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Mr. Osborne then discussed the ways to attack a DAPT. In general you need to prove a 1) fraudulent transfer, 2) sham transaction – settlor is controlling the trust rather than trustee,or 3) against public policy of the state to allow self-settled asset protection trusts in other states. Once you obtain a favorable ruling you must get a judgment, and then you have to deal with jurisdictional and conflict of law issues to enforce the judgment. As a result, DAPT assets have become extremely unattractive to creditors as this process may take years. Judge Mahoney noted that most cases settle.
Mr. Rothschild noted that asset protection trusts are not bulletproof, but provide a substantial amount of leverage to a client when faced with a creditor. He noted it is also important to consider other methods of asset protection for clients such as spousal lifetime access trusts, GRATS, QPRTS, and SCINS which does not take on the same smell as DAPT.
The panel also went through some hypothetical planning scenarios. During the hypotheticals they emphasized that you must consider fraudulent transfer law in panning. They also emphasized that transferring assets may result in a denial of discharge in bankruptcy, and Judge Mahoney noted that it is not always the debtor who chooses bankruptcy. Overall, the panel feels asset protection trusts work to a degree, but may not be a strategy for all individuals. They also noted that off shore provides greater obstacles to enforcing judgments, but they also entail greater risks for the client.
Session I-E What You Never Knew You Never Knew: More Tax Administration and Procedural Rules for Estate Planners (Focus Series) M. Read Moore, Nancy G. Henderson This workshop will consider in depth a number of additional rules that apply to tax returns and tax audits, including transferee liability, fiduciary personal liability, estate and gift tax liens, tax payments and deposits, extraterritorial application of U.S. tax laws, equitable recoupment and setoff, and similar topics. The last time this topic was addressed in depth at the Institute was in 1999, so don’t miss out on this once in a blue moon but nevertheless important topic.
Reporter:Michelle R. Mieras
This session expanded upon Mr. Moore’s morning presentation by applying the technical rules to three case studies designed to present issue that would likely arise in real life practice. In particular, Mr. Moore and Ms. Henderson wanted to take a closer look at the adequate disclosure rules, statutes of limitations, the mailbox rule, fiduciary liability, transferee liability, equitable doctrines, and tax liens and collections. The first two case studies are discussed below.
CASE STUDY 1: Decedent with Many Open Tax Issues at Death
Case Study 1 Facts:
In December 2012, MB gifted a 35% interest in a single member LLC (which owned commercial real estate) to an IDGT she had formed for the benefit of her children. A gift tax return for this gift was filed in August, 2013, using figures from a) a qualified appraiser’s valuation of the underlying real estate, and b) MB’s CPA firm’s appraisal of the LLC interest, which included a 41% discount for lack of control and marketability. The appraisals, but not the trust, were attached to the return.
In March 2013, MB sold another 35% LLC interest to the IDGT for a note, using the same value she had used for the December gift. MB learned she was ill in early 2014, and to settle the note, transferred an LLC interest back to herself with a value equal to the balance due on the note. Not wanting to pay for more appraisals, MB used the grossed up property values to reflect the percentage increase in revenues and applied a 41% discount as the CPA had done.
MB appears to have made several transfers during her lifetime that were not reported and may have exceeded the gift tax annual exclusion. MB’s cousin in the UK died in 2006, leaving an account overseas to MB, which MB never reported.
MB died August 1, 2014. Shortly before her death, her 2010, 2011, and 2012 income tax returns were audited, with a focus on the deduction of personal expenses as expenses related to her rentals. Her 2013 income tax returns was not filed before her death.
Case Study 1 Discussion:
If you are an executor faced with tax fraud, unfiled tax returns, and gifts without statute of limitations running, what do you do? Option one is resign and ask to be relieved of further liability. Option two is to continue to serve, get the statute of limitations running on the matters in question. But be aware of the executor’s potential personal liability.
Ms. Henderson pointed out the fiduciary’s obligation to file all of the decedent’s tax returns that have not been filed, although there may be exceptions for gift tax returns if there would be no tax due and the gifts are disclosed on the estate tax return. If you are unsure what may have been filed, copies of the past three years’ returns can generally be obtained from the IRS, and a transcript can be obtained and will list returns filed over at least the past ten years. The executor has a responsibility to try to get the information.
Ms. Henderson cautioned against inadvertently opening the statute of limitations on an issue that would otherwise be closed. The adequate disclosure rules were not in effect before 1997. Therefore, at that time, a gift tax return could have been filed and cause the statute of limitations to run on undisclosed gifts. Rather than reopening that return, disclose on the estate tax return (or later gift tax returns that have to be filed) that the gift was made but the statute of limitations has run.
The point was made that even after the estate tax return statute of limitations has passed, the IRS can still assess tax on unreported gifts. This makes it very important to get the statute of limitations running (and closed) on gifts made. For this reason, it may be more favorable to file past gift tax returns (if the statute of limitations has not already run on the gifts) and file a Form 4810 (which can only be filed after the return is filed and the tax is paid) to shorten the statute of limitations, rather than relying on disclosure of gifts on a 709.
Remember, for gift tax returns filed starting in 1997, the statute of limitations does not generally run on gifts not adequately disclosed. In MB’s case, there were two deficiencies in the 2012 return. First, the copy of the trust agreement was not attached. Mr. Moore believes there is still a return filed even if the trust was not attached (and therefore the requirements have not been fulfilled), as long as there is enough information on the return to give the government the ability to dig in. Second, the appraisal provided by the CPA was probably not a qualified appraisal.
What about the gifts made by MB in 2013? The executor will probably want to get a gift tax return filed to get the statute of limitations running. A full new appraisal probably does not need to be obtained, but the executor will need to justify relying on the prior report. Mr. Moore pointed out that the 2013 and 2014 returns have to have the correct adjusted prior gift numbers. So even if the executor is not filing the prior 2012 return, he has to make sure the figures are correct.
The executor is probably not responsible for going back and fixing fraudulent returns, but he does need to handle any audits going on. The executor could amend returns to eliminate any fraud.
Since MB did not file her 2013 income tax return before she died, the executor will need to file it. If he can show that MB filed to file for an extension because she was sick, the executor could ask the IRS for a good cause exception for the failure to file.
With regard to the foreign account MB inherited from her cousin, the executor has a duty to make sure the FBAR and 8939, if necessary, is filed. After 2010, the failure to complete foreign reporting on an income tax return prevents the statute of limitations from running on the return entirely (even with regard to the properly reported domestic income). Note the steep penalties for not completing FBAR filing.
When an executor has or should have knowledge of a liability and takes action to reduce the value of available assets (other than by paying appropriate administration expenses), then the executor can be liable for the liabilities.
The executor can generally seek a discharge from liability, but that doesn’t mean the tax is not collectible. Instead, the tax is collectible from the successors in interest.
CASE STUDY 2: Transferee Liability
Case Study 2 Facts:
Mom and Dad owned a closely held business. Beginning in 2005, they made annual gifts of company stock to a Crummey trust established for their children, in an attempt to take advantage of the annual gift tax exclusion. For this purpose, the business was valued using the CFO’s estimate based on the financials and a cap rate, less a 35% discount for lack of control and marketability. None of the gifts were reported for gift tax purposes.
In 2012, Mom and Dad gifted $250,000 cash to each of their 5 children. They also used the balance of their lifetime gift tax exclusions to gift the remaining stock in the business to the trust. They timely filed gift tax returns for the 2012 gifts, including copies of an appraisal from a qualified appraiser and the trust agreement.
Dad became ill in 2013. Son tried to run the business. Mom had faith and continued to pump money into the business. Dad’s illness consumed Mom and Dad’s other resources. Dad died in January 2015, by which time their home was mortgaged, all personal and business lines of credit were maxed, there accounts were drained, and the business is being liquidated by a receiver. The only remaining asset is an ILIT established by Dad for Mom’s benefit, which held $4 million insurance proceeds. Mom is entitled to all trust income, and the trustee (Mom) may distribute principal for Mom’s health and support.
The 2012 gift tax returns were selected for audit. The agent inquired into prior transfers of company stock, and argues that the annual gift tax exclusion did not apply due to restrictions on transferability and lack of dividend distributions. The IRS assets that Mom and Dad each owe about $700,000 in gift tax, interest and penalties from the 2012 transfers.
Case Study 2 Discussion:
Mr. Moore gave a general overview of the tax deficiency process was given, and the basic three year statute of limitations, or six year statute in the case of a 25% or more omission, were discussed.
Does the IRS have to file a claim in the state probate court? The IRS can file a claim, but it is not subject to state nonclaims statutes. The IRS may not want to file a claim, because it is putting itself within the probate procedures, and may have to deal with the executor disallowing the claim. The IRS does not want to create a situation where state court could be determining a federal liability issue. If it finds itself in that position, it would probably try to remove the matter to federal court. Note that the government cannot use its levy functions as part of a collection action inside of a probate action. Therefore, as long as probate is occurring, the government cannot enforce its liens in the normal ways. This does not, however, apply to nonprobate property, regardless of whether a probate is in progress.
In the case of the destitute surviving spouse, who is to pay the liability? Be on the lookout for gift splitting by spouses, which creates joint and several liability. If Mom and Dad gift split on the 2012 gift tax return, the IRS could go after Mom for all of Dad’s gift tax liability. Think about this when considering filing a gift tax return with gift splitting. It makes the spouse liable for all gift tax liability, even for gifts not actually reported on the return (and that the other spouse made). Unlike the income tax arena, there is no innocent spouse relief for the joint and several liability arising from gift tax returns with gift splitting.
Can the IRS pursue the donees for the tax liability? Under Section 6324(b), there is a lien on property transferred by gift for unpaid gift taxes for 10 years following gift. The IRS can collect on this lien without going to court. In this case, there is a lien on the $250,000 cash gifts to the kids. The lien follows the asset, so if a child purchased a home with that money, the lien would apply to the real estate. Note that the IRS does not need the lien for the transferee to be liable. The government can sue the transferees who will be liable to the extent of the gift received.
This means one donee could be liable for the entire unpaid gift tax, if the gift he received is sufficient.
Does the liability of a transferee include interest on the deficiency? A November 2014 5th Circuit case held that a beneficiary liable under Section 6324(b) is liable for interest on the tax (the 3rd Circuit has reached a different conclusion). This case may be reargued, but it potentially means the transferee could end up owing more than what they received from the donor. They may then have a right of contribution under state law to get repaid from the other transferees.
The IRS has yet another avenue to collect against the children under Section 6901, and under this method the government can get taxes, interest and penalties from the donee. Significantly, 6901 applies to any taxes owed at the time the transfer was made (not just gift taxes).
What about the life insurance trust for Mom? Can liability be assessed against the life insurance or the trust? Ms.
Henderson commented that the ILIT could have some transferee liability due to transfers to the trust in 2012.
Additionally, a lien could be placed on Mom’s account to which mandatory distributions are made.
Does the IRS have to go against Mom and Dad’s estate before it goes after the transferees? Not if the IRS is using a special gift tax lien. But, if the IRS is using Section 6901 for fraudulent transfers or other equitable doctrine under state law, then the IRS must pursue all possible actions against Mom and Dad’s Estate unless doing so would be futile.