Out On A Limb

I met a new client recently.

He made me laugh.

Not to his face, though. That would be rude.

He was running me through a series of HSA/single member LLC/loan transactions.  And then the inevitable: will this get me in trouble with the IRS?

This is not as easy a question to answer as it used to be.

The IRS is experiencing a phenomenal brain drain, as its baby boomers are retiring left and right. They are replacing 25-or-more-years of tax experience with … well, let’s just say that they are not comparable. Add in the Congressional budget restrictions. Continue with the new-and-novel political presumption that every known societal problem can be addressed through the tax Code, and the IRS is having issues.

Will he get in trouble? Well, if he is unfortunate enough to be audited, he likely will face an examiner with fewer years of experience than the shoes I am wearing. His or her group manager is unlikely to be much better. This raises our risk profile, as they probably will not (a) understand and/or (b) care for our “novel” tax ideas. Now we go to Appeals. I have to draft the written appeal, with cites and arguments and precedents. It can be a hassle, and I won’t be cheap.

How much money is he saving by climbing-out on a far limb of the tax tree?

My point exactly. I am not a fan of taking nine-standard-deviations-from-the-mean positions on a tax return just to save $50. Folks, the Empire can strike back. I have seen it hit and hit hard.

There was a dentist in 2002 and 2003 that wanted to climb one of those high and far branches. There were several issues in the case, but the one that interests us is the vehicle deduction. It was a husband and wife team, with the husband being a dentist. She might have some argument for business use of the vehicle if she was the office manager, as perhaps she was going to the bank or post office, for example. Still, that is unlikely to amount to much. His argument was much more tentative. Was he visiting patients? Was he running to/from the dental lab(s)? What exactly would a dentist do that would rack up any significant business mileage?

Let’s climb up that tax tree. Let’s edge out on that limb. Let’s gaze into the verdant valley below.

Their argument?

Here is the first: He had applied veneers to his wife’s teeth, so whenever she went somewhere she was …

“… a walking, talking billboard for [the] dental office.”

Alrighty then. There is a journalism career in there for that depth of intellect.

How about a second?

Additionally, each vehicle had a license plate holder that displayed the name of the dental practice.”

Petitioners contend that even when the vehicles were being used for personal reasons they provided a valuable advertising service to the practice.”

These people are like giving a fish a bath.

You can anticipate how this turned out: the Court bounced the entire vehicle deduction, even the part that may have been legitimate.

Was it a novel argument? Yes .... It wasn’t a good one, though.

The case for the home players is Willock v Commissioner.

Ducking Taxes With A Dynasty Trust

Dynasty trust are back in the news. Dynasty trusts are the province of the ultrawealthy, and are not likely to impact you or me much.

However, allow one or two favorable turns of fate and you or I might find ourselves interested in such things. Let’s hope for the best.

What sets up the discussion is three main issues:

(1)  Estate taxes

(2)  Generation-skipping taxes

(3)  The rule against perpetuities

Estate taxes are also called death taxes and apply to your net worth (everything you own less everything you owe) at death. If you own too much, you owe estate tax – short and sweet. Granted, it is getting harder and harder too own too much. The threshold for 2017 is $5.49 million per person, or almost $11 million per married couple.

I would say that – if you have accumulated $11 million – you have done well.

The estate tax intends for every generation to pay tax.

Let’s say that you are worth $15 million. The estate tax will apply. Your assets go to your child. Let’s presume that the assets inherited bounce back to $15 million (remember: there were taxes at your death) and the exemption remains at $5.49 million. The estate tax presumes that your child will pay tax again, repeating a virtuous cycle.

Well, an advisor can break that cycle pretty quickly: have some of the assets go to the grandkids. That skips the estate tax on (at least some of) the assets upon your child’s death.

Congress figured this out too and introduced the generation-skipping tax (GST). Its purpose was straightforward: to tax the assets that skipped tax when your child died. Those assets would otherwise have “skipped” a generation of estate tax.

A favored and common way to transfer assets across multiple generations is through use of a trust. There are more varieties of trusts than there are flavors of  Baskin Robbins ice cream. We however are looking at one trust and one only: the shy and elusive dynasty trust, which has rarely been captured on camera.

Tax archeologists believe that the dynasty trust evolved in response to state liberalization of the rule against perpetuities. Trusts themselves are created under state law, and all 50 states used to prohibit a trust from existing more than 21 years after the death of the last beneficiary who was alive when the trust was created.

To rephrase: the law (1) looked at the beneficiaries born when the trust was created; (2) took the youngest beneficiary; (3) waited until his/her death; and (4) said “All right, boys and girls, you have 21 years to finish this”

The point is that the trust had to eventually wrap up its affairs. It could not be “perpetual.”

In that context, the estate tax – GST tax value meal worked relatively well in identifying and taxing transfers of intergeneration wealth. No matter how complex, trusts simply had to give up the ghost eventually.

However, several states have since either modified or abolished their rule against perpetuities (Alaska and Nevada come to mind). A trust created in one of these jurisdictions can last for … who knows how long.

This has tax implications.

Because the trust is not required to terminate, tax planners can more easily get around the estate and GST combo that worked well enough in an earlier, simpler era.

It is relatively easy to avoid the estate tax issue: the planner simply does not give the beneficiary so much authority that the trust would be pulled into the beneficiary’s estate at death. While a minefield, it is a relatively well-trod minefield.

The GST is a bit more complicated.

I now go where many tax nerds would refuse to go: to give a quick overview of how a dynasty trust and the GST interact. We are venturing to the Mordor of tax practice.

Here goes:

(1)  You have a GST exemption equal to your estate tax exemption. Therefore, if the estate exemption is $5.49 million, your GST exemption is the same amount.

(2)  Meaning you can transfer $5.49 million across as many generations as you like without triggering the GST.

(3)  Rule (2) is not interpreted the way you expect when using a trust.

a.     One would think that trust distributions over $5.49 million to a skip beneficiary would trigger the GST tax.

b.    But not necessarily. The planner instead applies the $5.49 million test at a different point in time. Instead of waiting until the trust actually writes checks to a grandkid or great-grandkid decades from now (that is, the distribution date), the planner measures at the moment the settlor puts money into the trust.

c.     Here is an example. Say your great-grandkid is 15 months old, and you put $5.49 million into a dynasty trust. You next burn your $5.49 million GST exemption on the trust.

d.    We calculate a ratio: GST Exemption Used/Total Gift. Let’s give the ratio a name. We will call it “Jackson.” In our example, Jackson is $5.49 million/$5.49 million or “1.0.”  

e.    We next calculate a second ratio: 1.0 – Jackson. We will call this the “inclusion ratio.” Our inclusion ratio is 1.0 – 1.0 or zero (-0-).

f.      Tax nirvana is an inclusion ratio of zero (-0-).

                                                              i.     The magic to an inclusion ration of zero (-0-) is that future distributions from this trust are exempt from any more GST. That happens because you are multiplying [it doesn’t matter the number] by zero.

                                                            ii.     If the inclusion ratio was 45%, then 45% of future distributions from the trust would be subject to GST.

g.     To press the point, if the trust is worth a quantazillion dollars decades from now but has an inclusion ratio of zero (-0-), it is still exempt from GST.

                                                              i.     There are of course ways to ruin this outcome. One way is to put more money into the trust. The result would be to increase the denominator with no increase in the numerator. The resulting inclusion ratio would not be zero. A tax planner would tell you to NOT DO THAT.

To recap, the change in some states concerning the rule against perpetuities allowed planners to devise near-immortal trusts.

And the estate, gift and GST exemptions have been increasing every year and are now at $5.49 million per person. A married couple can of course double that.

Take the near-immortal trusts, stir in the big-bucks exemption, add a few spices (like family limited partnerships or remainder annuities) and you have a very nice tax tool for keeping wealth within the family across generations.

Just Pay The Tax, Boris

I have no problem with minimizing one’s tax liability.

But then there are people who will go to extremes.

Boris Putanec is one of these. I am skimming over a 34-page Tax Court case about a tax shelter he used.

Let’s travel back in time to the dot-com era.

Putanec was one of the founders of Ariba, a business-to-business software company. The initial idea was simple: let’s replace pencil- and pen-business functions with a computerized solution. There are any number of areas in business accounting - routine, repetitious, high-volume – that were begging for an easier way to get things done.

Enter Ariba.

Which eventually went public. Which meant stock. Which meant big bucks to the founders, including Putanec.

Up to this point I am on his side.

This guy wound-up owning more than 6 million shares in a company valued (at one point) around $40 billion.

How I wish I had those problems.

You can anticipate much of the next stretch of the story.

Most of Putanec’s money was tied-up in Ariba stock. That is generally considered unwise, and just about every financial planner in the world will tell you to diversify. When 90-plus-% of your net worth is held in one stock, “diversify” means “sell.”

Now Putanec acquired his stock when the company was barely a company. That meant that he paid nothing or close to nothing to get the stock. In tax talk, that nothing is his “basis.” Were he to sell his stock, he would subtract his basis from any sales proceeds to calculate his gain. He would pay tax on the gain, of course. Well, when you subtract nothing (-0-) from something, you have the same something left over.

In his case, big something.

Meaning big tax.

Rather than just paying the tax and celebrating his good fortune, Putanec was introduced to a tax shelter nicknamed CARDS.

Sigh.

CARDS stands for “custom adjustable rate debt structure.” Yes, it sounds like BS because it is. Tax shelters tend to have one thing in common: take a tax position, pretzel it into an unrecognizable configuration and then bury the whole thing in a series of transactions so convoluted and complex that it would take a team of tax attorneys and CPAs a half-year to figure out.

Let’s go through an example of a CARDS deal.

1. Someone has a gigantic capital gain, perhaps from selling Ariba sock.
1. CARDS deals routinely started at $50 million. That threshold easily weeds out you and me.
2. There will be a foreign bank (FB) involved. 
3. There will be foreign currency involved. 
4. The promoter forms a limited liability company (LLC) somewhere. 
5. The FB loans money (let’s say $100 million) to the LLC. 
1. The LLC deposits around 85% of the money in a bank – probably the same bank (FB) that started this thing. 
2. The LLC keeps the other 15%. 
3. The FB wants collateral, so the LLC gives the FB a promissory note. 
1. That note is special. The bank probably has 85% of its money in an account by this point, but the note is for 100%. Why? It’s part of the BS. 
2. There is also something crazy about this note. It can stretch out as long as 30 years, although the bank reserves the right to call it early (probably annually).
6. We now have an LLC somewhere on the planet with an $85 million CD or savings account, a $15 million checking account, and a $100 million promissory note. Just to remind, this is all happening overseas and in foreign currency.
2. Now we leave the rails. 
1. Someone (say Putanec) assumes joint and several liability for that $100 million loan. 
1. Remember that $85 million is already sitting in a CD or likewise, so this is not as crazy as it seems.
2. The LLC will continue to pay the bank interest on the loan. Said someone is not to be bothered. Goes without saying that the bank (FB) will eventually slide the $85 million to itself and make the loan go away.
3. Said someone also takes control of the $15 million parked in that foreign checking account. 
1. In the tax universe, the conversion of that foreign currency to American dollars is a taxable event. Let’s now add gas to the fire.
4. Remember that gain = proceeds – basis.
5. Proceeds in this case are $15 million.
6. Basis in this case … 
1. Is $100 million. 
2. Huh? Yep, because that someone gets to add that $85 million promissory note to his/her $15 million paid in cash.
7. The LOSS therefore is $15 million – $100 million = $85 million.

Now, this could make sense – if said someone had to - some day - write a check to the bank for $85 million.

Not going to happen. The bank already has that $85 million tucked-away in a CD or savings account it controls. The bank never has to leave its front door to get its hands on that $85 million.

But our someone has a sweet yet nutritiously-balanced $85 million capital loss to offset a capital gain.

If only we could come up with a capital gain…. What to do? What can we …? Visualize severe forehead frown.

Got it!!

Let’s sell that Ariba stock. That will generate the gain to absorb that $85 million loss.

Call me He-Man, Tax Master of the Universe.

Yes folks, that is what the gazillion-dollars-a-year “consultants” were peddling to people to avoid paying taxes on something with a huge, latent capital gain.

 Of which Boris Putanec was one.

 The Court bounced him with the following flourish:

The deal is the stuff of tax wizardry, while the Code treats us all as mere muggles. The loan he assumed wasn’t all genuine debt, and any potential obligation he had to repay the entire loan was unlikely or at best contingent.”

I suppose winning the lottery was not enough.

Just pay the tax, Boris.

The $64 Million Question

Let’s talk about hard rules in the tax Code.

Let’s say that you donate $500 to your church or synagogue. You come to see me to prepare your taxes. I ask you whether you have received a letter concerning that $500 donation.

You think that I am a loon. You after all have the cancelled check. What more does the government want?

That’s the problem.

Here’s the rule:

A single contribution of $250 or more – whether by cash, check or credit card – must be supported by a receipt that meets the following requirements:

a.    It must identify the amount.

b.    It must state that no goods or services were given in exchange (alternatively, it must subtract said goods and benefits from the donation if such were given); and

c.     The taxpayer must have such receipt before filing his/her tax return.

To restate this: you can give the IRS a cancelled check and it will not be enough to save your contribution deduction - if that deduction is over $250.

The tax Code is spring-loaded with traps like this. Congress and the IRS say this is necessary for effective tax administration. Nonsense. What they are interested in is taking your money.

There is a super-sized type of charitable deduction known as an “easement.” Think real property, like land or a building. The concept is that real estate is a combination of legal rights: the right to ownership, to development, to habitation, to just leave it alone and look at it.

Let’s say that you own a historical building in name-a-town USA. Chances are that restrictions are in place disallowing your ability to upsize, downsize, renovate the place or whatever. You decide to donate a “façade” easement, meaning that you will not mess with the exterior of the building. Well, messing with the exterior of the building is one of those legal rights that together amalgamate to form real estate, and you just gave one such right away. Assuming that a value can be placed on it, you may have a charitable donation.   

There are a couple of questions that come to mind immediately:

(1) Depending upon the severity of town restrictions, you may not have had a lot of room to alter the exterior anyway. You may not have given away much, in truth.

(2) Even hurdling (1), how do you value the donation?

Sure enough, there are people who value such things.

That is one thing about the tax Code: Congress is always employing somebody to do something whenever it changes the rules, and it is forever changing the rules. Virtually all tax bills are jobs bills. We can question whether those jobs are useful to society, but that is a different issue.

You will not be surprised that a super deduction brings with it super rules:

(1) One must attached a specific tax form (8283)

(2) One must attach a qualified appraisal

(3) One must attach a photograph of the building exterior

(4) One must attach a description of all restrictions on the building

There is an LLC in New York that claimed a 2007 easement deduction of $64.5 million.

Folks, you know this is going to be looked at.  

Let’s set the trap:

The LLC received a letter from the charity acknowledging the easement. Assuming the return had been extended, this would have been a timely letter.

However, the letter did not contain all the “magic words” necessary to perform the required tax incantation. More specifically, it did not say whether the charity had provided any benefits to the LLC in return.

Guess who gets pulled for audit in 2011? Yeah, a $64 million-plus easement donation will do that.

While preparing for audit, the tax advisors realized that they did not have all the magic words. They contacted the charity, which in turn amended its 2007 Form 990 to upgrade the information provided about the donation.

Strikes you as odd?

Here is what the LLC was after:

IRC Section 170(f)(8):

(A) General rule

No deduction shall be allowed under subsection (a) for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the contribution by the donee organization that meets the requirements of subparagraph (B).

(D) Substantiation not required for contributions reported by the donee organization

Subparagraph (A) shall not apply to a contribution if the donee organization files a return, on such form and in accordance with such regulations as the Secretary may prescribe, which includes the information described in subparagraph (B) with respect to the contribution.

The LLC was after that “(A) shall not apply if the donee organization files a return” language. The charity amended its return, after all, to beef-up its disclosure of the easement donation.

Nix, said the IRS. All that hullabaloo was predicated on “regulations as the Secretary may prescribe.” And guess what: the Secretary did not prescribe Regulations.

Do you remember about a year ago when we talked about charitable organizations issuing 1099-like statements to their donors? We here at CTG did not care for that idea very much, especially in an era of increasing identity theft. Many charities are small and simply do not have the systems and resources to secure this information.

Well, that was also the IRS trying to prescribe under Section 170(f)(8)(D). You may remember the IRS took a tremendous amount of criticism, after which it withdrew its 1099-like proposal.

The LLC argued that Congress told the IRS to issue rules under Section 170(f)(8)(D) but the IRS did not. It was unfair to penalize the LLC when the IRS did not do its job.

The IRS took a very different tack. It argued that Section 170(f)(8)(D) gave it discretionary and not mandatory authority. The IRS could issue regulations but did not have to. In the jargon, that section was not “self-executing.”

The Tax Court had to decide a $64 million question.

And the Tax Court said the IRS was right.

At which point the LLC had to meet the requirements discussed earlier, including:

The taxpayer must have such receipt before filing his/her tax return.

It had no such receipt before filing its return.

It now had no $64.5 million deduction. 

The taxpayer was 15 West 17th Street, and they ran into an unforgiving tax rule. I am not a fan of all-or-nothing-magic-tax-incantations, as the result appears ... unfair, inequitable, almost cruel ... and as if tax compliance is a cat-and-mouse game.

What’s Fair Got To Do With It?

I am reading a tax case with an unfortunate result.

It does not seem that difficult to me to have planned for a better outcome.

I have to wonder: why didn’t they?

Let’s set it up.

We have a law firm in New York. There is a “heavy” partner and the other partners, which we will call “everybody else.” The firm faced hard times, and “everyone else” kept-up their bleed rate (the rate at which they withdraw cash), with the result that their capital accounts went negative.

COMMENT: A capital account is increased by the partner’s share of the income and reduced by cash withdrawn by said partner. When income goes down but the cash withdrawn does not, the capital account can (and eventually will) go negative. 

Let’s return to our heavy partner.

He was concerned about the viability of the firm. He was further concerned that New York law imposed on him a fiduciary responsibility to assure that the firm be able to pay its bills. I applaud his sense of responsibility, but I have to point out that any increased uncertainty over the firm’s capacity to pay its bills might have something to do with “everybody else” taking out too much cash.

Just sayin’.

Our partner’s share of firm income was almost $500 grand.

Problem is that the cash did not follow the income. His “share” of the income may have been $500 grand, but he left around $400 grand in the firm to make-up for the slack of his partners.

And you have one of those things about partnership taxation:   

·      The allocation of income does not have to follow the allocation of cash.

There are limits to how far one can push this, of course.

Sometimes the effect is beneficial to the partner:

·      A partner tales out more cash than his/her share of the income because the partnership owns something with big-time depreciation. Depreciation is a non-cash expense, so it doesn’t affect his/her distribution of cash.

Sometimes the effect is deleterious to the partner:

·      Our guy took out considerably less cash than the $500K income.

Our guy did not draw enough cash to even pay the taxes on his share of the income.

OBSERVATION: That’s cra-cra.

What did he do?

He reported $75K of income on his tax return. Seeing how did not receive the cash, he thought the reduction was “fair.”

Remember: his partnership K-1 reported almost half a million.

The number on his personal return did not match what the partnership reported.

COMMENT: By the way, there is yet one more form to your tax return when you do not use a number reported by a partnership. The IRS wants to know. He might as well just have booked the audit.

Sure enough, the IRS sent him a notice for over $140,000 tax and $28,000 in penalties.

Off to Tax Court they went.

And he had … absolutely … no … chance.

Partnerships have incredibly flexible tax law. There is a reason why the notorious tax shelters of days past were structured around partnerships. One could send income here, losses there, money somewhere else and muddy the waters so much that you could not see the bottom.

In response, Congress and the IRS tightened up, then tightened some more. This area is now one of the most horrifying, unintelligible stretches in the tax Code.  It can – with little exaggeration – be said that all the practitioners who truly understand partnership tax law can fit into your family room.

Back to our guy.

The Court did not have to decide about New York law and fiduciary responsibility to one’s law firm or any of that. It just looked at tax law and said:

Your income did not match your cash. You set this scheme up, and – if you did not like it – you could have changed it. Once decided, however, live with your decision.

Those are my words, by the way, and not a quote.

Our law partner owed the tax and penalties.

Ouch and ouch.

I must point out, however, that the law firm’s tax advisors warned our guy that his “fiduciary” theory carried no water and would be disregarded by the IRS, but he decided to proceed nonetheless. He brought much of this upon himself.

What would I have recommended?

For goodness’ sake, people, change the partnership agreement so that the “everybody else” partners reported more income and our guy reported less. It is fairly common in more complex partnerships to “tier” (think steps in a ladder or the cascade of a fountain) the distribution of income, with cash being the second – if not the first – step in the ladder. The IRS is familiar with this structure and less likely to challenge it, as the movement of income would make sense.

Another option of course would be to close down the law firm and allow “everybody else” to fend for themselves.

I would argue that my recommendation is less harsh.

“Destination-Based” “Border Adjustment” “Indirect Tax” … What?

The destination-based border adjustment tax.

I  have been reading about it recently.

If you cannot distinguish it from a value-added tax, a national sales tax, a tariff or all-you-can eat Wednesdays at Ruby Tuesday, you are in good company.

Let’s talk about it. We need an example company and exemplary numbers. Here is one. Let’s call it Mortimer. Mortimer’s most recent (and highly compressed) income statement numbers are as follows:

Sales			10,000,000
Cost of sales			(3,500,000)
Operating expenses			(4,000,000)
Net profit			2,500,000

How much federal tax is Mortimer going to pay? Using a 34% federal rate, Mortimer will pay $850,000 ($2,500,000 * 34%).

Cue the crazy stuff….

A new tax will bring its own homeboy tax definitions. One is “WTO,” or World Trade Organization, of which the U.S. is a part and whose purpose is to liberalize world trade. The WTO is a fan of “indirect taxes,” such as excise taxes and the Value Added Tax (VAT). The WTO is not so much a fan of “direct taxes,” such as the U.S. corporate tax. To get some of their ideas to pass WTO muster, Congressional Republicans and think-tankers have to reconfigure our corporate income tax to mimic the look and feel of an indirect tax.

One way to do that is to disallow deductions for Operating Expenses. An example of an operating expense would be wages.

As a CPA by training and experience, hearing that wages are not a deductible business expense strikes me as ludicrous. Let us nonetheless continue.

Our tax base becomes $6,500,000 (that is, $10,000,000 – 3,500,000) once we leave out operating expenses.

Not feeling so good about this development, are we?

Well, to have a prayer of ever getting out of the Congressional sub-subcommittee dungeon of everlasting fuhgett-about-it, the tax rate is going to have to come down substantially. What if the rate drops from 35% to 20%?

I see $6,500,000 times 20% = $1,300,000.

Well, this is stinking up the joint.

VATs normally allow one to deduct capital expenditures. We did not adjust for that. Say that Mortimer spent $1,500,000 on machinery, equipment and what-not during the year, What do the numbers now look like? 

• Sales                                       10,000,000
• Cost of Sales                            3,500,000
• Operating Expenses                 4,000,000
• Capital Additions                       1,500,000 

I am seeing $5,000,000 ($10,000,000 – 3,500,000 – 1,500,000) times 20% =  $1,000,000 tax.

Still not in like with this thing.

Let’s jump on the sofa a bit. What if we not tax the sale if it is an export? We want to encourage exports, with the goal of improving the trade deficit and diminishing any incentive for companies to invert or just leave the U.S. altogether.

Here are some updated numbers:

• Sales                                        10,000,000 (export $3,000,000)
• Cost of Sales                             3,500,000
• Operating Expenses                  4,000,000
• Capital Additions                        1,500,000 

I see a tax of: (($10,000,000 – 3,000,000) – (3,500,000 + 1,500,000) * 20% = 2,000,000 * 20% = $400,000 federal tax.

Looks like Mortimer does OK in this scenario.

What if Mortimer buys some of its products from overseas?

Oh oh.

Here are some updated, updated numbers:

• Sales                                       10,000,000
• Cost of Sales                            3,500,000 (import $875,000)
• Operating Expenses                 4,000,000
• Capital Additions                       1,500,000 

This border thing is a two-edged blade. The adjustment likes it when you export, but it doesn’t like it when you import. It may even dislike it enough to disallow a deduction for what you import.

I see a tax of: ($10,000,000 – (3,500,000 - 875,000) – 1,500,000) * 20% = 5,875,000 * 20% = $1,175,000 federal tax.

Mortimer is not doing so fine under this scenario. In fact, Mortimer would be happy to just leave things as they are.

Substitute “Target” or “Ford” for “Mortimer” and you have a better understanding of recent headlines. It all depends on whether you import or export, it seems, and to what degree.

By the way, the “border adjustment” part means the exclusion of export income and no deduction for import cost of sales. The “destination” part means dividing Mortimer’s income statement into imports and exports to begin with.

We’ll be hearing about this – probably to ad nauseum – in the coming months.

And the elephant in the room will be clearing any change through the appropriate international organizations. The idea that business expenses – such as labor, for example – will be nondeductible will ring very odd to an American audience.

  

Marty McFly and Future Interests In A Trust

Let’s talk about gift taxes.

Someone: What is an annual gift tax exclusion?

Me: The tax law allows you to gift any person on the planet up to $14,000 a year for any reason without having to report the gift to the IRS. If you are married, your spouse can do the same – meaning you can team-up and gift up to $28,000 to anybody.

Someone: What if you go over $14,000 per person?

Me: It is not as bad as it used to be. The reason starts with the estate tax, meaning that you die with “too many” assets. This used to be more of an issue a few years back, but the exclusion is now north of $5.4 million. There are very few who die with more than $5.4 million, so the estate tax is not likely to impact ordinary people.

Someone: What does the gift tax have to do with this $5 million?

Me: Congress and the IRS saw gifting as the flip side of the coin to the estate tax, so the two are combined when calculating the $5.4 million. Standard tax planning is to gift assets while alive. You may as well (if you can) because you are otherwise going to be taxed at death. Gifting while alive at least saves you tax on any further appreciation of the asset.

Someone: Meaning what?

Me: You will not owe tax until your gifts while alive plus your assets at death exceed $5.4 million.

Someone losing interest: What are we talking about again?

Me: Riddle me this, Batman: you transfer a gaztrillion dollars to your irrevocable trust. It has 100 beneficiaries. Do you get to automatically exclude $1,400,000 ($14,000 times 100 beneficiaries) as your annual gift tax exclusion?

Someone yawning: Why are we talking about this?

Me: Well, because it landed on my desk.

Someone: Do you make friends easily?

Me: Look at what I do for a living. I should post warnings so that others do not follow.

Someone looking around: How about hobbies? Do you need to go home to watch a game or anything?

Me: There is a tax concept that becomes important when gifting to a trust. A transfer has to be a “present interest” to qualify for that $14,000 annual exclusion.

Someone resigned: And a “present interest” is?

Me: Think cash. You can take it, frame it, spend it, make it rain. You can fold it into a big wad, wrap a hundred-dollar bill around it and pull the wad out every occasion you can.

Someone: What is wrong with you?

Me: Maybe it’s just me that would do that.

Me: I tell you what a “present interest” is not: cash in a trust that can only be paid to you when some big, bad, mean trustee decides to pay. You cannot party this weekend with that. You may get cash, but only someday … and in the future.

Someone: Hence the “future?”

Me: Exactly, Marty McFly.

Someone surprised: Hey, there’s no need ….

Me: Have you ever heard of a Crummey power?

Someone scowling: Good name for it. Fits the conversation.

Me: That is the key to getting a gift to a trust to qualify as a present interest.

Someone humoring: What makes it crummy?

Me: Crummey. That’s the name of the guy who took the case to court. Like a disease, the technique got named after him.

Someone looking at watch: I would consider a disease right about now.

Me: The idea is that you give the trust beneficiary the right to withdraw the gift, or at least as much of the gift as qualifies for the annual exclusion. You also put a time limit on it – usually 30 days. That means – at least hypothetically – that the beneficiary can get his/her hands on the $14 grand, making it a present interest.

Someone: I stopped being interested ….

Me: Have you heard of a “in terrorem” provision?

Someone: Sounds terrifying.

Me: Yea, it’s a great name, isn’t it? The idea is that – if you behave like a jerk – the trustee can just cut you out. Hence the “terror.”

Someone: I cannot see a movie coming out of this.

Me: Let’s wait and see what Ben Affleck can do with it.

Me: I was looking at a case called Mikel, where the IRS said that the “in terrorem” provision was so strong that it overpowered the Crummey power. That meant that there was no present interest.

Someone: Can you speed this up?

Me: The transfer to the trust was over $3.2 million ….

Someone: I wish I could meet these people.

Me: The trust also had around 60 beneficiaries.

Someone: 60 kids? Who is this guy – Mick Jagger?

Me: Nah, his name is Mikel.

Someone: I was being sarcastic.

Me: Mikel was Jewish, and he put a provision in the trust that beneficiary challenges to a trustee’s decision would go to a panel of 3 persons of Orthodox Jewish faith, called a beth din.

Me: I suppose if the beth din sides with the trustees, the beneficiary could go to state court, but then the in terorrem provision would kick-in. The beneficiary would lose all rights to the trust.

Someone: So some rich person gets cut-off at the knees. Who cares?

Me: The IRS said that the in terrorem provision was strong enough to make the gift a future interest rather than a present interest. That meant there was no $14,000 annual exclusion per beneficiary. Remember that there were around 60 beneficiaries, so the IRS was after taxes on about $800 grand. Not a bad payday for the tax man.

Someone: Sounds like they can afford it.

Me: No, no. The Court disagreed with the IRS. The taxpayer won.

Someone backing away: What was the court’s hesitation?

Me: The Court felt the IRS was making too many assumptions. If the beneficiaries disagreed with the trustees, they could go to the beth din. The beth din did not trigger the in terrorem. The beneficiaries would have to go to court to trigger the in terrorem. The Court said there was no reason to believe the beth din would not decide appropriately, so it was unwilling to assume that the beneficiaries were automatically bound for state court, thereby triggering the in terrorem provision.

Someone leaving: Later Doc.