Federal Tax Bulletin - Issue 13 - June 22, 2012

IRS Issues Temporary Regs on the Estate and Gift Tax Exclusion Amount and Requirements for Electing Portability of a Deceased Spousal Unused Exclusion

In December 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA) amended Code Sec. 2010(c) to allow portability of the applicable estate and gift tax exclusion amount between spouses. Code Sec. 2010(c)(2) defines the applicable exclusion amount, used to determine the applicable credit amount, as the sum of the basic exclusion amount and, in the case of a surviving spouse, the deceased spousal unused exclusion (DSUE) amount. The basic exclusion amount is $5 million, which is adjusted for inflation in each year after calendar year 2011. For 2012, the basic exclusion amount is $5,120,000. (As currently written, the portability provision applies only with respect to deaths occurring in 2011 and 2012. After 2012, the portability provision is scheduled to sunset, and the estate and gift taxes are scheduled to return to their pre-2001 levels, which included an applicable exclusion amount of $1 million.)

Special rules apply to the portability of a DSUE amount. For example, there are certain requirements that must be met to allow a surviving spouse to take into account a DSUE amount. In particular, the executor of the estate of the deceased spouse must file an estate tax return, compute the DSUE amount on that return, elect portability of the DSUE amount on that return, and ensure that the return is filed by the due date (including extensions) for filing the return. The IRS can examine a return of the deceased spouse to determine the DSUE amount, even after the statute of limitations has expired.

As a result of the new portability provisions, practitioners had many questions about applying the provisions. The IRS has now issued temporary regulations in T.D. 9593 (6/18/12) that clarify how the rules should be applied and answer many of those practitioner questions.

Sections of the temporary regulation relating to portability of a deceased spousal unused exclusion amount apply to estates of decedents dying on or after January 1, 2011. Other provisions apply to estates of decedents dying on or after June 15, 2012. The temporary regulations relating to the unified credit against the gift tax apply to gifts made on or after January 1, 2011, while the other gift tax provisions apply to gifts made on or after June 15, 2012.

Applicable Terminology

For purposes of understanding and applying the temporary regulations, it is important to understand the following terms:

(1) Applicable credit amount This is the allowable credit against estate tax and gift tax. The applicable credit amount equals the amount of the tentative tax that would be determined if the amount on which the tentative tax is to be computed were equal to the applicable exclusion amount. The applicable credit amount is determined by applying the unified rate schedule in Code Sec. 2001(c) to the applicable exclusion amount.

(2) Applicable exclusion amount This is the sum of the basic exclusion amount and, in the case of a surviving spouse, the DSUE amount.

(3) Basic exclusion amount This is the sum of (1) for any decedent dying in calendar year 2011, $5 million; and (2) for any decedent dying after calendar year 2011, $5 million multiplied by the cost-of-living adjustment.

(4) Deceased spousal unused exclusion (DSUE) amount This amount refers, generally, to the unused portion of a decedent's applicable exclusion amount to the extent this amount does not exceed the basic exclusion amount in effect in the year of the decedent's death.

(5) Last deceased spouse The term last deceased spouse means the most recently deceased individual who, at that individual's death after December 31, 2010, was married to the surviving spouse.

Background

In Notice 2011-82, the IRS alerted taxpayers to the requirements for the estate of a deceased spouse to elect portability of a DSUE amount. In addition, Notice 2011-82 announced that the estate of a deceased spouse is deemed to elect portability of the DSUE amount by timely filing a complete and properly-prepared estate tax return, and that this return will be deemed to include a computation of the DSUE amount until such time as the IRS revises the estate tax return to expressly contain the DSUE amount computation. The notice also provided guidance to the estates of deceased spouses who choose not to make the portability election.

Subsequently, in Notice 2012-21, the IRS granted to qualifying estates a six-month extension of time for filing an estate tax return to elect portability of an unused exclusion amount provided that the qualifying estate files Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes, within 15 months of the decedent's death. A qualifying estate is the estate of a person who died, survived by a spouse, during the first half of calendar year 2011, and whose gross estate has a fair market value that does not exceed $5 million. With the extension granted by Notice 2012-21, the estate tax return must be filed within 15 months of the decedent's death.

Making the Portability Election

The temporary regulations require an executor electing portability to make that election on a timely-filed estate tax return. The last return filed by the due date of the return, including extensions actually granted, will supersede any previously-filed return. Thus, an executor may supersede a previously-filed portability election on a subsequent timely-filed estate tax return.

An executor or administrator of the estate of a decedent (survived by a spouse) that is appointed, qualified, and acting within the United States (an appointed executor), may file the estate tax return on behalf of the estate of the decedent and, in so doing, elect portability of the decedent's DSUE amount. An appointed executor also may elect not to have portability apply. If there is no appointed executor, any person in actual or constructive possession of any property of the decedent (a non-appointed executor) may file the estate tax return on behalf of the estate of the decedent and, in so doing, elect portability of the decedent's DSUE amount, or, by complying with certain requirements, may elect not to have portability apply. A portability election made by a non-appointed executor cannot be superseded by a contrary election made by another non-appointed executor of that same decedent's estate (unless such other non-appointed executor is the successor of the non-appointed executor who made the election).

The temporary regulations provide that a portability election is irrevocable once the due date (as extended) of the return has passed.

Under Code Sec. 6075(a), an estate tax return must be filed within nine months of the date of the decedent's death. An estate tax return must be filed when the gross estate of a citizen or resident exceeds the excess (if any) of the basic exclusion amount in effect in the calendar year of the decedent's death over the sum of the decedent's adjusted taxable gifts and the amount allowed to the decedent as a specific exemption under Code Sec. 2521 as in effect before its repeal by the Tax Reform Act of 1976.

When an executor is not required to file an estate tax return, the Code does not specify a due date for a return filed for the purpose of making the portability election. The temporary regulations require every estate electing portability of a decedent's DSUE amount to file an estate tax return within nine months of the decedent's date of death, unless an extension of time for filing has been granted.

Requirement to File a Complete and Properly-Prepared Estate Tax Return

As noted above, in Notice 2011-82, the IRS provided that the estate of a decedent dying after December 31, 2010, will be deemed to make the portability election upon the timely filing of a complete and properly-prepared estate tax return. The temporary regulations provide that the estate of a decedent (survived by a spouse) makes the portability election by timely filing a complete and properly-prepared estate tax return for the decedent's estate.

Tax practitioners questioned what the IRS meant by a complete and properly-prepared estate tax return. Those practitioners requested that the IRS consider the cost and burden associated with filing an estate tax return and establishing and substantiating the values reported on the return for those estates that are not required to file a return but are filing such a return solely to elect portability of the decedent's DSUE amount.

In response, the temporary regulations provide that an estate tax return prepared in accordance with all applicable requirements is considered a complete and properly-prepared estate tax return. However, the temporary regulations also provide that executors of estates that are not otherwise required to file an estate tax return do not have to report the value of certain property that qualifies for the marital or charitable deduction. If an executor chooses to use this special rule in filing an estate tax return, the executor must estimate the total value of the gross estate (including the values of the property that do not have to be reported on the estate tax return under this provision), based on a determination made in good faith and with due diligence regarding the value of all the assets includible in the gross estate.

PRACTICE TIP: According to the IRS, the estate tax return instructions will provide ranges of dollar values, and the executor must identify on the estate tax return the particular range within which falls the executor's best estimate of the total gross estate. An amount corresponding to this range will be included on Line 1, Part 2, of the estate tax return, along with an indication of whether the Line 1 total includes an estimate under this special rule. By signing the return, the executor is certifying, under penalties of perjury, that the estimate falls within the identified range of values to the best of the executor's knowledge and belief. The inquiry required to determine the executor's best estimate is the same an executor of any estate must make under current law to determine whether the estate has a filing obligation; that is, to determine whether the fair market value of the gross estate exceeds the excess of the basic exclusion amount over the sum of the decedent's adjusted taxable gifts and the amount allowed to the decedent as a specific exemption under Code Sec. 2521.

Opting Out of Portability Election

If the executor of the estate of a decedent with a surviving spouse does not wish to make the portability election, the temporary regulations require the executor to make an affirmative statement on the estate tax return signifying the decision to have the portability election not apply. If no estate tax return is required for that decedent's estate, not filing a timely return will be considered to be an affirmative statement signifying the decision not to make a portability election.

Executor Responsible for Making Portability Election

A practitioner suggested that the temporary regulations allow a surviving spouse to file an estate tax return on behalf of a decedent independently of a duly-appointed executor if the surviving spouse notifies the executor of the intention to file and the executor does not, in fact, file a return. The IRS responded that Code Sec. 2010(c)(5), allows only the executor of the decedent's estate to file the estate tax return and make the portability election. Code Sec. 2203 defines the term executor for purposes of the estate tax to mean the executor or administrator of the decedent, or, if there is no executor or administrator appointed, qualified, and acting within the United States, then any person in actual or constructive possession of any property of the decedent.

The temporary regulations provide that an executor or administrator that is appointed, qualified, and acting within the United States for the decedent's estate (an appointed executor), may file an estate tax return to elect portability or to opt to have the portability election not apply. The temporary regulations provide that, if there is no appointed executor, any person in actual or constructive possession of any property of the decedent may file the estate tax return to elect portability or to opt to have the portability election not apply. The temporary regulations refer to such a person as a non-appointed executor and provide that a portability election made by a non-appointed executor cannot be superseded by a contrary election made by another non-appointed executor of that same decedent's estate.

Computing the DSUE Amount

Computation Required On Estate Tax Return to Elect Portability

The temporary regulations require that an executor include a computation of the DSUE amount on the estate tax return of the decedent to allow portability of that decedent's DSUE amount. A complete and properly-prepared return contains the information required to compute a decedent's DSUE amount. Accordingly, in a transitional rule consistent with Notice 2011-82, the temporary regulations provide that the IRS will deem the required computation of the decedent's DSUE amount to have been made on an estate tax return that is considered complete and properly-prepared. The temporary regulations further clarify that, once the IRS revises the prescribed form for the estate tax return expressly to include the computation of the DSUE amount, executors that previously filed an estate tax return under the transitional rule will not be required to file a supplemental estate tax return using the revised form.

Method of Computing the DSUE Amount

Code Sec. 2010(c)(4)(A) and Code Sec. 2010(c)(4)(B)(i) and (ii) define the DSUE amount as the lesser of (1) the basic exclusion amount, or (2) the excess ofbasic exclusion amount of the last deceased spouse of the surviving spouse, over the amount with respect to which the tentative tax is determined on the estate of such deceased spouse.

The temporary regulations confirm that the term basic exclusion amount means the basic exclusion amount in effect in the year of the death of the decedent whose DSUE amount is being computed. Generally, only the basic exclusion amount of the decedent, as in effect in the year of the decedent's death, will be known at the time the DSUE amount must be computed and reported on the decedent's estate tax return. Because Code Sec. 2010(c)(5)(A) requires the executor of an estate electing portability to compute and report the DSUE amount on a timely filed estate tax return, and because the basic exclusion amount is integral to this computation, the term basic exclusion amount in Code Sec. 2010(c)(4)(A) necessarily refers to such decedent's basic exclusion amount.

In responding to Notice 2011-82, several practitioners argued that the reference to basic exclusion amount in Code Sec. 2010(c)(4)(B)(i) should be interpreted to mean applicable exclusion amount, citing to the computation of the DSUE amount in Example 3 on page 53 of the Technical Explanation and to footnote 1582A that was added to the General Explanation by the ERRATA General Explanation of Tax Legislation Enacted in the 111th Congress (ERRATA).

According to the IRS, Example 3 computes the DSUE amount of a deceased spouse who was preceded in death by one spouse and was survived by another spouse. The deceased spouse's DSUE amount is computed using the applicable exclusion amount rather than the basic exclusion amount of the deceased spouse (as reduced by the amount of the deceased spouse's taxable estate). Example 3 is reproduced verbatim in the General Explanation. See JCS-2-11 at page 555. The ERRATA acknowledges that Code Sec. 2010(c)(4)(B)(i) uses the term basic exclusion amount, but notes that [a] technical correction may be necessary to replace the reference to the basic exclusion amount of the last deceased spouse of the surviving spouse with a reference to the applicable exclusion amount of such last deceased spouse, so that the statute reflects intent.

According to the IRS, construing the language of Code Sec. 2010(c)(4)(B)(i) as referring to the same number described in Code Sec. 2010(c)(4)(A) would lead to an illogical result because it would effectively render the use of basic exclusion amount in Code Sec. 2010(c)(4)(A) meaningless. Specifically, the basic exclusion amount (the amount referenced in Code Sec. 2010(c)(4)(A)) cannot be less than that same number reduced by another number (the amount referenced in Code Sec. 2010(c)(4)(B)). Under such an interpretation, the basic exclusion amount referenced in Code Sec.could not limit or impact the DSUE amount, and thus it would serve no purpose as written. Based on the principle that a statute should not be construed in a manner that renders a provision of that statute superfluous and consistent with the indicia of legislative intent reflected in the Technical Explanation and the General Explanation, and in the exercise of the express authority granted by Congress in Code Secs. 2010(c)(6) and 7805, Treasury and the IRS have determined that the reference in Code Sec. 2010(c)(4)(B)(i) to the basic exclusion amount is properly interpreted to mean the applicable exclusion amount. Thus, the temporary regulations adopt this interpretation.

Effect of Gift Taxes Paid and Payable on Computing the DSUE Amount

Several practitioners suggested that, for purposes of computing the DSUE amount under Code Sec. 2010(c)(4), the amount referred to in Code Sec. 2010(c)(4)(B)(ii), which is the amount on which the decedent's tentative tax is determined under Code Sec. 2001(b)(1), be construed to take into account gift tax paid by such decedent. The practitioners noted that, to avoid using exclusion for amounts on which gift tax was paid, this construction should apply in computing the DSUE amount of such a decedent if (1) gift tax was paid by a decedent on transfers that caused the total of his or her taxable transfers to exceed the applicable exclusion amount at the time of the transfer, and (2) the total adjusted taxable gifts of the decedent is less than the applicable exclusion amount on the date of his or her death. The temporary regulations provide that amounts on which gift taxes were paid by a decedent are excluded from adjusted taxable gifts for the purpose of computing that decedent's DSUE amount.

Potential Impact of Credits in Code Sections 2013 - 2015 on the DSUE Amount

Practitioners requested clarification as to whether the DSUE amount is determined before or after applying other available credits, such as the credit for tax on prior transfers (Code Sec. 2013), the credit for foreign death taxes (Code Sec. 2014), and the credit for death taxes on remainders (Code Sec. 2015). According to the IRS, the issue of the impact of the credits in Code Secs. 2013 to 2015 on computing the DSUE amount merits further consideration. Thus, the temporary regulations reserve Reg. Sec. 20.2010-2T(c)(3) to provide future guidance on this issue. The IRS is requesting comments regarding appropriate rules to coordinate these credits with portability of the exclusion.

Use of the DSUE Amount by the Surviving Spouse

Date DSUE Amount May Be Taken into Consideration by Surviving Spouse

Practitioners asked for clarification on when the DSUE amount of a decedent is available to the surviving spouse or to the surviving spouse's estate for use in determining the surviving spouse's applicable exclusion amount. The temporary regulations provide that, if the decedent is the last deceased spouse of the surviving spouse on the date of a transfer by the surviving spouse that is subject to gift or estate tax, the surviving spouse, or the estate of the surviving spouse, of that decedent may take into account that decedent's DSUE amount in determining the applicable exclusion amount of the surviving spouse when computing the surviving spouse's gift or estate tax liability on that transfer. This rule applies only if the decedent's executor elected portability. In addition, the temporary regulations provide that a portability election made by the executor of a decedent's estate is effective as of the date of the decedent's death. Thus, the DSUE amount of a decedent survived by a spouse may be included in determining the applicable exclusion amount of the surviving spouse under Code Sec. 2010(c)(2), subject to any applicable limitations, with respect to all transfers occurring after the death of the decedent, if the executor of the decedent's estate makes a portability election and the election is not superseded by the executor of the decedent's estate before the due date of the return, including extensions.

Last Deceased Spouse Limitation on DSUE Amount Available to Surviving Spouse

Some practitioners suggested that the regulations clarify the scope of the last deceased spouse limitation in Code Sec. 2010(c)(4)(B)(i). The temporary regulations explain that the term last deceased spouse referred to in Code Sec. 2010(c)(4)(B)(i) means the most recently deceased individual who was married to the surviving spouse at that individual's death, except that an individual dying before calendar year 2011 cannot be considered the last deceased spouse of such surviving spouse. The temporary regulations clarify that remarriage alone does not affect who will be considered the last deceased spouse and does not prevent the surviving spouse from including in the surviving spouse's applicable exclusion amount the DSUE amount of the deceased spouse who most recently preceded the surviving spouse in death.

The temporary regulations further clarify that the identity of the last deceased spouse of the surviving spouse for purposes of portability is not affected by whether the estate of the last deceased spouse elects portability of the deceased spouse's DSUE amount or whether the last deceased spouse has any DSUE amount available. According to the IRS, this is consistent with the statutory language, which refers to the last deceased spouse of such surviving spouse without further qualification, as well as with the Technical Explanation, which states that [t]he last deceased spouse limitation applies whether or not the last deceased spouse has any unused exclusion or the last deceased spouse's estate makes a timely election.

For purposes of determining the applicable gift tax credit amount under Code Sec. 2505(a)(1), a practitioner asked the IRS to clarify when the identity of the last deceased spouse is determined. The IRS responded that, although Code Sec. 2505(a)(1) refers to the applicable credit amount in effect under Code Sec. 2010(c) as would apply if the donor died as of the end of the calendar year, this does not mean that the identity of the last deceased spouse is subject to change for purposes of computing the surviving spouse's applicable exclusion amount if the surviving spouse is preceded in death by a subsequent spouse after the gift transfer but before the end of the calendar year. Therefore, the temporary regulations provide that for purposes of determining a surviving spouse's applicable exclusion amount when the surviving spouse makes a taxable gift, the surviving spouse's last deceased spouse is identified as of the date of the taxable gift.

DSUE Amount Available in Case of Multiple Spouses and Previously-Applied DSUE Amount

Some practitioners requested that the regulations clarify the outcome when a surviving spouse is preceded in death by more than one spouse. In particular, practitioners asked how the DSUE amount to be included in the applicable exclusion amount of a surviving spouse is affected when a decedent who is currently considered the last deceased spouse of such surviving spouse either has no DSUE amount or has a smaller amount of DSUE in comparison to a decedent who previously was considered the last deceased spouse of such surviving spouse. The temporary regulations clarify that, in either situation, the surviving spouse may not apply any remaining DSUE amount from a prior deceased spouse.

In addition, the temporary regulations address how to compute the DSUE amount included in the applicable exclusion amount of a surviving spouse who made gifts between the deaths of two decedents, each of whom were at separate times the last deceased spouse of such surviving spouse. First, the temporary regulations create an ordering rule by providing that, when a surviving spouse makes a taxable gift, the DSUE amount of the decedent who is the last deceased spouse of such surviving spouse will be considered to apply against the amount of the surviving spouse's taxable gifts for that calendar year before the surviving spouse's own basic exclusion amount will apply.

Second, the temporary regulations compute the DSUE amount available to such a surviving spouse or to his or her estate, respectively, as including both:

(1) the DSUE amount of the surviving spouse's last deceased spouse, and

(2) any DSUE amount actually applied to taxable gifts under the rule in Reg. Sec. 25.2505-2T(b) to the extent the DSUE amount so applied was from a decedent who no longer is the last deceased spouse for purposes of Code Sec.

Under the temporary regulations, a surviving spouse may use the DSUE amount of a predeceased spouse as long as, for each transfer, such DSUE amount is from the surviving spouse's last deceased spouse at the time of that transfer. Thus, a spouse who has survived multiple spouses may use each last deceased spouse's DSUE amount before the death of that spouse's next spouse, and thereby may apply the DSUE amount of multiple deceased spouses in succession. However, this does not permit the surviving spouse to use the sum of the DSUE amounts of those deceased spouses at one time, and a surviving spouse may not use the remaining DSUE amount of a prior deceased spouse following the death of a subsequent spouse.

Applicability of Portability Rules to Nonresidents Who Are Not Citizens

Several practitioners requested that the regulations clarify the applicability of the rules in Code Sec. 2010(c) to estates of nonresidents who are not citizens. In response, the temporary regulations provide that an executor of the estate of a nonresident decedent who was not a citizen of the United States at the time of death may not make a portability election on behalf of that decedent. The temporary regulations provide that a nonresident surviving spouse who was not a citizen of the United States at the time of such surviving spouse's death may not take into account the DSUE amount of any deceased spouse of such surviving spouse, except to the extent allowed under a treaty obligation of the United States.

Applicability of Portability in Case of Qualified Domestic Trusts

When property of a decedent passes to a QDOT, the decedent's estate is allowed a marital deduction for the value of such property. Ultimately, however, estate tax is imposed on such property as distributions constituting taxable events are made from the QDOT. The estate tax imposed by Code Sec. 2056A on a QDOT is the decedent's estate tax liability, and that tax generally equals the amount of additional estate tax that would have been imposed under Code Sec. 2001 if the amount involved in the taxable event had been included in the decedent's taxable estate and had not been deductible. The estate tax that would have been imposed is computed by determining the net tax under Code Sec. 2001 after the allowance of any credits, including the applicable credit amount determined under Code Sec. 2010(c). Consequently, when a QDOT has been created for the benefit of a decedent's surviving spouse, the executor of the decedent's estate will compute a DSUE amount, on a preliminary basis, that may decrease as distributions constituting taxable events under Code Sec. 2056A are made.

The temporary regulations allow the decedent's estate full availability of the decedent's applicable exclusion amount until such time as the final estate tax liability of the decedent is computed. The temporary regulations provide that the executor of a decedent's estate claiming a marital deduction for property passing to a QDOT must compute the decedent's DSUE amount on a preliminary basis on the decedent's estate tax return for the purpose of electing portability, although such amount subsequently will be reduced by the estate tax imposed by Code Sec. 2056A.

The temporary regulations further provide that the DSUE amount of such a decedent is redetermined upon the final distribution or other taxable event on which estate tax under Code Sec. 2056A is imposed, which is generally upon the death of the surviving spouse or the earlier termination of all QDOTs created for that surviving spouse. The earliest date such a decedent's DSUE amount may be included in determining the applicable exclusion amount available to the surviving spouse or the surviving spouse's estate is the date of the event that triggers the final estate tax liability of the decedent under Code Sec. 2056A. Generally, this means that such a decedent's DSUE amount is available for transfers occurring by reason of the surviving spouse's death, but generally will not be available to the surviving spouse during life. However, the decedent's DSUE amount will be available to apply to the surviving spouse's taxable gifts made in the year of the surviving spouse's death, or, if the event terminating the QDOT occurs before the surviving spouse's death, then in the year of that terminating event and/or any subsequent year during the surviving spouse's life.

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Absent Congressional Action, Many Tax Provisions Are Due to Expire at the End of 2012

Unless Congress acts, numerous tax provisions adopted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) are scheduled to expire at the end of 2012. They were originally scheduled to expire at the end of 2010, but the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended the provisions for another two years. The following is a summary of some of the more important tax provisions scheduled to expire.

Individual Tax Rates

EGTRRA created a 10-percent regular income tax bracket for a portion of taxable income that was previously taxed at 15 percent. EGTRRA also reduced the other regular income tax rates. Thus, under EGTRRA, the tax rates are 10, 15, 25, 28, 33, and 35 percent. Unless Congress acts, for tax years after 2012, the tax rates will go back to the pre-EGTRRA rates of 15, 28, 31, 36, and 39.6 percent.

Marriage Penalty Relief

EGTRRA increased the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. The basic standard deduction for a married taxpayer filing separately continued to equal one-half of the basic standard deduction for a married couple filing jointly; thus, the basic standard deduction for unmarried individuals filing a single return and for married couples filing separately are the same.

After 2012, the law will revert to married couples filing jointly receiving a standard deduction which is 167 percent of the deduction for single individuals rather than 200 percent. Individuals filing as married filing separately will receive half of that amount.

EGTRRA also increased the size of the 15-percent regular income tax rate bracket for a married couple filing a joint return to twice the size of the corresponding rate bracket for an unmarried individual filing a single return. After 2012, the upper limit of the 15 percent bracket for married individuals filing jointly is scheduled to be 167 percent of the upper limit for single individuals, rather than 200 percent.

Child Tax Credit

EGTRRA increased the child tax credit from $500 to $1,000. After 2012, the credit is scheduled to revert to $500. In addition, the more favorable rules relating to the amount of the credit that is refundable are scheduled to expire in 2012.

Overall Limitation on Itemized Deductions

EGTRRA repealed the overall limitation on itemized deductions. The repeal was phased-in over five years. EGTRRA provided: (1) a one-third reduction of the otherwise applicable limitation in 2006 and 2007: (2) a two-thirds reduction in 2008, and 2009; and (3) no overall limitation on itemized deductions in 2010, 2011, and 2012. Thus in 2009, for example, the total amount of otherwise allowable itemized deductions (other than medical expenses, investment interest, and casualty, theft, or wagering losses) was reduced by 3 percent of the amount of the taxpayer's AGI in excess of $166,800 ($83,400 for married couples filing separate returns). Then the overall reduction in itemized deductions was phased-down to 1/3 of the full reduction amount (that is, the limitation was reduced by two-thirds). Pursuant to the general EGTRRA sunset, the phased-in repeal of the limitation sunsets and the limitation becomes fully effective again in 2013.

Personal Exemption Phase-out for Certain Taxpayers

EGTRRA repealed the personal exemption phase-out (PEP) for certain taxpayers with the repeal phased-in over five years. EGTRRA provided: (1) a one-third reduction of the otherwise applicable limitation in 2006 and 2007: (2) a two-thirds reduction in 2008, and 2009; and (3) no PEP in 2010. This was extended for another two years through 2012. However, absent new legislation, the PEP becomes fully effective again in 2013.

Dependent Care Tax Credit

Currently, the maximum dependent care tax credit is $1,050 (35 percent of up to $3,000 of eligible expenses) if there is one qualifying individual, and $2,100 (35 percent of up to $6,000 of eligible expenses) if there are two or more qualifying individuals. The 35-percent credit rate is reduced but not below 20 percent, by one percentage point for each $2,000 (or fraction thereof) of adjusted gross income (AGI) above $15,000. Therefore, the credit percentage is reduced to 20 percent for taxpayers with AGI over $43,000.

Under the extended EGTRRA sunset rules, the percent of eligible expenses is reduced from 35 percent to 30 percent and the AGI limitation is reduced from $15,000 to $10,000 for tax years beginning after December 31, 2012.

Capital Gains and Dividends

EGTRRA reduced the tax rate on net capital gains to 15 percent for gain other than gains relating to collectibles, qualified small business stock and unrecaptured Section 1250 income, if the regular tax rate that would otherwise apply is 25 percent or higher and 0 percent for the same type of gains if the regular tax rate that would otherwise apply is lower than 25 percent. Qualified dividend income is subject to the same maximum capital gain rates as net capital gains. The reduced maximum capital gains and dividend rates of 15 percent and 0 percent are scheduled to expire for tax years beginning after December 31, 2012.

Education Incentives

Effective for tax years beginning after December 31, 2012, the changes made by EGTRRA to Coverdell education savings accounts no longer apply. The EGTRRA changes scheduled to expire are: (1) the increase in the contribution limit to $2,000 from $500; (2) the increase in the phaseout range for married taxpayers filing jointly to $190,000-$220,000 from $150,000-$160,000; (3) the expansion of qualified expenses to include elementary and secondary education expenses; (4) special age rules for special needs beneficiaries; (5) clarification that corporations and other entities are permitted to make contributions, regardless of the income of the corporation or entity during the year of the contribution; (6) certain rules regarding when contributions are deemed made and extending the time during which excess contributions may be returned without additional tax; (7) certain rules regarding coordination with the Hope and Lifetime Learning credits; and (8) certain rules regarding coordination with qualified tuition programs.

Effective for tax years beginning after December 31, 2012, the changes made by EGTRRA to the student loan interest deduction provisions no longer apply. The EGTRRA changes scheduled to expire are: (1) increases that were made in the AGI phaseout ranges for the deduction and (2) rules that extended deductibility of interest beyond the first 60 months that interest payments are required. With the expiration of EGTRRA, the phaseout ranges will revert to a base level of $40,000 to $55,000 ($60,000 to $75,000 in the case of a married couple filing jointly), but adjusted for inflation since 2002.

Under the sunset provisions of EGTRRA, the exclusion from gross income and wages for the NHSC Scholarship Program and the Armed Forces Scholarship Program will no longer apply for tax years beginning after December 31, 2012.

The specific exclusion for employer-provided educational assistance was originally enacted on a temporary basis and was subsequently extended 10 times. EGTRRA deleted the exclusion's explicit expiration date and extended the exclusion to graduate courses. However, those changes are subject to EGTRRA's sunset provision so that the exclusion will not be available for tax years beginning after December 31, 2012. Thus, at that time, educational assistance will be excludable from gross income only if it qualifies as a working condition fringe benefit (i.e., the expenses would have been deductible as business expenses if paid by the employee). To meet such requirement, the expenses must be related to the employee's current job.

Adoption Credit

The EGTRRA sunset provisions would also reduce the adoption credit available by reducing the dollar limitation on qualified adoption expenses that may be taken into account as well as reducing the modified adjusted gross income limitation, which would affect the number of individuals eligible for the credit.

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Prop. Regs Aim to Clarify Requirements for Increasing S Shareholder Basis in Debt

There has been an ongoing dispute between S shareholders and the IRS as to whether shareholders can increase their S corporation debt basis. Code Sec. 1366(d)(1) provides that a shareholder can take into account losses and deductions to the extent of the adjusted basis of the shareholder's stock and the adjusted basis of any debt of the S corporation to the shareholder. However, the Code does not define what constitutes debt basis.

As a result, the IRS has issued proposed regulations in REG-134042-07 (6/12/12) aimed at clarifying the requirements for increasing debt basis and assisting S corporation shareholders in determining with greater certainty whether their particular arrangement creates debt basis.

The proposed regulations would apply to loan transactions entered into on or after the date final regulations are issued.

Background

Under Code Sec.1366(d)(1), the aggregate amount of losses and deductions that an S shareholder takes into account for any tax year cannot exceed the sum of that shareholder's adjusted basis in S stock and adjusted basis of any debt of the S corporation to that shareholder. According to the IRS, the legislative history to that provision illustrates Congress's intent to limit the loss that a shareholder takes into account to that shareholder's investment in the corporationthat is, to the adjusted basis of the stock in the corporation owned by the shareholder and the adjusted basis of any indebtedness of the corporation to the shareholder.

Reg. Sec. 1.1366-2 provides rules relating to limitations on the deduction of passthrough items of an S corporation to its shareholder. Under Reg. Sec. 1.1366-2(a)(1), a shareholder's aggregate amount of losses and deductions taken into account under Reg. Sec. 1.1366-1(a)(2), (3), and (4) for any S corporation tax year cannot exceed that shareholder's adjusted basis in stock in the corporation and adjusted basis of any indebtedness of the corporation to that shareholder.

Several court cases have interpreted Code Sec. 1366 to require an investment in the S corporation that constitutes an actual economic outlay by the shareholder to create debt basis. Often, the cases involve attempts by an S corporation shareholder to obtain debt basis by borrowing from another persontypically, a related entityand then lending the proceeds to the S corporation (i.e., a back-to-back loan transaction). Alternatively, an S corporation shareholder might seek to restructure an existing loan of the S corporation into a back-to-back loan by assuming the S corporation's liability on the loan and creating a commensurate obligation from the S corporation to the shareholder. Disagreements continue to arise over whether a back-to-back loan gives rise to an actual economic outlay and, in particular, whether a shareholder has been made poorer in a material sense as a result of the loan.

In Maloof v. Comm'r, 456 F.3d 645 (6th Cir. 2006), the taxpayer owned several S corporations and claimed that a $4 million bank loan to the corporations, on which he was a co-obligor and guarantor, permissibly increased his basis in debt of the S corporation. The Sixth Circuit affirmed the Tax Court and held there was no increase in debt basis. According to the court, the relevant statutes and case law permit an increase S corporation debt basis (and stock basis) only when the taxpayer makes an economic outlay to the corporation, and the taxpayer's status as a co-obligor on the loan established just the possibility, not the reality, of an economic outlay for the corporation.

In Oren v. Comm'r, 357 F.3d 854 (8th Cir. 2004), the taxpayer owned three S corporations. He and the three S corporations entered into a series of loan transactions whereby one corporation loaned, over three years, approximately $15 million to the taxpayer, who, in turn, made loans totaling the same amount to the other two S corporations, both of which, over time, lent the same amount back to the first S corporation. Each loan transaction within a cycle occurred on the same day or within a few days of each other. The terms of the loans, including interest rate and repayment conditions, were the same in each transaction. The first S corporation's checks were drafted against its sweep account with its bank. That bank permitted the corporation to lend funds to the taxpayer so long as he contemporaneously lent the same amount to another related entity. All checks were drawn on the taxpayer or entity's bank account. The taxpayer signed all of the notes himself except the note from the first corporation to him, which was signed by that corporation's president. The taxpayer and the S corporations paid all interest due under the loan agreements by check. The Eighth Circuit affirmed the Tax Court and held that the taxpayer's loans were not actual economic outlays because he was in the same position after the transactions as before he was not materially poorer afterwards. According to the court, the transactions much more closely resembled offsetting book entries or loan guarantees than substantive investments in the S corporations. The court also concluded that the money the taxpayer lent to the corporations was not truly at risk because the possibility that he would suffer a direct loss was so remote. He was protected from personal loss by the circular nature of the loan transactions.

Proposed Regulations

The proposed regulations provide that, in order to increase a shareholder's debt basis, a loan must represent bona fide debt of the S corporation that runs directly to the shareholder. The proposed regulations provide that a shareholder acting as a guarantor of S corporation debt does not create or increase basis of indebtedness simply by becoming a guarantor.

The key requirement of the proposed regulations is that purported debt of the S corporation to a shareholder must be bona fide debt to the shareholder. The proposed regulations do not attempt to provide a different standard for purposes of Code Sec. 1366 as to what constitutes bona fide indebtedness. Rather, general federal tax principles determine whether indebtedness is bona fide.

Under the proposed regulations, shareholder guarantees of S corporation debt do not result in debt basis. As the IRS notes in the preamble to the proposed regulations, an overwhelming majority of courts considering whether shareholders may increase debt basis from their guarantees of S corporation debt have determined that the shareholders' guarantees did not create debt basis. Where an S corporation shareholder acts merely as a guarantor of a loan made by another party directly to the S corporation, or acts in a capacity similar to a guarantor (for example, as a surety or accommodation party), then the courts have held that the shareholder adjusts debt basis only to the extent the shareholder actually performs under the guarantee. One exception, the IRS notes, is the Eleventh Circuit's decision in Selfe v. U.S., 778 F.2d 769 (11th Cir. 1985), where the court held that under unique and limited circumstances, a shareholder who guarantees a loan to an S corporation may increase debt basis where, in substance, that shareholder has borrowed funds and subsequently advanced them to the S corporation.

The proposed regulations provide that an S corporation shareholder who merely acts as a guarantor or in a similar capacity has not created debt basis unless the shareholder actually makes a payment, and then only to the extent of the payment.

Additionally, the IRS notes, some taxpayers have relied on an incorporated pocketbook theory to claim an increase in debt basis in circumstances that involve a loan directly to the S corporation from an entity related to the S corporation shareholder. In these transactions, an S corporation shareholder claims that a transfer from the related entity directly to the shareholder's S corporation was made on the shareholder's behalf and is, in substance, a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corporation. A limited number of court decisions (e.g., Yates v. Comm'r, T.C. Memo. 2001-280 and Culnen v. Comm'r, T.C. Memo. 2000-139) have allowed shareholders to increase debt basis as a result of incorporated pocketbook transactions. Under the proposed regulations, an incorporated pocketbook transaction increases debt basis only where the transaction creates a bona fide creditor-debtor relationship between the shareholder and the borrowing S corporation.

The proposed regulations only address whether a shareholder has debt basis for purposes of Code Sec. 1366(d)(1)(B) and do not address how to determine the basis of the shareholder's stock in the S corporation. Therefore, the IRS notes, the proposed regulations leave unchanged the conclusion in Rev. Rul. 81-187 that a shareholder of an S corporation does not increase basis in stock upon the contribution of the shareholder's own unsecured demand promissory note to the corporation. According to the IRS, this conclusion is consistent with published guidance and case law in the partnership context that the contribution of the partner's own note will not increase such partner's basis in its partnership interest under Code Sec. 722.

The IRS is considering whether the principal holding of Rev. Rul. 81-187, and the holding of Rev. Rul. 80-235 as it relates to a partner's basis in its partnership interest upon the contribution of the partner's own note, should be issued as regulations. It has considered alternatives to the discussion of the applicable law in those revenue rulings. As one model, the IRS has, with respect to basis calculations in the S corporation and partnership context, considered adopting a rule similar to the one currently in Reg. Sec. 1.704-1(b)(2)(iv)(d)(2). That regulation provides that a partner's capital account is increased with respect to non-readily-tradable partner notes only (1) when there is a taxable disposition of the note by the partnership, or (2) when the partner makes principal payments on the note. The IRS is requesting comments concerning the propriety of this model in the S corporation and the partnership context.

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Circuit Courts Split on Whether UK's Windfall Tax Is a Creditable Foreign Income Tax

Contrary to the Third Circuit's decision in PLL Corp. v. Comm'r, 665 F.3d 60 (3d Cir. 2011), the Fifth Circuit concluded that the United Kingdom's windfall tax is a creditable foreign income tax for purposes of the foreign tax credit. Entergy Corporation and Subs v. Comm'r, 2012 PTC 142 (5th Cir. 6/5/12).

Entergy Corporation owns London Electricity, one of 32 companies, generally utilities, that the U.K. privatized through the 1980s and 1990s. The U.K. government set price controls on these utilities but not caps on profits; the newly privatized corporations quickly reduced costs beyond governmental expectations, reaping higher-than-expected profits, share prices, and executive compensation. This in turn led to a public backlash. In response, the then-opposition Labour Party proposed a new tax on the utilities a windfall levy on the excess profits of the privatised utilities. Enlisting the accounting firm Arthur Andersen, the Labour Party designed a series of proposals, including gross receipts taxes and profits taxes, to recoup a desired proportion of the utilities' profits, and it was passed into law. The windfall tax was designed to address the public's concern that the utilities had been sold too cheaply in light of their profit potential. It imposed on each of the utilities a one-time 23 percent assessment on the difference between: (1) a company's profit-making value, defined as its average annual profit per day over an initial period (typically, as here, four years) multiplied by 9, an imputed price-to-earnings ratio, and (2) its flotation value, or the price for which it was privatized. London Electricity timely paid slightly less than 140 million pounds as a result of the windfall tax, and Entergy filed an amended U.S. federal tax return in 1998 claiming an equivalent credit of approximately $234 million. The IRS disallowed the credit, and Entergy filed suit in Tax Court.

The Tax Court relied on its parallel decision in PPL Corp. v. Comm'r, 135 T.C. 304 (2010), applying the relevant regulation interpreting Reg. Sec. 1.901-2(a), and concluded that the tax was creditable. The Tax Court concluded that the windfall tax was based on excess profits, and that it therefore necessarily satisfied Reg. Sec. 1.901-2(a)'s three-part predominant character test: namely, that the windfall tax (1) reached only realized income, (2) was imposed on the basis of gross receipts, and (3) targeted only net income. The IRS appealed in both PPL v. Comm'r and the instant case. In PPL v. Comm'r, the Third Circuit reversed the Tax Court and held that the tax was not creditable.

The Fifth Circuit agreed with the Tax Court's conclusion that the windfall tax satisfied each of the net gain test's three requirements, and that it was therefore a creditable foreign income tax. The court found the IRS's reliance on the primacy of the windfall tax's text, which uses the term profit-making value to describe the base for calculation of the tax, easy to dispatch. The case law from which Reg. Sec. 1.901-2 is derived, the court stated, refutes the IRS's assertion that the court should rely exclusively, or even chiefly, on the text of the windfall tax in determining the tax's predominant character. According to the Fifth Circuit, the label and form of a foreign tax is not determinative.

The Fifth Circuit rejected the IRS argument that because the British Parliament computed the windfall tax based on profit-making value, calculated according to average profits over an initial period, the tax was not designed to reach gross receipts, even though the tax may be based on gross receipts in some indirect way. The Fifth Circuit was persuaded by the Tax Court's observations as to the windfall tax's predominant character: the tax's history and practical operation were to claw back a substantial portion of privatized utilities' excess profits in light of their sale value. These initial profits were the difference between the utilities' income from all sources less their business expenses in other words, gross receipts less expenses from those receipts, or net income.

For a discussion of the foreign taxes for which the foreign tax credit is allowed, see Parker Tax ¶101,910.

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Office of Chief Counsel Reviews Procedures for Levies on Thrift Savings Plan Accounts

A levy on a Thrift Savings Plan account should be treated in the same way as a levy on a private pension or retirement plan or IRA; however, the IRS should consider alternative means of collecting tax liability. CC-2012-11 (5/31/12).

On May 3, 2010, the Department of Justice Office of Legal Counsel (OLC) issued a memorandum opinion holding that Thrift Savings Plan (TSP) accounts are subject to federal tax levy. The OLC memorandum opinion focuses largely on Code Sec. 6334, which provides that notwithstanding any other law of the United States, no property or rights to property are exempt from levy unless listed in Code Sec. 6334(a). TSP accounts are not listed in Code Sec. 6334(a). The OLC held that the notwithstanding clause in Code Sec. 6334(c) indicates by its terms that all other law[s] of the United States, a category that necessarily includes the Federal Employees' Retirement System Act of 1986 (FERSA), are ineffective to bar a federal tax levy, except as provided by the express exceptions in Code Sec. 6334(a). The OLC concluded that FERSA's anti-alienation provision does not protect TSP accounts from the federal tax levy.

In CC-2012-11, the Office of Chief Counsel discusses the procedures for levies upon TSP accounts. The Chief Counsel's Office notes that the procedures for levying upon a taxpayer's TSP account are in IRM 5.11.6.2.1(4). A levy on a TSP account should be treated in the same way as a levy on a private pension or retirement plan or IRA, the Chief Counsel's Office stated.

Under the procedures set forth in the IRM, IRS personnel are required to consider alternative means of collecting the liability. The IRS personnel are also required to consider whether the taxpayer's conduct has been flagrant and whether the taxpayer depends on the money in the TSP account (or will in the near future) for necessary living expenses.

According to the IRS, the following are examples of flagrant conduct: (1) taxpayers who continue to make voluntary contributions to retirement accounts while asserting an inability to pay an amount that is owed, (2) taxpayers who voluntarily contributed to retirement accounts during the time period the taxpayer knew unpaid taxes were accruing, (3) taxpayers assessed with a fraud penalty for the tax debt, (4) taxpayers assisting others in evading tax, (5) taxpayers with liabilities based on illegal income, (6) taxpayers who are in business, pyramiding unpaid trust fund taxes, and will not comply with the results of the IRS's financial analysis, (7) individual taxpayers who are accumulating unpaid income taxes over multiple tax periods and will not adjust their withholding or make timely and adequate estimated tax payments to prevent future delinquencies, (8) taxpayers against whom the trust fund recovery penalty has been asserted on more than one occasion, (9) taxpayers who have demonstrated a pattern of uncooperative or unresponsive behavior, (10) taxpayers who have placed other assets beyond the reach of the government, e.g., sending them outside the country, concealing them, dissipating them, or transferring them to other people, and (11) taxpayers with jeopardy or termination assessments subject to collection.

For a discussion of property exempt from levy, see Parker Tax ¶260,540.

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IRS Extends Time for Paying 2011 Tax for Certain Spouses of Active Duty Servicemembers

Similar to guidance issues for 2009 and 2010 tax returns, the IRS has extended the time allowed for certain spouses of servicemembers to pay their taxes for 2011. Notice 2012-41.

In Notice 2010-30, the IRS provided an extension of time for paying tax for certain spouses (civilian spouses) of active duty members of the uniformed services. The relief and procedures were made available to civilian spouses who (1) accompany their servicemember spouses to a military duty station in American Samoa, Guam, the Northern Mariana Islands (NMI), Puerto Rico, or the U.S. Virgin Islands (USVI) (each a U.S. territory) and claim residence or domicile (i.e., tax residence) in one of the 50 States or the District of Columbia under the Military Spouses Residency Relief Act (MSRRA) or (2) accompany their servicemember spouses to a military duty station in one of the 50 states or the District of Columbia and claim tax residence in a U.S. territory under MSRRA. The relief and procedures set forth in Notice 2010-30 were initially available for 2009 and, in Notice 2011-16, the relief was extended to 2010.

In Notice 2012-41, the IRS further extends the relief set forth in Notice 2010-30 for civilian spouses to 2011 and subsequent calendar years and provides that such civilian spouses should follow the applicable procedures described in Notice 2010-30.

The extension of time to pay federal income taxes is available to eligible civilian spouses claiming MSRRA relief with respect to individual federal income tax returns filed for 2011 and subsequent tax years. To obtain an extension of time through October 17, 2012, to pay federal income taxes for 2011, such taxpayers should follow the procedures in Part III(A)(1)(b) of Notice 2010-30. To obtain an extension to pay federal income taxes for subsequent tax years, such taxpayers should follow those same procedures adjusted for the appropriate filing dates in each such subsequent tax year.

As provided in Notice 2010-30, the IRS has also stated that, with respect to civilian spouses eligible for the extension of time to pay federal income taxes, the addition to tax under Code Sec. 6654(a) will not apply in the case of an underpayment of estimated tax by such civilian spouses for 2011 and subsequent tax years due to unusual circumstances.

Civilian spouses who obtain the extension to pay federal income taxes for 2011 and subsequent tax years are required to pay interest on the amount of tax from the original payment due date until the date the tax is paid. Under Code Sec. 6601, interest is calculated from the prescribed payment due date without regard to any extension to pay federal income tax, including the extension to pay tax provided by Notice 2012-41.

The extension to pay federal income taxes is not available to civilian spouses claiming tax residence in a state or the District of Columbia under MSRRA and filing individual federal income tax returns for 2011 and subsequent tax years who are (1) federal employees in American Samoa, Guam, or the USVI, or (2) individuals working in Guam or the NMI to whom Code Sec. 935 applies. These civilian spouses should file their individual federal income tax returns for 2011 and subsequent tax years, and pay any taxes due, according to the procedures described in Notice 2010-30.

Civilian spouses who accompany their servicemember spouses to a military duty station in one of the 50 States or the District of Columbia and who claim tax residence in a U.S. territory under MSRRA should follow the procedures in Part III(B) of Notice 2010-30 with respect to their individual federal income tax returns for 2011 and subsequent tax years.

For a discussion of the extension of time to pay federal tax available to certain civilian spouses, see Parker Tax ¶15,350.

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Eleventh Circuit Rejects Challenge to IRS Authority to Charge Annual Fee for PTIN

Because in exchange for the tax preparer user fee the IRS assigns a PTIN and confers a special benefit upon tax return preparers, the IRS has the statutory authority to impose the fee. Jesse E. Brannen, III, P.C. v. U.S., 2012 PTC 150 (11th Cir. 6/7/12).

Jesse Brannen is an attorney and CPA in Georgia who prepares tax returns and refund claims for others for compensation. In 2010, in accordance with the new tax preparer regulations, Jesse filed for and paid $64.25 to receive a PTIN. He then filed for a refund with the IRS, but it was rejected. Jesses filed suit in a district court, arguing that the IRS lacks the statutory authority to issue regulations imposing a user fee. Specifically, he challenged the IRS regulation's requirement that compensated tax return preparers obtain a preparer tax identification number (PTIN) and its imposition of an annual fee for that number. The district court dismissed Jesse's complaint and he appealed to the Eleventh Circuit.

The Eleventh Circuit affirmed the decision of the district court. The Eleventh Circuit noted that, under the Independent Offices Authorities Act, 31 U.S.C. Section 9701, agencies are permitted to issue regulations that establish a charge for a service or thing of value that the agency provides. Those charges are required to be:

(1) fair; and

(2) based on the costs to the government, the value of the service or thing to the recipient, public policy or interest served, and other relevant facts.

In addition, the court said, Code Sec. 6109(a)(4) and (d) expressly provide authority for the IRS to require that tax return preparers use the PTIN assigned by the IRS, i.e. a number other than the preparer's social security number. And Code Sec. 6109(a)(4) expressly provides that any return prepared by a tax return preparer must bear the number assigned by the IRS, meaning that a tax return preparer cannot prepare returns for others for compensation without such number. Because in exchange for the user fee the IRS assigns a PTIN and confers a special benefit upon tax return preparers (i.e., they are thus privileged to prepare returns for others for compensation), the Eleventh Circuit held that the IRS's user fee complies with 31 U.S.C. Section 9701.

For a discussion of the PTIN application process, including the user fee requirement, see Parker Tax ¶275,115.

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Since Taxpayer Did Not Provide TSP with Reinstatement Notice, Penalty Tax on Early Distribution Applies

Where the taxpayer offered no proof that he gave the appropriate notice within 90 days to the Thrift Savings Plan that he had been reinstated with the Air Force after being wrongfully terminated, he could not avoid the early distribution penalty tax on the deemed distribution of his TSP loan. Ryan v. Comm'r, 2012 PTC 151 (5th Cir. 6/6/12).

Raymond Ryan worked for the U.S. Air Force and had a Thrift Savings Plan account. In 2003, he borrowed $50,000 from this account. It was not a taxable distribution because it qualified as a loan that met the requirements for an exception under Code Sec. 72(p)(2). On March 21, 2006, Raymond failed to report for duty, as ordered, in a new location asserting that illness prevented him from working at that location. The Air Force removed Raymond from employment, citing excessive absence. Thereafter, Raymond pursued his remedies to obtain reinstatement. Ultimately, on October 4, 2007, the Merit Systems Protection Board ruled partially in his favor and ordered that the Air Force had to restore Raymond to employment and provide an appropriate amount of back pay. The Air Force then cancelled his removal and directed him to return to work, which he failed to do. Ultimately, Raymond received no back pay and filed proceedings to enforce the Board's back pay order, which he ultimately lost.

In the meantime, Raymond received a letter regarding his TSP loan requesting repayment due to his removal from service. Raymond did not repay the loan but continued to make monthly payments on his loan, which the TSP personnel accepted and applied to his loan balance until they closed his account in 2006, at which time he owed $9,784. Subsequently, Raymond sent a letter requesting that his loan be restored due to his challenge to his removal from service, but his request was rejected. Raymond received a Form 1099-R indicating that he received an early distribution from his TSP account. Raymond and his wife included this amount on their timely filed 2006 federal income tax form but did not include the Code Sec. 72(t) 10-percent penalty tax for early distributions from a qualified retirement plan.

The Tax Court concluded that the Ryans owed the 10-percent penalty tax. The Tax Court explained that if a TSP participant separates from Government service, the TSP can accelerate the repayment in full by giving notice to the participant. The Tax Court found that this notice was given, and the Ryans did not challenge this notice. The regulations also provide that, if a wrongfully terminated employee is reinstated, the employee-participant must notify the TSP within 90 days of reinstatement in order to reinstate a loan which was previously declared to be a taxable distribution. At best for him, the Tax Court stated, Raymond was reinstated in October of 2007, but he offered no proof that he gave the appropriate notice within 90 days thereof. Moreover, the Tax Court concluded that Raymond's letter in August of 2006 requesting reinstatement was ineffective to constitute the necessary notice because, at that point, Raymond had not been reinstated (and, indeed, he subsequently received an adverse ruling from the Administrative Law Judge). The Ryans appealed.

Before the Fifth Circuit, the Ryans argued that Raymond notified the TSP that the report of his separation from service was erroneous and that the TSP advised him to continue to pay on his loan, which he did. Thus, they contended that Raymond neither failed to make required payments nor had he separated from service. As a result, the Ryans argued that they did not receive a taxable distribution in 2006.

The Fifth Circuit upheld the Tax Court's decision, saying it agreed with the Tax Court on both counts: Raymond was required to give notice to the TSP no later than 90 days from October 15, 2007, and he failed to prove that he did so. Accordingly, the loan was never timely reinstated, and, thus, the Fifth Circuit did not need to determine whether any such reinstatement would have altered the deemed distribution calculus.

For a discussion of the 10-percent penalty tax on early distributions from qualified plans, see Parker Tax ¶131,560.

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Accounting Firm to Pay IRS a $34.4 Million Penalty for Promoting Tax Shelter Products

Under a settlement agreement with the IRS, BDO USA, LLP will pay a civil penalty to the IRS stemming from tax law violations relating to the registration of tax shelters. IR-2012-61 (6/13/12).

The IRS has reached a settlement agreement with the accounting firm of BDO USA, LLP (formerly BDO Seidman LLP). Under the settlement, BDO will pay a civil penalty to the IRS of slightly more than $34.4 million stemming from its violation of the tax law concerning the registration of tax shelters. BDO did not register various tax shelters as required by law, some of which were abusive and fraudulent, in an effort to conceal the tax shelters from the IRS and assist high-income taxpayers evade federal income taxes.

This penalty is part of a $50 million payment that BDO has agreed to pay the United States in connection with the filing of an information charging the firm with one count of engaging in a tax fraud conspiracy from approximately 1997 to 2003, and a deferred prosecution agreement with the United States for the criminal charge if specific conditions are met.

In addition to the civil penalty payment, BDO has agreed to cooperate with the IRS in civil matters, including IRS audits and litigations relating to its tax shelter products, and to work with the IRS to ensure that it is in compliance with federal tax laws involving tax shelters.

The settlement and payment resulted from the following determinations:

(1) Between 1997 and 2003, BDO violated federal tax laws concerning the registration, and maintenance and turning over to the IRS of tax shelter investor lists, involving abusive and fraudulent tax shelters.

(2) Primarily through a group within the firm known as The Tax Solutions Group, BDO developed, marketed, sold, and implemented fraudulent tax shelter products to high net worth individuals, who had, or expected to have, reportable income or gains in excess of $5 million.

(3) These fraudulent tax shelters, although designed to appear to the IRS to be investments, were, in fact, a series of pre-planned steps that assisted BDO's high net worth clients to evade individual income taxes of approximately $1.3 billion.

(4) The fraudulent tax shelters were sometimes known under the following names: SOS, Short Sale, BEST, BEDS, Spread Options, Currency Option Investment Strategy or COINS, Digital Options, G-1 Global Fund, FC Derivatives, Distressed Asset Debt, POPS, OPIS, Roth IRA, and OID Bond.

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Evidence That Tax Preparer Filed Some Accurate Returns Is Irrelevant to Charge of Falsifying Other Returns

Statistical evidence was presented at trial for the purpose of showing how a tax return preparer convicted of filing false returns for clients came to the attention of the IRS; evidence that some returns were accurate was not relevant. Diallo v. U.S., 2012 PTC 157 (6th Cir. 6/6/12).

Thierno Diallo was charged with 15 counts of aiding and assisting in the preparation of false tax returns. He pled not guilty, and proceeded to a jury trial. At trial, the government introduced evidence that Thierno had a tax-preparation business in addition to his regular job, and that he prepared approximately 750 tax returns for the years 2006 and 2007, mostly for other members of the West African immigrant community. The government presented evidence that an unusual percentage of the returns prepared by Thierno resulted in refunds to the taxpayers. The taxpayers involved in the 15 charged returns testified that Thierno prepared their returns, which were false in that they claimed an erroneous filing status, number of dependents, or business expenses. Thierno presented the defense that he had prepared the returns with the information provided by the individuals, and that they had blamed him for the false returns to avoid deportation. The jury convicted Thierno on seven counts and acquitted him on eight counts. He was sentenced to 24 months and went to prison.

Thierno appealed to the Sixth Circuit, arguing that the district court erred in granting a government motion that prevented him from arguing that the over 700 returns that he was not charged with falsifying were in fact accurate. Thierno argued that the government's statistical evidence presented at trial regarding the number of refunds received by his clients implied that most of the returns he prepared were false, and was therefore unduly prejudicial. Thierno had wanted the district court to allow him to argue that, because he was charged with only 15 counts, the remainder of the returns he prepared must have been accurate. The district court found that the statistical evidence was presented for the purpose of showing how Thierno's tax preparation business came to the attention of the IRS. It ruled that evidence that the other returns were accurate would not be relevant to Thierno's guilt on the charged counts.

The Sixth Circuit affirmed Thierno's conviction. The court noted that the district court relied on U.S. v. Daulton, No. 06-4593 (6th Cir. 2008), a similar case where the Sixth Circuit concluded that evidence that the defendant filed some accurate tax returns was irrelevant to whether he was guilty of falsifying the returns that he was charged with falsifying. The Sixth Circuit found no abuse of discretion in the district court's ruling.

For a discussion of the penalty for a tax preparer who willfully aids or assists in preparing a fraudulent or false tax return, see Parker Tax ¶277,110.

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Debtors Entitled to Tax Refund Grabbed by Government Agency

Allowing the government to take the debtors' tax refund would reduce the debtors' post-petition assets by 65 percent, which weighed in favor of returning the tax refund to the debtors. In re Riley, 2012 PTC 158 (Bankr. W.D. Ky 6/7/12).

In 1989, Kenneth and Sheila Riley executed a note to Farmers Home Administration (FmHA) in the face amount of $39,500. The Riley's subsequently defaulted and, in 2008, foreclosure proceedings began. The U.S. Department of Agriculture, Rural Housing Service (USDA RHS) referred the foreclosure to the U.S. Attorney's Office and, in 2010, the USDA RHS, for purposes of setoff against the Rileys of any federal payments due to them, certified to the Treasury Secretary that a debt of $8,500 was still owing. On March 25, 2011, the Rileys filed for Chapter 7 bankruptcy. They listed a tax refund of approximately $1,500 in their Schedule B and claimed the refund as exempt in their Schedule C. They also listed USDA RHS as a creditor in the petition. The Rileys filed their tax return after the filing of the petition. On May 12, 2011, the Chapter 7 Trustee filed a Report of No Distribution. Two weeks later, the Rileys received notice that their joint tax refund in the amount of $5,140 had been intercepted by USDA RHS. The Riley's bankruptcy schedules were amended to reflect the greater tax refund amount and discharges in the joint bankruptcy case were entered on July 11, 2011.

The Rileys filed suit in district court arguing that they were entitled to the intercepted refund under 11 U.S.C. Sections 522 and 542(a). They argued, among other things, that although it was clear that their obligation to the USDA RHS arose pre-petition, the IRS did not owe them a tax refund until they filed their return, post-petition. The USDA RHS argued that the IRS owed the Rileys an undetermined amount of money on January 1, 2011, in the form of a potential tax refund, and therefore the mutual debts arose pre-petition. When the Rileys filed their 2010 federal tax return, postpetition, the exact amount owed by the IRS became set at $5,140.

The Rileys also alleged that the trustee could have avoided the transfer as a preference under 11 U.S.C. Section 547. The USDA RHS argued that the overpayment never became a refund, so there was no property to which the exemption could attach. It argued that under 11 U.S.C. Section 553(a), the Rileys did not have a right to the overpayment until the IRS had completed the statutory setoff under 31 U.S.C. Section 3720A.

The district court sided with the Rileys and held that the USDA RHS had to return the intercepted refund to the Rileys. The court noted that 11 U.S.C. Section 553(b) establishes a 90-day look-back period in which the trustee may recover any offset taken during that period to the extent the creditor has improved its position during that period. The Rileys filed their Chapter 7 petition on March 25, 2011. Ninety days before the petition date was December 26, 2010. On that date, the court stated, there was no right to set-off because the overpayment was not absolutely owing to the Rileys. The purpose of Section 553(b), the court observed, is to remove the creditor's temptation to take a set-off when its position is improved by conduct during the 90-day preceding the petition. The concern of Congress in enacting the improvement-in-position test was that creditors would foresee the approach of bankruptcy and scramble to secure a better position for themselves by decreasing the insufficiency, to the detriment of the other creditors. The USDA RHS should have been aware of the financial difficulties that the Rileys were having since it had recently completed foreclosure proceedings against the Rileys and had filed periodic reports with the IRS on the amount still owed. According to the court, during the six days from December 26, 2010, to January 1, 2011, the USDA RHS clearly improved its position when the IRS became indebted to the Rileys on January 1, 2012. It went from having no right of setoff to having a right of setoff. Thus, the court concluded, by the clear language of Section 553(b), the USDA RHS could not gain a right to set-off the tax refund when the IRS became indebted on January 1, 2011.

The district court looked at the decision in In re Alexander, 225 B.R. 145 (Bankr. W.D. Ky. 1998) in which the bankruptcy court noted that exemptions promote a fresh start by not depriving a debtor of the basic means of survival. The Alexander court then reviewed the amount of the debtor's exempt assets subject to set-off and found that allowing set-off would eliminate 81 percent of the debtor's exempt assets. In balancing the fresh start with equity among creditors, the court found that the large proportion subject to set-off weighed in favor of the former.

In the instant case, the district court noted that the Rileys claimed exemptions for their federal tax refund of $5,140, their 1995 Chevy Corsica (FMV $800), their household furnishing (FMV $1250), their mower and tools (FMV $80), their wedding rings ($120); and the $500 in their bank account. Allowing the set-off of exempt assets, the court stated, would reduce the Rileys' post-petition assets by 65 percent.

Finally, the court addressed the USDA RHS argument that the overpayment never became a refund nor property of the bankruptcy estate because it was offset under Code Sec. 6402(a). Code Sec. 6402(a) provides that, in the case of any overpayment, the IRS, within the applicable statute of limitations, may credit the amount of such overpayment, including any interest allowed thereon, against any tax liability. The district court noted that in In re Jones v. IRS, 359 B.R. 837 (Bankr. M.D. Ga. 2006), a bankruptcy court held that the debtor had a right to a tax refund only to the extent his overpayment exceeded any pre-existing tax liability. In the Jones case, the refund did not become property of the bankruptcy estate subject to exemption until after the IRS had effected any offset. The district court rejected the attempt by the USDA RHS to use this argument, saying that the statute creates a distinction between tax liability and a debt owed to another agency. The court said that while it recognized the unitary creditor theory reasoning and its application to the federal government (i.e., debts owing to one government agency can be collected by another government agency), there remained a significant difference between offsetting a 2010 tax refund against a 2009 tax liability and offsetting the same 2010 tax refund against a 1998 notice of a past due debt based on a guaranty.

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Tax Court Excuses S Corp from Late Filing Penalty In First Case to Deal with Code Sec. 6699

In the first judicial opinion to consider the scope of the reasonable cause exception to the Code Sec. 6699 penalty for late filing of an S corporation return, the Tax Court held that the failure of an S corporation to timely file its annual return was due to reasonable cause and thus no penalty applied. Ensyc Technologies v. Comm'r, T.C. Summary 2012-55 (6/14/12).

Ensyc Technologies is an S corporation that manufactures radio frequency identification equipment. Ensyc is operated entirely by its president, Steven Jessup, with the assistance of subcontractors. Steven works from his home in Meridian, Idaho. Ensyc's tax returns are prepared by an outside accountant in Reno, Nevada. Steven signs the returns and mails them to the IRS.

Ensyc's annual tax return for 2008 was due March 16, 2009. On March 10, 2009, Ensyc's accountant sent Steven a Form 1120S, U.S. Income Tax Return for an S Corporation, to file with the IRS. The accountant also sent copies of Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., for Steven to distribute to each of Ensyc's shareholders. Steven's files contained a copy of a Form 1120S bearing Steven's signature and dated March 16, 2009. The IRS had no record of receiving a Form 1120S from Ensyc around that time. It received a Form 1120S from Ensyc six months later, on September 11, 2009. The form received by the IRS was in an envelope bearing a September 8, 2009 postmark. However, the form itself was dated February 24, 2009.

Code Sec. 6699 provides that an S corporation that does not timely file its annual tax return is liable for a per-shareholder penalty for every month the tax return is late (but not to exceed 12 months). The penalty is not imposed if the failure to timely file the return is due to reasonable cause.

On the theory that the Form 1120S it received on September 11, 2009, was the only Form 1120S Ensyc had filed for the tax year 2008, the IRS assessed a $6,408 late-filing penalty against Ensyc. The IRS mailed a notice to Ensyc that it intended to collect the late-filing penalty by levying on Ensyc's property. On February 1, 2010, Ensyc requested a collection-review hearing with the Office of Appeals. During the hearing, Steven represented Ensyc. Subsequently, the Office of Appeals determined that (1) Ensyc did not timely file a Form 1120S and (2) Ensyc did not have reasonable cause for failing to timely file the form. The Office of Appeals sustained the levy. Ensyc took the case to the Tax Court, arguing that it was not liable for the late-filing penalty because it mailed a Form 1120S on March 16, 2009.

The Tax Court examined the possible explanations for why the IRS had no record of receiving the Form 1120S and found by a preponderance of the evidence that Steven never mailed the Form 1120S that the accountant had sent him on March 10, 2009. The court then considered whether there was reasonable cause for not filing the form on time. The court noted that, as far as it could tell, no judicial opinion had yet considered the scope of the reasonable cause exception to the Code Sec. 6699 penalty.

The court held that the failure of an S corporation to timely file its annual return is due to reasonable cause if the S corporation exercised ordinary business care and prudence and was nevertheless unable to timely file its return. In effect, the court said it was applying the ordinary-business-care-and-prudence test from the Code Sec. 6651 regulations.

The Tax Court concluded that a preponderance of the evidence showed that Ensyc exercised ordinary business care and prudence in its efforts to timely file its Form 1120S for 2008. Steven usually mailed Ensyc's tax returns on time, the court noted. Ensyc's accountant sent Steven the 2008 return in time for Steven to file it by the March 16, 2009 deadline. Steven executed the Form 1120S. According to the court, he retained a copy of the Form 1120S in his files, erroneously thinking he had mailed the original. Steven mailed the Schedules K-1 to Ensyc's shareholders. The court surmised this because an Ensyc shareholder filed an annual individual income-tax return on April 15, 2009, that reflected the shareholder's passthrough loss from Ensyc.

Although Steven could not explain why he had misdated the Form 1120S, the court did not think misdating the form was a deliberate attempt to mislead the IRS. It seemed unlikely to the court that Steven thought that mailing a return in September with a February date would fool the IRS into thinking that he actually mailed the return in February. Although Steven misdated the September Form 1120S, the court believed his testimony that he thought he had mailed the March Form 1120S on March 16, 2009. As a result, the court found that Ensyc's failure to timely file a Form 1120S for the 2008 tax year was due to reasonable cause and, thus, Ensyc was not liable for the Code Sec. 6699 penalty.

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