uniform Principal and Income Act (UPIA), those states with a unitrust definition of income, and those states with a traditional definition of income.

The guidance from the Office of Tax Policy indicates that the spouse may compel IRA withdrawals of the greater of income or required minimum distributions. In each case, income is computed by looking at the trust without regard to the payment from the IRA to the trust as if the IRA and the trust were "two separate buckets."

The Revenue Ruling considers whether a surviving spouse is considered to have a qualifying income interest for life in the IRA (or qualified retirement plan) and in the trust for purposes of an election to treat both the IRA and the trust as qualified terminable interest property (QTIP) under section 2056(b)(7) of the Internal Revenue Code.

In a state adopting section 409(c) of the UPIA, treating 10% of distributions as income does not satisfy marital deduction requirements. Such a trust can qualify if the surviving spouse has the power to force the trustee to demand an adjusted distribution based on total returns. A straight-up 4% unitrust approach as well as a traditional income approach does qualify for the marital deduction.

Valuation of Closely Held Business

With numerous valuation approaches and variables, the valuation of a closely held business remains a matter of both art and science.

A recent noteworthy case held that an accounting firm's valuation established a fair market value for gifts of company stock. In, Huber v. Commissioner; T.C. Memo. 2006-96, the Tax Court noted that the company stock was not publicly traded. The company generated $500 million of annual sales and had 250 shareholders.

The Court noted that the company, though private, emulated the communication level of publicly held companies. There is no public market for shares, but shares can be transferred or redeemed under a set of bylaws, such as 14 redemptions over a five-year period. Those shareholder transactions were evidence that the valuation was being applied in an arm's-length setting that established a market price. Petitioners valued their gifts on the basis of prices used for shareholder stock transactions.

Probate Jurisdiction

In a decision on May 1, 2006, the Supreme Court sided with celebrity and former Playboy model Anna Nicole Smith in the case of Marshall v. Marshall. However, the case focuses on the issue of the probate exception to federal jurisdiction, a judicially created doctrine that the Judiciary Act of 1789 does not confer federal equity jurisdiction for probate matters.

Ms. Smith had raised a probate-related issue of tortious interference, claiming that Texas oilman J. Howard Marshall II had authorized a gift to her which Marshall's son interfered with. The Supreme Court has now reversed the 9th Circuit Court of Appeals regarding the probate exception. The case is remanded.