The Skip Tax - Part Two

 

How does one work with the skip?

In my experience, the skip is usually the realm of the tax attorneys, although that is not to say the tax CPA does not have a role. The reason is that most skips involve trusts, and trusts are legal documents. CPAs cannot create legal documents. However, let that trust age a few decades, and it is possible that the next set of eyes to notice a technical termination or taxable distribution will be the CPA.

Let’s pause for a moment and talk about the annual exclusion and lifetime exemption.

The gift tax has an annual exclusion of $18,000 per donee per year. There is also a (combined gift and estate tax) lifetime exemption of $13.6 million per person. If you gift more than $18 grand to someone, you start carving into that $13.6 million lifetime exemption.

The skip tax has the same exclusion and exemption limits as the gift tax.

The problem is that a gift and a skip may not happen at the same time.

Let’s take two examples.

(1)  A direct skip

That is the proverbial gift to the grandchild. Let’s say that it well over $18 grand, so you must file a return with the IRS.

You gift her a $100 grand.

The gift is complete, so you file Form 709 (the gift tax return) with your individual tax return next year.

The transfer immediately dropped at least two generations, so the skip is complete. You complete the additional sections in Form 709 relating to skips. You claim the annual exclusion of $18 grand, and you apply some of the $13.6 million exemption to cover the remaining $82 grand.

Done. Directs skips are easy.

(2)  An indirect skip

Indirects are another way of saying trusts.

Remember we discussed that there is a scenario (the taxable termination) where the trust itself is responsible for the skip tax. However, there is no skip tax until the exemption is exhausted. The skip may not occur for years, even decades, down the road. How is one to know if any exemption remains?

Enter something called the “inclusion ratio.”

Let’s use an example.

(1)  You fund a trust with $16 million, and you have $4 million of (skip) lifetime exemption remaining. 

(2)  The skip calculates a ratio for this trust.

4 divided by 16 is 25%.

Seems to me that you have inoculated 25% of that trust against GST tax.

(3)  Let’s calculate another ratio.

1 minus 25% is 75%.

This is called the inclusion ratio.

It tells you how much of that trust will be exposed to the skip tax someday.

(4)  Calculate the tax. 

Let’s say that the there is a taxable termination when the trust is worth $20 million.

$20 million times 75% equals $15 million.

$15 million is exposed to the skip tax.

Let’s say the skip tax rate is 40% for the year the taxable termination occurs.

The skip tax is $6 million.

That trust is permanently tainted by that inclusion ratio.

Now, in practice this is unlikely to happen. The attorney or CPA would instead create two trusts: one for $4 million and another for $11 million. The $4 million trust would be allocated the entire remaining $4 million exemption. The ratio for this trust would be as follows:

                       4 divided by 4 equals 1

                       1 minus 1 equals -0-.

                       The inclusion ratio is zero.

                       This trust will never have skip tax.

What about the second trust with $11 million?

You have no remaining lifetime exemption.

The second trust will have an inclusion ratio of one.

There will be skip tax on 100% of something in the future.

Expensive?

Yep, but what are you going to do?

In practice, these are sometimes called Exempt and Nonexempt trusts, for the obvious reason.

Reflecting, you will see that a direct skip does not have an equivalent to the “inclusion ratio.” The direct skip is easier to work with.

A significant issue involved with allocating is missing the issue and not allocating at all.

Does it happen?

Yes, and a lot. In fact, it happens often enough that the Code has default allocations, so that one does not automatically wind up having trusts with inclusion ratios of one.

But the default may not be what you intended. Say you have $5 million in lifetime exemption remaining. You simultaneously create two trusts, each for $5 million. What is that default going to do? Will it allocate the $5 million across both trusts, meaning that both trusts have an inclusion ratio of 50%? That is probably not what you intended. It is much more likely that you intend to allocate to only one trust, giving it an inclusion ratio of zero.

There is another potential problem.

The default does not allocate until it sees a “GST trust.”

What is a GST trust?

It is a trust that can have a skip with respect to the transferor unless one or more of six exceptions apply.

OK, exceptions like what?

Exception #1 – “25/46” exception. The trust instrument provides that more than twenty-five percent (25%) of the trust principal must be distributed (or may be withdrawn) by one or more persons who are non-skip persons before that individual reaches age forty-six (46) (or by a date that will occur or under other circumstances that are likely to occur before that individual reaches age forty-six (46)) (IRC §2632(c)(3)(B)(i)).”

Here is another:

Exception #2 – “25/10” exception. The trust instrument provides that more than twenty-five percent (25%) of the trust principal must be distributed (or may be withdrawn) by one or more persons who are non-skip persons and who are living on the date of the death of another person identified in the instrument who is more than ten (10) years older than such individual (IRC §2632(c)(3)(B)(ii)).”

Folks, this is hard terrain to navigate. Get it wrong and the Code does not automatically allocate any exemption until … well, who knows when?

Fortunately, the Code does allow you to override the default and hard allocate the exemption. You must remember to do so, of course.

There is another potential problem, and this one is abstruse.

One must be the “transferor” to allocate the exemption.

So what, you say? It makes sense that my neighbor cannot allocate my exemption.

There are ways in trust planning to change the “transferor.”

You want an example?

You set up a dynasty trust for your child and grandchildren. You give your child a testamentary general power of appointment over trust assets.

A general power of appointment means that the child can redirect the assets to anyone he/she wishes.

Here is a question: who is the ultimate transferor of trust assets – you or your child?

It is your child, as he/she has last control.

You create and fund the trust. You file a gift tax return. You hard allocate the skip exemption. You are feeling pretty good about your estate planning.

But you have allocated skip exemption to a trust for which you are not the “transferor.” Your child is the transferor. The allocation fizzles.

Can you imagine being the attorney, CPA, or trustee decades later when your child dies and discovering this? That is a tough day at the office.

I will add one more comment about working in this area: you would be surprised how legal documents and tax returns disappear over the years. People move. Documents are misplaced or inadvertently thrown out. The attorney has long since retired. The law firm itself may no longer exist or has been acquired by another firm. There is a good chance that your present attorney or CPA has no idea how – or if – anything was allocated many years ago. Granted, that is not a concern for average folks who will never approach the $13.6 million threshold for the skip, but it could be a valid concern for someone who hires the attorney or CPA in the first place. Or if Congress dramatically lowers the exemption amount in their relentless chase for the last quarter or dollar rolling free in the economy.

With that, let’s conclude our talk about skipping.

 

Spotting The Skip Tax - Part One

I was reviewing something this week we may not have discussed before. Mind you, there is a reason we haven’t: it is a high-rent problem, not easy to understand or likely to ever apply to us normals. If you work or advise in this area (as attorney, CPA, trustee or so on), however, it can wreck you if you miss it.

Let’s talk a bit about the generation skipping tax. It sometimes abbreviated “GST,” and I generally refer to it as the “skip.”

Why does this thing even exist?

It has to do with gift and estate taxes.

You know the gift tax: you are allowed to make annual gifts up to a certain amount per donee before having to report the gifts to the IRS. Even then, you are spotted an allowance for lifetime gifts. While there may be paperwork, you do not actually pay gift tax until you exhaust that lifetime allowance.

You know the estate tax: die with enough assets and you may have a death tax. Once again, there is an allowance, and no tax is due until you exceed that allowance. The 2024 lifetime exemption is $13.6 million per person, so you can be wealthy and still avoid this tax.

As I said, we are discussing high-end tax problems.

Then there is the third in this group of taxes: the generation skipping tax. It is there as a backstop. Without it, gift and estate taxes would lose a significant amount of their bite.

Why Does the Skip Exist?

Let go through an example.

When does the estate tax apply (setting aside that super-high lifetime exemption for this discussion)?

It applies when (a) someone with a certain level of assets (b) dies.

How would a planner work with this?

Here is an idea: what if one transfers assets to something that itself cannot die? Without a second death, the estate tax is not triggered again.

What cannot die, without going all Lovecraftian?

How about a corporation?

Or – more likely – a trust?

When Does The Skip Apply?

It applies when someone transfers assets to a skip person.

Let’s keep this understandable and not go through every exception or exception to the exception.

A skip person is someone two or more generations below the transferor.

          EXAMPLE:

·       A transfer to my kid would not be a skip.

·       A transfer to my grandchild would be a skip.

What Constitutes a Transfer?

There are two main types:

·       I simply transfer assets to my grandchild. Perhaps she finishes her medical degree, and I buy and deed her first house.

·       I transfer assets through a trust.

The first type is called a direct skip. Those are relatively easy to spot, trigger the skip immediately and require a tax filing.

You already know the form on which the skip is reported: the gift tax return itself (Form 709). The form has additional sections when the skip tax applies.

          EXAMPLE:

·       I give my son a hundred grand. This is over the annual dollar limit, so a gift tax return is required. My son is not a skip person, so I need not concern myself with the skip tax sections of Form 709.

·       I give my grandson a hundred grand. This is over the annual limit, so a gift tax return is required. My grandson is also a skip person, so I need to complete the skip tax sections of Form 709.

What Is the Second Type of Transfer?

Use a trust.

Here is an example:

• Create a trust in a state that has relaxed its rule against perpetuities (RAP).

a.     This rule comes from English common law, and its intent was to limit how long a person can control the ownership and transfer of property after his/her death.

• Fund the trust at the settlor’s death.

a.     If that someone is Jeff Bezos or Elon Musk, there could be some serious money involved here.

•   The settlor’s children receive distributions from the trust. When they die, the settlor’s grandchildren take their place.

• When the grandchildren die, the great grandchildren take their place, and so on.

What we described above BTW is a dynasty trust.

The key here is - before the skip tax entered the Code in the 1970s - the then-existing gift and estate tax rules would NOT pull that trust back onto anyone’s estate return for another round of taxation.

Congress was not amused.

And you can see why a skip is defined as two generations below the transferor. Congress wanted a bite into that apple every generation, if possible.

How Does Skipping Through A Trust Work?

There are two main ways: 

EXAMPLE ONE: Say the trust has a mix of skip and nonskip beneficiaries, say children (nonskip) and grandchildren (skip). The IRS chills, because the trust might yet be includable in the taxable estate of a nonskip person. Say the last nonskip person dies (leaving only skips as beneficiaries) AND nothing is includable in an estate return somewhere. Yeah, no: this will trigger the skip tax. To make things confusing, the skip refers to this as a “termination,” even though nothing has actually terminated.   

EXAMPLE TWO: The trust again has a mix of skip and nonskip beneficiaries. This just like the preceding, except we will not kill-off the nonskip beneficiary. Instead, the trust simply distributes to a skip or skips (say the grandchildren or great-grandchildren). This triggers the skip tax and is easier to identify and understand.

If Skipping Through A Trust, When Is the Tax Due?

Look at Example One above. This could be years – or decades – after the creation of the trust.  

The trustee is supposed to recognize that there has been a skip “termination” of the trust. The trustee would file the (Form 709) tax return, and the trust would pay the skip tax.

And – yes – in the real world it is a problem. What if the trustee (or attorney or CPA) misses the termination as a taxable event?

Malpractice, that’s what. An insurance company will probably be involved.

What About Example Two?

This is a backstop to the first type of transfer. In the second type there is still a nonskip beneficiary, meaning that the trust has not “terminated” for skip purposes. The trust distributes, but the distribution goes to a skip.

Say the trust distributes a 1965 Shelby Mustang GT350 R.

First, nice.

Second, the skip tax is paid by the beneficiary receiving the distribution. The trust does not pay this one.

Third, the trustee may want to warn the beneficiary that he/she owes skip tax on a car worth at least $3.5 million.

Fourth, realistically the trust is going to pay, whether upfront or as a reimbursement to the beneficiary. The tax paid is itself subject to the skip tax if it comes out of the trust.

How Much Is the Skip Tax?

Right now, it is 40 percent.

It changes with changes to the gift and estate tax rates.

That 1965 Shelby GT 350R comes with a skip tax of at least $1.4 million. It takes a lot of green to ride mean.

How Do You Plan for This Tax?

The skip is very much a function of using trusts in estate planning.

Trust taxation can be oddball on its own.

Introduce skip tax and you can go near hallucinatory.

This is a good spot for us to break.

We will return next post to continue our skip talk.

The Consistent Basis Rule

 

I was talking to two brothers last week who are in a partnership with their two sisters. The partnership in turn owns undeveloped land, which it sold last year. The topic of the call was the partnership’s basis in the land, considering that land ownership had been divided in two and the partnership sold the property after the death of the two original owners. Oh, and there was a trust in there, just to add flavor to the stew.

Let’s talk about an issue concerning the basis of property inherited from an estate.

Normally basis means the same as cost, but not always. Say for example that you purchased a cabin in western North Carolina 25 years ago. You paid $250 grand for it. You have made no significant improvements to the cabin. At this moment your basis is your cost, which is $250 grand.

Let’s add something: you die. The cabin is worth $750 grand.

The basis in the cabin resets to $750 grand. That means – if your beneficiaries sell it right away – there should be no – or minimal – gain or loss from the sale. This is a case where basis does not equal cost, and practitioners refer to it as the “mark to market,” or just “mark” rule, for inherited assets.

There are, by the way, some assets that do not mark. A key one is retirement assets, such as 401(k)s and IRAs.

A possible first mark for the siblings’ land was in the 1980s.

A possible second mark was in the aughts.

And since the property was divided in half, a given half might not gone through both marks.

There is something in estate tax called the estate tax exemption. This is a threshold, and only decedents’ estates above that threshold are subject to tax. The threshold for 2024 is $13.6 million per person and is twice that if one is married.

That amount is scheduled to come down in 2026 unless Congress changes the law. I figure that the new amount will be about $7 million. And twice that, of course, if one is married.

COMMENT: I am a tax CPA, but I am not losing sleep over personal estate taxes.

However, the exemption thresholds have not always been so high. Here are selected thresholds early in my career: 

		Estate Tax
Year		Exclusion
1986		500,000
1987- 1997		600,000
1998		625,000

I would argue that those levels were ridiculously low, as just about anyone who was savings-minded could have been exposed to the estate tax. That is – to me, at least – absurd on its face.

One of our possible marks was in the 1980s, meaning that we could be dealing with that $500,000 or $600,000 estate threshold.

So what?

Look at the following gibberish from the tax Code. It is a bit obscure, even for tax practitioners.

Prop Reg 1.1014-10(c):

               (3) After-discovered or omitted property.

(i)  Return under section 6018 filed. In the event property described in paragraph (b)(1) of this section is discovered after the estate tax return under section 6018 has been filed or otherwise is omitted from that return (after-discovered or omitted property), the final value of that property is determined under section (c)(3)(i)(A) or (B) of this section.

(A) Reporting prior to expiration of period of limitation on assessment. The final value of the after-discovered or omitted property is determined in accordance with paragraph (c)(1) or (2) of this section if the executor, prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, files with the IRS an initial or supplemental estate tax return under section 6018 reporting the property.

(B) No reporting prior to expiration of period of limitation on assessment. If the executor does not report the after-discovered or omitted property on an initial or supplemental Federal estate tax return filed prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, the final value of that unreported property is zero. See Example 3 of paragraph (e) of this section.

(ii) No return under section 6018 filed. If no return described in section 6018 has been filed, and if the inclusion in the decedent's gross estate of the after-discovered or omitted property would have generated or increased the estate's tax liability under chapter 11, the final value, for purposes of section 1014(f), of all property described in paragraph (b) of this section is zero until the final value is determined under paragraph (c)(1) or (2) of this section. Specifically, if the executor files a return pursuant to section 6018(a) or (b) that includes this property or the IRS determines a value for the property, the final value of all property described in paragraph (b) of this section includible in the gross estate then is determined under paragraph (c)(1) or (2) of this section.

This word spill is referred to as the consistent basis rule.

An easy example is leaving an asset (intentionally or not) off the estate tax return.

Now there is a binary question:

Would have including the asset in the estate have caused – or increased – the estate tax?

If No, then no harm, no foul.

If Yes, then the rule starts to hurt.

Let’s remain with an easy example: you were already above the estate exemption threshold, so every additional dollar would have been subject to estate tax.

What is your basis as a beneficiary in that inherited property?

Zero. It would be zero. There is no mark as the asset was not reported on an estate tax return otherwise required to be filed.

If you are in an estate tax situation, the consistent basis rule makes clear the importance of identifying and reporting all assets of your estate. This becomes even more important when your estate is not yet at – but is approaching – the level where a return is required.

At $13.6 million per person, that situation is not going to affect many CPAs.

When the law changes again in a couple of years, it may affect some, but again not too many, CPAs.

But what if Congress returns the estate exemption to something ridiculous – perhaps levels like we saw in the 80s and 90s?

Well, the consistent basis rule could start to bite.

What are the odds?

Well, this past week I was discussing the basis of real estate inherited in the 1980s.

What are the odds?

Inheriting A Tax Debt

 I am looking at a decision coming from a New Jersey District Court, and it has to do with personal liability for estate taxes.

Clearly this is an unwanted result. How did it happen?

To set up the story, we are looking at two estates.

The first estate was the Estate of Lorraine Kelly. She died on December 30, 2003. The executors, one of whom was her brother, filed an estate tax return in September, 2004. The estate was worth over $1.7 and owed $214 grand in tax. Her brother was the sole beneficiary.

OK.

The estate got audited. The estate was adjusted to $2.6 million and the tax increased to $662 grand.

COMMENT: It does not necessarily mean anything that an estate was adjusted. Sometimes there are things in an estate that are flat-out hard to value or – more likely – can have a range of values. I will give you an example: what is the likeness of Prince (the musician) worth? Reasonable people can disagree on that number all day long.

The estate owed the IRS an additional $448 grand.

The brother negotiated a payment plan. He made payments to the IRS, but he also transferred estate assets to himself and his daughter, using the money to capitalize a business and acquire properties. He continued doing so until no estate assets were left. The estate however still owed the IRS.

OK, this is not fatal. He had to keep making those payments, though. He might want to google “transferee tax liability” before getting too froggy with the IRS.

He instructed his daughter to continue those payments in case something happened to him. There must have been some forewarning, as he in fact passed away.

His estate was worth over a million dollars. It went to his daughter.

The daughter he talked to about continuing the payments to the IRS.

Guess what she did.

Yep, she stopped making payments to the IRS.

She had run out of money. Where did the money go?

Who knows.

COMMENT: Folks, often tax law is not some abstruse, near-impenetrable fog of tax spew and doctrine descending from Mount Olympus. Sometimes it is about stupid stuff – or stupid behavior.

Now there was some technical stuff in this case, as years had passed and the IRS only has so much time to collect. That said, there are taxpayer actions that add to the time the IRS has to collect. That time is referred to as the statute of limitations, and there are two limitations periods, not one:

·      The IRS generally has three years to look at and adjust a tax return.

·      An adjustment is referred to as an assessment, and the IRS then has 10 years from the date of assessment to collect.

You can see that the collection period can get to 13 years in fairly routine situations.

What is an example of taxpayer behavior that can add time to the period?

Let’s say that you receive a tax due notice for an amount sufficient to pay-off the SEC states’ share of the national debt. You request a Collections hearing. The time required for that hearing will extend the time the IRS has to collect. It is fair, as the IRS is not supposed to hound you while you wait for that hearing.

Back to our story.

Mrs. Kelley died and bequeathed to her brother.

Her brother later died and bequeathed to his daughter

Does that tax liability follow all the way to the daughter?

There is a case out there called U.S. v Tyler, and it has to do with fiduciary liability. A fiduciary is a party acting on behalf of another, putting that other person’s interests ahead of their own interests. An executor is a party acting on behalf of a deceased. An executor’s liability therefore is a fiduciary liability. Tyler says that liability will follow the fiduciary like a bad case of athlete’s foot if:

(1)  The fiduciary distributed assets of the estate;

(2)  The distribution resulted in an insolvent estate; and

(3)  The distribution took place AFTER the fiduciary had actual or constructive knowledge of the unpaid taxes.

There is no question that the brother met the Tyler standard, as he was a co-executor for his sister’s estate and negotiated the payment plan with the IRS.

What about his daughter, though?

More specifically, that third test.

Did the daughter know – and can it be proven that she knew?

Here’s how: she filed an inheritance tax return showing the IRS debt as a liability against her father’s estate.

She knew.

She owed.

Our case this time was U.S. v Estate of Kelley, 126 AFTR 2d 2020-6605, 10/22/2020.

You Inherit. Can You Owe Estate Tax?

I came across an estate tax lien case the other day.

It has become unlikely that one will owe estate tax, as the lifetime exclusion has now gone over $11 million. Still, it can and does happen.

The federal estate tax is an odd beast. It is a combination of assets owned or controlled at death, increased by an addback for reportable lifetime gifts. This system is called a “unified” tax, and the intent is to not avoid the estate tax by giving property away to family over the course of a lifetime. In truth, the addback is necessary, as tax planners (including me) would drive an 18-wheeler through the estate tax if the lifetime-gift addback did not exist.

There is a potential trap if the estate tax kicks-in.

Let me give you a scenario, very loosely based on the case.  

Mr Arshem was successful. He created and funded a family limited partnership with real estate, stock and securities. He began a multi-year gifting sequence to his children, each time claiming a generous discount for lack of control and marketability. He had cumulatively gifted away $5 million in this manner.

He passed away early in 2019. He died with an estate of $6 million.

On first pass, $6 million plus $5 million equals $11 million. He is just under the threshold, so he should not have an estate tax issue – right?

Not so fast.

The IRS audits one or more of those gift tax returns. They argue that the discounts were too generous, and the reportable gifts were actually $8 million. The estate disagrees; they go to Court; the estate loses.

Now we have $8 million plus $5 million for $13 million.

There is an estate tax filing requirement.

And estate tax due.

Let’s say that the estate had been probated and closed. There no estate assets remaining.

Who pays the tax?

Look over this little beauty:

§ 6324 Special liens for estate and gift taxes.

(a)  Liens for estate tax.

Except as otherwise provided in subsection (c) -

(1)  Upon gross estate.

Unless the estate tax imposed by chapter 11 is sooner paid in full, or becomes unenforceable by reason of lapse of time, it shall be a lien upon the gross estate of the decedent for 10 years from the date of death, except that such part of the gross estate as is used for the payment of charges against the estate and expenses of its administration, allowed by any court having jurisdiction thereof, shall be divested of such lien.

(2)  Liability of transferees and others.

If the estate tax imposed by chapter 11 is not paid when due, then the spouse, transferee, trustee (except the trustee of an employees' trust which meets the requirements of section 401(a) ), surviving tenant, person in possession of the property by reason of the exercise, nonexercise, or release of a power of appointment, or beneficiary, who receives, or has on the date of the decedent's death, property included in the gross estate under sections 2034 to 2042 , inclusive, to the extent of the value, at the time of the decedent's death, of such property, shall be personally liable for such tax.

It is not the easiest of reading.

What (a)(2) means is that the IRS can after the transferees – the children of Mr Arshem in our example. There is also a sneaky twist. Income tax liens have to be recorded; estate tax liens do not. They are referred to as “silent” liens and can create unexpected – and unpleasant – surprises.  You cannot go to the courthouse and research if one exists.

What if Arshem’s children received his assets and thereafter sold them? What happens to the lien?

The children are “transferees.” They are personally liable for the estate tax.

COMMENT: There are procedures to possibly mitigate this consequence, but we will pass on their discussion in this post.

The case is U.S. v Ringling. The moral of the story is – if the estate is large enough to draw the wrath of the federal estate tax – please consult an experienced professional. Think of it as insurance.

Spouses Owning Businesses, Divorce And Taxes

A fundamental concept in taxation is that an “accession to wealth” represents taxable income, unless the Code says otherwise.

There are limits on this, of course, otherwise you would be immediately taxed when your mutual fund or house went up in value. The Code will (usually) want to see a triggering event, such as a sale, exchange or disposition by other means. You don’t pay tax on your stock gain, for example, until you sell the stock.

But the concept also creates problems. For example, consider the recent development of crowdfunding. You have an idea for the next great breakfast sandwich, and you reach out on the internet for money to get the idea going. You have accession to wealth, but is the money taxable to you? The tax consequence can get very murky very quickly. For example:

·        If you provide investors with breakfast sandwiches, there is an argument that you sold sandwiches.

·        If investors instead receive ownership (say shares of stock), we would sidestep that sale-of-sandwiches thing, but you might have an issue with securities laws.

·        If investors receive nothing, one could argue that the monies were a gift. The closer you get to detached generosity without expectation of economic gain, the better the argument.

Let's next consider accession to wealth in a divorce context. Here is Code Section 1041:

(a) General rule. No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)—

(1) a spouse, or

(2) a former spouse, but only if the transfer is incident to the divorce.

(c) Incident to divorce. For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer— 

(1) occurs within 1 year after the date on which the marriage ceases, or

(2) is related to the cessation of the marriage.

Believe it or not, the general definition of income could trigger when marital assets are divided upon divorce. That makes little sense, of course, so Section 1041 provides an escape clause.

Question: how much time do you have to separate the marital assets?

The first answer provided in (c)(1) is one year. It is immediately followed by (c)(2) which (appears to) expand the answer to any period as long as the asset transfer is related to the cessation of marriage. That is a bit open-ended, so the tax Regulations interpret (c)(2) as up to six years.

The Belots started a dance school in New Jersey in 1989. The wife was the dancer and creative force, while the husband attended to the business side. Eventually they had several dance studios, a corporation to manage them and a partnership to own the real estate. They did well. While owned 100% by the spouses, the husband and wife were not necessarily 50:50 owners in each entity.

They started divorce action in 2006,and adjusted their ownership in each entity to 50:50. The divorce was finalized in January, 2007.

There is a reason they got divorced. Tired of her ex-husband's participation, Ms. Belot bought-out his share in 2008 for $1,580,000.

Mr. Belot took the position that this was not taxable under Section 1041. The IRS took the opposite position and billed him almost $240,000 in tax and penalties.

Off to Tax Court they went.

The IRS argued that each and every transaction had to come under the umbrella of Section 1041. There was no question that the first transaction qualified, but the second transaction – cashing-out Mr. Belot entirely – did not because it represented an event arising after the divorce. The second settlement represented a business contingency and was not related to the divorce decree.

The IRS was following a hyper-technical interpretation of its Regulations.

The problem is that the Code does not say "pursuant to the divorce decree." It instead says "related to the cessation of marriage." The divorce decree is arguably the most vivid expression of such cessation, but it is not the only one. The Belots were clearly still dividing marital assets owned at the time of divorce.

The Court decided in favor of the Belots.

Why did the IRS even pursue this?

The IRS was enforcing the everything-is-taxable position, unless excluded by the Code somewhere. 

Vanguard's Whistleblower Tax Case

Can the IRS go after you for not making enough profit?

There is a whistleblower case against Vanguard, the mutual fund giant. Even though there is a tax angle, I had previously sidestepped the matter. Surely it must involve some mind-numbing arcana, and –anyway- why enable some ex-employee with a grudge? 

And then I saw a well-known University of Michigan tax professor supporting the tax issues in the whistleblower case.

Now I had to look into the matter.

My first reaction is that this case represents tax law gone wild. It happens. Sometimes tax law is like the person looking down at his/her cell phone and running into you in the hall. They are too self-absorbed to look up and get a clue.

What sets this up is the management company: Vanguard Group, Inc. (VGI). Take a look at other mutual fund companies and you will see that the management company is separately and independently owned from the mutual funds themselves.  The management company provides investment, financial and other services, and in turn it receives fees from the mutual funds.  

The management company receives fees irrespective of whether the funds are doing well or poorly. In addition, the ownership of the management company is likely different from the ownership of the funds. You can invest in the management company for T. Rowe Price (TROW), for example, even if you do not own any T. Rowe Price funds.

Vanguard however has a unique structure. Its management company – VGI – is owned by the funds themselves. Why? It goes back to Jack Bogle and the founding of Vanguard: he believed there was an inherent conflict of interest when a mutual fund is advised by a manager not motivated by the same financial interests as fund shareholders.  Since the management company and the funds are essentially one-and-the-same, there is little motivation for the management company to maximize its fees. This in turn has allowed Vanguard funds to provide some of the lowest internal costs in the industry

My first thought is that every mutual fund family should be run this way.

VGI and all the funds are C corporations under the tax Code. The funds themselves are more specialized and are “registered investment companies” under Subchapter M. Because the funds own VGI, the “transfer pricing” rules of IRC Section 482 apply.

COMMENT: The intent of Section 482 is to limit the ability of related companies to manipulate the prices they charge each other. Generally speaking, this Code section has not been an issue for practitioners like me, as we primarily serve entrepreneurs and their closely-held companies. This market tends to be heavily domestic and unlikely to include software development, patent or other activity which can easily be moved overseas and trigger transfer pricing concerns. 

Practitioners are however starting to see states pursue transfer pricing issues. Take Iowa, with its 12% corporate tax rate as an example. Let’s presume a multistate client with significant Iowa operations. Be assured that I would be looking to move profitability from Iowa to a lower taxed state. From Iowa’s perspective, this would be a transfer pricing issue. From my perspective it is common sense.

Section 482 wants to be sure that related entities are charging arm’s-length prices to each other. There are selected exceptions for less-than-arm’s-length prices, such as for providing routine, ministerial and administrative services. I suppose one could argue that the maintenance and preparation of investor statements might fit under this exception, but it is doubtful that the provision of investment advisory services would.  Those services involve highly skilled money managers, and are arguably far from routine and ministerial.

So VGI must arguably show a profit, at least for its advisory services. How much profit?

Now starts the nerds running into you in the hall while looking down at their cell phones.

We have to look at what other fund families are doing: Janus, Fidelity, Eaton Vance and so on. We know that Vanguard is unique, so we can anticipate that their management fees are going to be higher, potentially much higher. An analysis of Morningstar data indicates as much as 0.5 percent higher. It doesn’t sound like much, until you consider that Vanguard has approximately $3 trillion under management. Multiply any non-zero number by $3 trillion and you are talking real money.

It is an interesting argument, although it also appears that the IRS was not considering Vanguard’s fact pattern when it issued Regulations. Vanguard has been doing this for 40 years and the IRS has not concerned itself, so one could presume that there is a détente of sorts. Perhaps the IRS realized how absurd it would be to force the management company to charge more to millions of Vanguard investors.

That might attract the attention of Congress, for example, which already is not the biggest fan of the IRS as currently administrated.

Not to mention that since the IRS issued the Regulations, the IRS can change the Regulations.

And all that presumes that we are correctly interpreting an arcane area of tax law.

The whistleblower is a previous tax attorney with Vanguard, and he argues that Vanguard has been underpaying its income taxes by not charging its fund investors enough.

Think about that for a moment. Who is the winner in this Alice-in-Wonderland scenario?

The whistleblower says that he brought his concerns to the attention of his superiors (presumably tax attorneys themselves), arguing that the tax structure was illegal. They disagreed with him. He persisted until he was fired.

He did however attract the attention of the SEC, IRS and state of New York.

I had previously dismissed the whistleblower argument as a fevered interpretation of the transfer pricing rules and the tantrum of an ex-employee bent on retribution.  I must now reevaluate after tax law Professor Reuven S. Avi-Yonah has argued in favor of this case.

I am however reminded of my own experience. There is a trust tax provision that entered the Code in 1986. In the aughts I had a client with that tax issue. The IRS had not issued Regulations, 20 years later. The IRS had informally disclosed its internal position, however, and it was (of course) contrary to what my client wanted. I in turn disagreed with the IRS and believed they would lose if the position were litigated. I advised the client that taking the position was a concurrent decision to litigate and should be addressed as such.

I became extremely unpopular with the client. Even my partner was stressed to defend me. I was basing professional tax advice on chewing gum and candy wrappers, as there was nothing else to go on.

And eventually someone litigated the issue. The case was decided in 2014, twenty eight years after the law was passed. The taxpayer won.

Who is to say that Vanguard’s situation isn’t similar?

What does this tax guy think?

I preface by saying that I respect Professor Avi-Yonah, but I am having a very difficult time accepting the whistleblower argument. Vanguard investors own the Vanguard funds, and the funds in turn own the management company. I may not teach law at the University of Michigan, but I can extrapolate that Vanguard investors own the management company – albeit indirectly – and should be able to charge themselves whatever they want, subject to customary business-purpose principles. Since tax avoidance is not a principal purpose, Section 482 should not be sticking its nose under the tent.

Do you wonder why the IRS would even care? Any income not reported by the management company would be reported by fund investors. The Treasury gets its pound of flesh - except to the extent that the funds belong to retirement plans. Retirement plans do not pay taxes. On the other hand, retirement plan beneficiaries pay taxes when the plan finally distributes.  Treasury is not out any money; it just has to wait. Oh well.

It speaks volumes that someone can parse through the tax Code and arrive at a different conclusion. If fault exists, it lies with the tax Code, not with Vanguard.

Then why bring a whistleblower case? The IRS will pay a whistleblower up to 30% of any recovery, and there are analyses that the Vanguard management company could be on the hook for approximately $30 billion in taxes. Color me cynical, but I suspect that is the real reason.