Tax (and Estate Planning) Happenings

Overview

In recent weeks, the Tax Court and the U.S. Court of Appeals for the Fifth Circuit have issued important decisions relevant to income tax and estate planning. Today’ post highlights those decisions.

Recent court decisions with implications for income tax and estate/business planning – it’s the topic of today’s post.

IRS Legal Advice Lacks Force of Law

Peak v. Comr., T.C. Memo. 2021-128

The petitioner received distributions from three different pension or retirement plans.  Each of the plans sent Form 1099-R to the IRS and to the petitioner indicating that the entire distribution was taxable and that it was a “normal distribution.”  The petitioner filed his return for the year reporting the total amount of distributions, but that the “taxable amount” was far less.  The IRS issued a CP12 Notice advising the petitioner that there were errors on the return and that the overpayment amount that he reported and that the refund due him was much less than he reported on the return.  The petitioner did not respond to the Notice, thereby agreeing to its calculations.  Later, the IRS relied on the various Forms 1099-R and issued the petitioner a notice of deficiency notifying the petitioner that the full amount of the distributions was taxable.  The petitioner timely filed for a redetermination on the basis that he followed the advice of the IRS helpline representative with respect to the reporting of the distributions.  He also claimed that the CP12 Notice confirmed his entitlement to a refund.  The Tax Court rejected the petitioner’s arguments, noting that IRS employee legal advice has no force of law and cannot bind the IRS or the Tax Court.  The Tax Court also determined that a CP12 Notice is not a settlement agreement and does not limit the IRS in assessing additional tax to be found due. 

Note:   Rely on the advice of IRS personnel to your own detriment.  The same is true for USDA employees.  They aren’t legally bound by any “advice” that they give.

For PTC Purposes, MAGI Includes Social Security Benefits

Knox v. Comr., T.C. Memo. 2021-126 

The petitioners, a married couple, reported nearly $60,000 of Social Security benefits for 2015.  During 2015, they also received $7,332 in advance premium tax credit (APTC) payments.  They did not file Form 8962 for 2015 to reconcile the APTC with their eligible premium tax credit (PTC) at the end of the year.  The IRS issued a Notice of Deficiency that the full $7,332 had to be paid back and that an accuracy-related penalty was due in the amount of $1,466.  The Tax Court, citing its prior decision in Johnson v. Comr., 152 T.C. 121 (2019), held that, for purposes of determining PTC eligibility, the petitioners’ Social Security benefits were required to be included in their modified adjusted gross income, including their lump-sum amounts relating to prior years which they elected to exclude from gross income.  By including such amounts in MAGI, the petitioners’ MAGI exceeded 400 percent of the federal poverty level thereby making them ineligible for the PTC. 

Note:   It is well settled law that Social Security benefits are include in MAGI for purposes of the PTC and the APTC. 

“Immediate Supervisor” is Person Who Actually Supervised Exam

Sand Investment Co., LLC v. Comr., 157 T.C. No. 11 (2021)

Under the Code, an IRS examining agent must obtain written supervisory approval to the agent’s determination to assess a penalty on any asserted tax deficiency.  Under I.R.C. §6751(b)(1), the approval must be from the agent’s “immediate supervisor” before the penalty determination if “officially communicated” to the taxpayer.  In a partnership audit case under TEFRA, supervisory approval generally must be obtained before the Final Partnership Administrative Adjustment (FPAA) is issued to the partnership.  See, e.g., Palmolive Building Investors, LLC v. Comr., 152 T.C. 75 (2019).  If an examiner obtains written supervisory approval before the FPAA was issues, the partnership must establish that the approval was untimely.  See, e.g., Frost v. Comr., 154 T.C. 23 (2020).  In this case, the IRS opened a TEFRA examination of the petitioner’s 2015 return.  The IRS auditor’s review was supervised by a team manager.  While the audit was ongoing, the agent was promoted and transferred to a different team, but continued handling the audit still under the supervision of the former team manager.  Ultimately, the agent asserted an accuracy-related penalty against the petitioner and the former team manager signed the approval form.  The next day, the auditor sent the petitioner several documents indicating that a penalty might be imposed.  Two days later the new team manager also signed the auditor’s penalty approval form.  The petitioner challenged the imposition of penalties because the new team manager hadn’t approved the penalty assessment before the auditor sent the penalty determination to the petitioner.  The Tax Court held that the supervisor who actually oversaw the agent’s audit of the petitioner was the “immediate supervisor” for purposes of the written supervisory approval requirement of I.R.C. §6751(b)(1).  There was no evidence that the new team manager had any authority to supervise the agent’s audit of the petitioner. 

Note:   Pending legislation would remove the requirement of supervisor approval before IRS can assess penalties.

LLC Gifts Recharacterized

Smaldino v. Comr., T.C. Memo. 2021-127

The petitioner and wife had a real estate portfolio of nearly $80 million including numerous rental properties that they owned and operated.  The couple agreed that the real estate should pass to the petitioner’s children and grandchildren from his prior marriage.  To accomplish that goal, the petitioner put 10 of the real estate properties into a family limited liability company (LLC) that he formed in 2003 (and which he was designated as the manager) but which remained inactive until late 2012.  The LLC, in turn, was placed into a revocable trust of which he was the trustee. In 2013, the petitioner transferred approximately eight percent of class B member interests in the LLC to an irrevocable trust (dynasty trust) that he had created a few months earlier for the benefit of his children and grandchildren. He named his son as trustee.  At about the same time as the transfer to the dynasty trust, the petitioner transferred approximately 41 percent of the LLC membership interests to his wife (in an amount that roughly matched her then available federal estate and gift tax exemption), who then in turn transferred the same interests to the dynasty trust the next day.  As a result, the dynasty trust owned 49 percent of the LLC.  Simultaneously, the petitioner amended the LLC operating agreement to provide for guaranteed payments to himself and identified the dynasty trust as the LLC’s sole member.  On his 2013 gift tax return, the petitioner reported only his direct transfer of LLC interests to the dynasty trust and not those of his wife.  A valuation report dated four months after the transfers to the dynasty trust stated that the 49 percent interest in the LLC had a value of $6,281,000.  The federal estate and gift tax exemption was $5,250,000 in 2013.  The IRS asserted that the petitioner had underreported the 2013 taxable gifts by not reporting the wife’s gift to the dynasty trust, and asserted a gift tax deficiency of $1,154,000. 

The Tax Court agreed with the IRS, concluding that the wife’s gift to the dynasty trust should be treated as a direct gift by the petitioner for numerous reasons.  The Tax Court noted that the wife was not a “permitted transferee” under the LLC operating agreement and, thus, could not have owned the LLC interest.  The Tax Court also pointed out that the petitioner had amended the LLC operating agreement on the same day of his transfer of LLC member units to the dynasty trust to reflect himself as the sole member.  The Tax Court also pointed out that the transfers of the wife’s LLC member interest were undated – they only had “effective” dates, and that the assignments were likely signed after the valuation report was prepared four months later.  This meant that the wife had no real ownership rights in the LLC.  In addition, the Tax Court pointed out that the 2013 LLC income tax return did not allocate any income to the wife even though the petitioner claimed that she had an ownership interest for one day.  The LLC’s return and associated Schedules K-1 listed the petitioner as a 51 percent partner and the dynasty trust as a 49 percent partner for the entire year.  The petitioner’s wife was not listed as a partner for any part of the year. 

Note:   The case is a good one for learning what not to do when setting up a trust and transferring LLC interests as part of an estate plan.  The wife’s holding of the LLC interests for a day (at most) before the transfer to the LLC and then transferring the exact same interests received as a gift to the dynasty trust is not a good approach.  It shows a lack of respect for the transaction.  The wife’s testimony at trial that she had no intent to hold the interest contradicted the alleged substance of the transaction.  It also shows that she didn’t understand the planning that was being engaged in – that’s the fault of the attorneys involved.  Also, the husband ‘s failure to report the gift to his wife on a gift tax return was further demonstration that he didn’t respect that transfer.  With the amount of wealth involved in the case, a team of professionals should have been engaged, and all formalities of the various transactions should have been closely followed.  This includes providing written consent for the wife’s admission as an LLC member; providing the dates that documents were actually signed; not transferring the precise amount to the trust as was initially gifted; and having more time pass between the date of the gift to the wife and her subsequent transfer.  There was also no amended and restated LLC operating agreement to reflect her ownership (however brief).  Also, tax returns did not properly reflect what the taxpayers were doing.  

Sole Shareholder Responsible for Corporation's Tax Debt 

United States v. Lothringer, No. 20-50823, 2021 U.S. App. LEXIS 30283 (5th Cir. Oct. 8, 2021)

The petitioner formed a corporation to operate used-car lots.  The petitioner was the sole director, office and shareholder.  He had complete control over the corporation.  The IRS claimed that the corporation owed almost $2 million in federal taxes, and asserted that the petitioner, his wife and the corporation were responsible for the deficiency.  The petitioner liquidated his corporation and various non-exempt assets to pay the tax and sued for a refund.  The trial court determined that the corporation was the petitioner’s alter ego and, as such, the petitioner was personally responsible for the tax.  The petitioner appealed and the appellate court affirmed.  The appellate court noted that under applicable Texas law a court may disregard the corporate “fiction” when it has been used as an unfair device to achieve an inequitable result – including use as a taxpayer’s alter ego.  There was no doubt, the appellate court concluded, that the facts established a unity between the corporation and the petitioner.  The appellate court noted that the petitioner failed to observe certain corporate formalities; loaned substantial sums to the corporation; and made payments from the corporate bank account to service personal loans. 

Note:   Again, following corporate formalities is important.