Losing A Refund: Revisiting The Statute(s) of Limitations

 

I am thinking she got hosed.

I am looking at a district court decision. It involves Michelle Moy, and it remarkably bridges 2011 to the 2020 COVID year.

Let’s talk about it.

In May 2011 Moy was assessed $32,507 by the IRS because she failed to file a 2008 tax return. In this situation, the IRS may prepare a return for you (called a substitute for return) and proceed accordingly with collections activity.

COMMENT: It is rare that a substitute for return (SFR) will be to your advantage. The IRS will throw in all the positive numbers it can find, but it will not include negative numbers with the same zeal. It is almost always to your advantage to file a return rather than accept an SFR.

QUESTION: Here is an obscure practice question: when you file the 2008 return with an SFR already on file, is it considered an amended return? The answer is below.

Turns out that Moy had $20,447 in 2008 U.K. foreign taxes available for credit. Assuming that the foreign tax credit was available dollar-for-dollar, Moy owed $12 grand rather than the $32 grand the IRS wanted.

Seems easy enough. File the return. Pay the $12 grand plus interest and penalties and move on.

It appears Moy instead paid the $32 grand. She did not realize and overpaid.

I say that because she filed a claim for refund in April 2018. I presume the claim was for the $20 grand of foreign taxes.

In August 2018, the IRS bounced the claim as being outside the statute of limitations.

COMMENT: The statute for a refund claim is generally the latter of (a) three years from assessment date or (b) two years from the date of payment. Assessment here was in 2011, so the first period would have expired in 2014. Assuming she paid the $32 grand before April 2016, the second period would have also expired before she filed in April 2018.

Moy filed a protest with Appeals.

Appeals stalled, responding three times (in December 2019, February 2020, and March 2020), each time asking for another 60 days.

I think we all remember what happened in March 2020, so I withhold blame.

The IRS dismissed her appeal in January 2021, arguing that the statute of limitations for refund had expired.

In June 2023, Moy filed a lawsuit against the United States.

Confused yet?

Let’s sort this out.

What is happening is that there are two statutes of limitations coming into play here. In fact, it would be more accurate to say two and a half.

The first is the standard 3 years/2 years. This is the statute for filing a refund claim. In this context, Moy filing a 2008 return showing that foreign tax credit counts as a refund claim.

NOTE: In answer to our question above, Moy would file an original – not a an amended – 2008 return. The SFR is not considered a return for this purpose, so the first filing by the taxpayer would be considered the original filing.

Mind you, her 2008 filing was likely outside the 3/2 combo, so how did Moy argue that the statute for refund was still open?

Look at this pearl:

        § 6511 Limitations on credit or refund.

(d)  Special rules applicable to income taxes.

(3)  Special rules relating to foreign tax credit.

(A)  Special period of limitation with respect to foreign taxes paid or accrued. If the claim for credit or refund relates to an overpayment attributable to any taxes paid or accrued to any foreign country or to any possession of the United States for which credit is allowed against the tax imposed by subtitle A in accordance with the provisions of section 901 or the provisions of any treaty to which the United States is a party, in lieu of the 3-year period of limitation prescribed in subsection (a) , the period shall be 10 years from the date prescribed by law for filing the return for the year in which such taxes were actually paid or accrued.

 

Yep, the foreign tax credit gets its own 10 year statute of limitations. Let’s see, the 2008 return was due April 2009. Add ten years and we get April 2019. She filed a refund claim in April 2018. She appears to be within the statute period for filing a refund claim.

So why did the Court say she was out of statute?

There is one more statute of limitations to consider.

        § 6532 Periods of limitation on suits.

(a)  Suits by taxpayers for refund.

(1)  General rule.

No suit or proceeding under section 7422(a) for the recovery of any internal revenue tax, penalty, or other sum, shall be begun before the expiration of 6 months from the date of filing the claim required under such section unless the Secretary renders a decision thereon within that time, nor after the expiration of 2 years from the date of mailing by certified mail or registered mail by the Secretary to the taxpayer of a notice of the disallowance of the part of the claim to which the suit or proceeding relates.

 What does this mishmash mean?

This statute applies to the IRS and authorizes the IRS to pay a refund up to two years after disallowing a claim for refund.

When did the IRS disallow Moy’s refund claim?

In August 2018.

Add two years and you have August 2020.

When did Moy file suit?

In 2023.

The IRS is prohibited from issuing a refund.

To recap, the familiar 3/2 statute of limitations applies to a taxpayer filing a refund claim.

The second statute (2 years, no more, no less) applies to the IRS paying the refund claim.

Moy cleared the first.

She did not clear the second.    

Are there administrative options?

None that excites me.

Could she have done something differently?

While a long shot, she could have asked to extend the refund statute. The difficulty is that both sides must sign, and it can be difficult to find someone at the IRS with authority to sign.

Realistically, her best option was filing a refund suit with the district court or U.S. Court of Claims. I would much rather go to Tax Court – as that court has procedures for pro se taxpayers – but the Tax Court does not accept refund suits. You must owe the IRS to get your ticket punched on the Tax Court Express.

Moy was hosed. She went into COVID with a two year window to get her refund. Little could she anticipate IRS employees being sent home - meaning no access to correspondence mailed to IRS addresses, unprocessed returns and mail accumulating in trailers, the later shredding of such returns and mail, and the agency becoming near unreachable for extended periods “due to a high volume of calls.”

And those IRS letters asking for “another 60 days”?

You would have to get a court to allow equitable tolling. Notice that the IRS did not do so on its own power. They were quick to ask for another six months while processing Moy’s appeal, but they did not toll a single minute on the Section 6532 limitation on her refund.

Looking back, IRS Appeals should have included Form 907 with any refund claims assigned during the COVID era. Unfortunately, the IRS still has no policy or practice of doing this, so any responsibility for this tax obscurity falls fully on the taxpayer (and his/her tax representative). 

Our case this time was Moy v United States, Case No 23-cv-03151-PP (Northern District of California 2024).

Paying Personal Expenses Through A Business

I am looking at a tax case.

It reminds me of something.

There is a too-common belief that paying an expense through a business can somehow transmute an otherwise personal expenditure into a tax deduction.

Here are common ways I have heard the question:

(1)  My spouse is going to replace her car. Should we buy it through the business?

(2)  I run my business from my home. That makes my home a “headquarters,” right? Can’t I deduct all the expenses related to my business headquarters?

(3)  I am going to borrow money to [go on vacation/pay college tuition/buy a boat I’ve been wanting]. Should I have the business borrow the money to make it deductible?

Do not misunderstand, many times there is a more tax-efficient way to accomplish something. There may still be some tax though, and the goal is to minimize the tax. Making it disappear may not be an option, at least for a responsible practitioner.

Let’s look at the above questions.

(1) Realistically, if there is no business use of the vehicle, you are not allowed to deduct any of the ownership or operating expenses of a vehicle. Despite that, does it happen routinely? Of course. Practitioners do what they can, but it is like fighting the tide.

(2)  I consider this quackery, but it is a true story. No, working from home does not make your house fully deductible. You might get a home office deduction out of it, but that is a fraction of some – and not all – expenses. No, your house is not Proctor and Gamble. Get over it.

(3) This one might have traction, but in general the answer is no. Even if the interest is deductible, how is the company getting you the money? Is it going to lend it to you? If so, you will have to pay interest to the company, although you may be able to arbitrage the rate. Will the company bonus you the money? If so, I see FICA and income taxes in your future. Explain to me the win condition here.

Let’s look at Justin Maderia (JM).

JM lived in Florida and owned 50% of Lindy Inc (Lindy).

Lindy must be a C corporation, which is the type that pays its own taxes. I say this because the Court refers to earnings and profits (E&P), which is a C corporation concept. The purpose of E&P is to track a corporation’s ability to pay dividends. When it pays dividends, a corporation is sharing its accumulated profits with its shareholders. The corporation has already paid taxes on these profits (remember: a C corporation pays taxes). When it pays dividends, you are personally taxed on that previously taxed profit. This is the reason for “qualified dividends” in the tax Code: to cut you a break on that second round of taxation.

The IRS was looking at JM’s 2018 personal return. It was also looking at Lindy’s 2018 business return.

COMMENT: It is not unusual to include a closely held company with the audit of an individual tax return.

The IRS wanted to increase JM’s 2018 income by $192 grand of “stuff” that Lindy paid on his behalf.

COMMENT:  Sounds to me like Lindy was paying for EVERYTHING.

Let’s talk procedure here.

The IRS identified personal transactions in Lindy. Lindy was the type of corporation that could pay dividends, and the IRS argument was – to the extent Lindy paid for personal stuff – that such payments represented constructive dividends to JM.

Fair. Consider that the serve.

JM gets to return.

He would argue that the payments were not personal because … well, who knows why.

JM did nothing.

Huh?

JM did nothing because he had a previous audit, and the IRS never pursued the issue of Lindy payments. JM believed he was immunized.

Mind you, there is a kernel of truth here, but JM has googled the concept beyond all recognition.

IF the IRS looks at an issue AND makes no change to your tax return for that issue, you can challenge a later proposed assessment based on that same issue. You might not win, mind you, but you have grounds for the challenge.

Is this what happened to JM?

Let’s look at it.

The IRS examined his prior year return.

Score one for JM.

The IRS never looked at Lindy.

We are done.

There is no immunity. JM cannot challenge a proposed 2018 assessment on an issue the IRS did not examine in a prior year.

JM had to return on different grounds. He did not. He - procedurally speaking - automatically lost.

JM had $192 grand of additional income.

The IRS next wanted the accuracy-related penalty.

Well, of course they did. If they were any more predictable, we could just put it on a calendar.

The Court said “no” to the penalty.

Why?

Because the IRS had looked at JM’s previous return. The IRS either did not bring up or dismissed the Lindy issue, so JM kept reporting the same way. While this would not protect him from a challenge of additional income, it did provide a “reasonable basis” defense against penalties.

Our case this time was Maderia v Commissioner, T.C. Summary 2024-5.

Income And Cancellation of Indebtedness

 

I am reading a case about cancellation of indebtedness income. 

Let’s take a moment to discuss the concept of income in the tax Code. 

The 16^th amendment, passed in 1913 and authorizing a federal income tax, reads as follows: 

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Needless to say, the definition of “incomes, from whatever source” became immediately contentious. 

Ask a tax practitioner for a definition of income, and it is likely that he/she will respond with “an accession to wealth.” 

That phrase comes from a 1955 Supreme Court case (Commissioner v Glenshaw Glass) which included the following: 

Here, we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." 

I am seeing three conditions, of which “accession to wealth” is but one. 

Let’s circle back to indebtedness and income.

Can one have income by borrowing money? 

Unless there is something extraordinarily odd about the loan, I would say “no.” The reason is that any increase in wealth (by receipt of the loan proceeds) is immediately offset by the requirement to repay the loan. 

Let’s say you buy a house. You take out a mortgage. 

What if you are in financial distress and mail the keys back to the mortgage company? 

Granted, the house secures the debt, but surrendering the house does not automatically release the debt. It however will likely result in your receiving the following 1099:

Like any 1099, there is a presumption of income. In this instance, there has been an exchange in the ownership of the house. There is another way to say this: the tax Code sees a sale of the property. 

It seems odd that tax sees potential income here. It is unlikely to happen if the surrendered asset is one’s principal residence, as one would have access to the $250,000/$500,000 gain exclusion. It could happen if the surrendered asset is rental or investment property, though. 

What about the debt on the property? 

Tax considers that a separate transaction. 

When the debt is discharged, the IRS has yet another form: 

Yes, it gets confusing. The system works much better when the two steps happen concurrently – such as in a short sale. In that case, it is common to skip the 1099-A altogether and just issue the 1099-C. 

NOTE: There is a twist in the straw depending upon whether the debt is recourse or nonrecourse. Believe it or not, there are about a dozen states where you can buy your principal residence with nonrecourse debt. You will not be surprised to learn that California is one of them. The upside is that you can return the keys to the bank and no longer be responsible for the mortgage. The downside is this policy was a major contributor to the burst of the housing bubble in the late aughts.

It is common for the 1099-C to be issued three years after the 1099-A. Why? The Code requires the reporting of cancellation of indebtedness on or before an “identifiable event” happens. 

An identifiable event in turn is defined as: 

1.  bankruptcy
2.  expiration of statute of limitations for collection
3.  cancellation of debt that renders it unenforceable in a receivership, foreclosure, or similar proceeding
4.  creditor's election of foreclosure remedies that statutorily bars recovery
5.  cancelation of debt due to probate proceedings
6.  creditor's discharge pursuant to an agreement
7.  discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt
8.  in specific cases, the expiration of a non-payment testing period [presumption of 36 months of no payment to the creditor]    

The three years is number (8). 

The income type we are discussing with the 1099-C is cancellation of indebtedness income. As discussed, just borrowing money does not create income. Whereas your assets may go up (you have cash from the loan or bought something with the cash), that amount is offset by the loan itself. The scales are balanced, and there is no accession to income. 

However, cancel the debt. 

The scale is no longer balanced. 

Meaning you have potential income. 

But the Code allows for exceptions. Here is Section 108: 

                (a) Exclusion from gross income

(1) In general Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

(A) the discharge occurs in a title 11 case,

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness,

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged—

(i) before January 1, 2026, or

(ii) subject to an arrangement that is entered into and evidenced in writing before January 1, 2026. 

The common ones are (a)(1)(A) for bankruptcy and (a)(1)B) for insolvency. 

Bankruptcy is self-explanatory. 

Solvency is not self-explanatory. You can think of insolvency as being bankrupt but not filing for formal bankruptcy. You owe more than you own. Let’s call the difference between the two the “hole.” To the extent that that cancelled debt is less than the “hole,” there is no cancellation of indebtedness income. Once the cancelled debt equals the “hole,” the exclusion ends. At that point, your net worth is zero (-0-). Technically the next dollar is an “accession to wealth” and therefore income. 

In our case this week Ilana Jivago borrowed from Citibank. She defaulted and was eventually foreclosed on in 2009. Citibank sent her a 1099-C. Jivago argued that it was nontaxable because it was qualified principal residence indebtedness per (a)(1)(E) above. 

Qualified principal residence indebtedness is defined as:         

Indebtedness incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer.

The Court looked at photographs of and admired the renovations she made in 2005 and 2006. The Court noted that Jivago did not use an interior designer, and she did much of the work herself.

The problem is that 2005 and 2006 were before she borrowed from Citibank. 

Easy win for the IRS.

Our case this time was Jivago v Commissioner, Docket No. 5411-21.

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.