Reading Tea Leaves — What Might Happen with the IRS

03-Feb-2022

Reading Tea Leaves What Might Happen with the IRS - Cantley Dietrich

Reading Tea Leaves What Might Happen with the IRS - Cantley Dietrich

Article Authored By Beckett Cantley and Geoffrey Dietrich

As of early January 2022, President Biden’s massive $1.8+trillion “Build Back Better” Bill (“BBB”) was declared dead as a single piece of legislation. While barely passing through the House of Representatives in a 220-213 vote in November, the President’s multiple trips to Capitol Hill and threats across the Senate by various leaders were unable to sway Sen. Joe Manchin (D-WVa.) to vote for the BBB. Sen. Manchin’s vote was necessary to have the BBB Senate vote reach 50-50, which would have allowed Vice President Harris to break the tie. Tucked away inside every version of the BBB was an $80 billion budgetary increase over ten years for the IRS.  Every year, the bureaucracy most despised by the American taxpayer would receive an additional $8 billion in funding.

The Starvation of the IRS

The IRS has been in a budgetary drought for over a decade.  The IRS budget absorbed a twenty percent (20%) cut (adjusting for inflation) since 2010.  IRS funding has not been increased at a proportionate rate to keep up with even then-moderate inflation, much less the inflation we are seeing today.

In its’ report to Congress, the Taxpayer Advocate Service listed the “most serious problems encountered by Taxpayers” in dealing with the IRS.  Said problems included but were not limited to: (1) processing and refund delays; (2) lack of sufficient and highly trained employees; (3) significant challenges reaching an IRS representative for either telephone or in-person services; and (4) lack of proactive transparency (See 2021 Annual Report to Congress, Taxpayer Advocate Service (January 2022)).

The individual income tax return filing season began January 24 and ends April 18, with neither Treasury nor the IRS having any illusion it will go smoothly.  There are no plans to extend the return filing closing date at this time, Treasury officials said on a January 10 call with reporters. Going into it, the administration is anticipating challenges.

A preexisting backlog of tax returns, with millions more in unprocessed returns than in years past, combined with staffing and logistical challenges, are expected to make for an especially frustrating filing season this year for both taxpayers and tax professionals, the officials said. That means that the IRS simply doesn’t have enough resources to provide adequate service or enforcement, they said.

(See Treasury, IRS Set Filing Season Kickoff for January 24, Tax Notes (January 11, 2022)).

This backlog is, in a good year, approximately 1-2 million returns.  Not an insignificant number by any calculus, but going into 2022, there are nearly 35 million unprocessed returns.  That is an astounding figure.  While recognizing that not every American will file a return, that number does represent ten percent (10%) of the population of America if every person filed a return.  What that really represents is a catastrophic backlog of returns that will likely never see the light of day.  To ease the process for both taxpayers and the IRS, officials advised taxpayers to avoid paper if possible, recommending that they file tax returns electronically and use direct deposit or pay taxes owed electronically.

Overall, tax practitioner patience is running out while taxpayer anxiety is growing.  President of Padgett Business Services, Roger Harris, remarked, “The excuse of COVID is about to run out [for lagging IRS services]. It’s already run out for a lot of people.”  Like the rest of the federal government, the IRS is operating on a continuing resolution which delays programs and improvements until the middle of the agency’s fiscal year (See A Look Ahead: In Battle of Wills, Will Congress Fund? Will IRS Reform?, Tax Notes (Dec. 27, 2021)). So, without any new funding and operating on last year’s budget, no change will really be possible until at least February, a less than ideal time to throw new agents, phone representatives, and auditors into the fire.

IRS Facing Off with an Angry Congress

As far back as 2019, the IRS has struggled with its optics.  A ProPublica report released May 30, 2019, found that the IRS audits the poorest Americans at approximately the same rate as the top 1% income earners (See Paul Kiel, It’s Getting Worse: The IRS Now Audits Poor Americans at About the Same Rate as the Top 1%). Recipients of the Earned Income Tax Credit (“EITC”) were audited at a higher rate than all but the richest taxpayers.

The most likely driver for auditing EITC issues is the ease of execution.  Audits of EITC recipients are largely automated and less complicated.  Conversely, the wealthiest Americans—think the billionaires we love to malign in the media—have teams of accountants and money managers that require a team of trained investigators to understand and attack the structures and documentation.  Every year, the IRS loses its trained auditors to retirement.  When subject matter experts disappear from the ranks, they are rarely replaced by similarly qualified persons.  These complicated audits require individual attention and in-person meetings—something the IRS is currently ill-equipped to handle.

Adding to the scrutiny, taxpayers have increasingly turned to their representatives in the House and Senate for assistance solving problems with the IRS.  From 2017-2019, members of Congress requested assistance from the Taxpayer Advocate approximately 10,000 times in a year.  In 2021, that number was 66,453 (See Lawmakers Report Surge in Requests for Help With Unresponsive IRS, Tax Notes (January 14, 2021).  A smaller work force, underfunded and technologically behind, dealing with six times as many calls just to the Taxpayer Advocate.  There were nearly 140 million calls to the IRS itself in 2021.

In typical political fashion, each political party is blaming someone on the other side of the aisle for the problems faced today.  Congressional Republicans have sent a letter to Commissioner of the IRS Chuck Rettig noting that righting the ship of the agency may require “significant tradeoffs” to “meaningfully reduce the backlog” (See House Ways & Means Committee, Letter to Commissioner Rettig (January 19, 2022)). Further advising that the service should take an “all hands on deck” approach to minimize the backlog and prepare for the current year’s filing season.  They also note that, despite the pleas of poverty, the IRS received over $1.4 billion in unobligated supplementary funds from Congress in 2021.

Possibility of a BBB Revival? 

It appears that the Biden administration is still seeking to enact a few provisions from the BBB, even though the larger BBB proposed legislation has been defeated.  On a January 25 2022 virtual meeting of the N.Y. State Bar Association Tax Section, Treasury Assistant Secretary for Tax Policy Lily Batchelder said the $80 billion boost in IRS funding over ten (10) years is among the items intended to be resurrected.  “The administration’s Build Back Better package has faced many twists and turns in its path to enactment,” Batchelder acknowledged. “Having worked in Congress, I can say this is true of every major — and minor — piece of legislation” (See Hope Springs Eternal for Some of Biden’s Tax Priorities, Tax Notes (January 26, 2022)). Batchelder previously served as chief tax counsel for the Senate Finance Committee from 2010 through 2014.  He stated that the Biden Administration remains “confident that many of the top priorities will ultimately be enacted,” including the increase in IRS funding.

House Majority Leader Steny H. Hoyer (D-Md.) has also sounded upbeat on passage of some of the items, saying in a January 25 live interview with Politico that “[y]ou pass what you can pass, and then in future years, future Congresses, you try to improve. And so I’m optimistic that we’re going to pass a significant, very positive for the American people, Build Back Better bill”.  Jorge E. Castro of Miller & Chevalier Chtd., a former House and Senate Democratic tax staffer, told Tax Notes that he thinks a robust BBB package still has a possibility of enactment this year, but the next few weeks will be critical.

Whatever is included in a scaled back BBB will ultimately be determined by moderate members of the House and Senate, Castro said. Lawmakers like Sens. Joe Manchin III (D-W.Va.) and Kyrsten Sinema (D-Ariz.) have shown at least some willingness to support revenue-raising proposals, suggesting IRS funding reforms remain on the table, he added.  Still, the IRS funding provision is intended to offset the BBB spending provisions, Castro continued. “Whatever those spending provisions are, I think that’s going to determine what the scope of the revenue raisers is going to be,” he said.

That being said, 2022 is an election year.  The likelihood is small that the Democratic majority in the House and their effective control of the Senate will remain after the 2022 elections.  President Biden’s unpopularity continues to plummet, so he will be of little assistance to his congressional allies.  Passing pro-IRS legislation is difficult when a political party is popular, but undertaking it in this environment may be devastating to congressional Democrat Party members running in red and purple states.  Recently, Democrat Party members released press statements desperately requesting their retiring members continue to work on the Biden Administration agenda.  We will see how effective these requests are to Democrat Party members who may be looking for new employment in 2023.

Tea Leaves. Divining the Unknowable.

Here we gaze into the hazy crystal ball of the future, pour out the tea and divine meaning from the leaves left, and shake our chicken bones and cast them on ground searching for answers.  We begin with what we know:

  • The IRS has been tragically underfunded for over a decade and, despite cash infusions, pleads continual poverty.
  • During this same season, more than 17% of the IRS workforce has retired or left for other pastures and hiring is down due to a weak job market and lack of applicants.[1]
  • The hoped-for $80 billion of BBB money meant to rescue the IRS may not materialize.
  • There are at least 16 million individual returns outstanding and a similar number of business
  • The Service faces increasingly antagonistic requests from Congress regarding: (1) customer service; (2) failures to provide accurate tax processing to the lowest income brackets who—historically—rely most on tax refunds; and (3) aggressive stances toward audits of wealthy individuals while a historically large backlog prevent even basic services.

What does this mean?  What do the tea leaves tell us?  As is often the case with divination, we may see what we want to see.  We may also guess completely wrong.  With those carefully laid disclaimers, we think that if no BBB money is forthcoming, continued pressures from Congress will likely divert new hires away from audit and toward basic customer service positions like telephone assistance and processing. Typically, one supervisor is needed for four telephone agents.  The IRS will likely have to triage and with new hires have a 1:8 ratio or greater.  This could result in slower outcomes or mistakes but should increase the available agents to take calls and at least ease some of the burden.

There is a distinct possibility things get worse before they get better.  Could the IRS put a “pin” in prior tax years and just set sights on the future?  While possible, certain tax years or risks or demographics may find themselves “outside” any silo shutting down prior tax years.  The IRS will need significant work and transparency in any determination to reduce or even delay collections activity.  Some of these possibilities may result in more paperwork, filings, requests, and delay than just pulling on the big kid boots and mucking through.

[1] IRS Letter to Senator Elizabeth Warren, August 27, 2021, pp. 10-11.

Does a Tax Return Filed in the United States Virgin Islands (“USVI”) Start the IRS Statute of Limitations?

20-Jan-2022

The Internal Revenue Code (“IRC”) § 6662(a) permits the IRS to impose a twenty-percent (20%) accuracy-related penalty to an underpayment of tax, and there are several different defenses to this penalty depending on the facts of the case and the reason for the penalty. One of the most common accuracy-related penalties is the negligence penalty. Although there are multiple different reasons for the application of an accuracy-related penalty, only one penalty may be applied for each understatement.

 
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Wells Fargo v. US: A Potential Beginning of The End of The Objective Reasonable Basis Tax Penalty Defense

16-Sep-2021

The Internal Revenue Code (“IRC”) § 6662(a) permits the IRS to impose a twenty-percent (20%) accuracy-related penalty to an underpayment of tax, and there are several different defenses to this penalty depending on the facts of the case and the reason for the penalty. One of the most common accuracy-related penalties is the negligence penalty. Although there are multiple different reasons for the application of an accuracy-related penalty, only one penalty may be applied for each understatement. If a taxpayer faces the negligence penalty, one common defense is that the taxpayer’s return position has a reasonable basis under the relevant authorities. Until recently, most courts simply proceeded through a discussion on whether the authorities supported the taxpayer’s return position, and did not even reach whether the taxpayer actually relied on relevant authorities when forming a return position. However, over the past few years, several courts have begun to require a subjective actual reliance component to the reasonable basis standard, in addition to the other requirements described under the regulations. This article explores these concepts more in detail in six parts.

 
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How Soon Is Now: Estate of Moore & the Unraveling of Deathbed Estate Planning

26-Jul-2021

How Soon Is Now: Estate of Moore & the Unraveling of Deathbed Estate Planning

Beckett G. Cantley [1]
Geoffrey C. Dietrich [2]

How Soon Is Now: Estate of Moore & the Unraveling of Deathbed Estate Planning

On April 7, 2020 the U.S. Tax Court ruled in Estate of Moore v. Commissioner, T.C. Memo. 2020-40, that certain deathbed transfers should be includible in the decedent’s estate for United States Federal Estate Tax (“estate tax”) purposes. The court applied Internal Revenue Code (“I.R.C.”) § 2036 to the transfers due to the decedent’s continued interests in the transferred property. The Tax Court stated that I.R.C. § 2036 creates “a general rule that brings back all property that a decedent transfers before he dies, subject to two exceptions.” [3] The first exception is for bona fide sales for full and adequate consideration. The second exception is for “any property that [the decedent] transferred in which he did not keep a right to possession, enjoyment, or rights to the issue of the transferred property.” [4] The Tax Court stated that the first exception depends on the transferor’s motivations, and that the decedent’s actions made it clear there was no bona fide sale. As a result, the Tax Court determined that I.R.C. § 2036(a)(1) applied to the transfer.

Estate of Moore is the latest in a line of cases in which taxpayers made deathbed transfers close to the date of death and the IRS successfully argued that the transferred property is includible in the decedent’s gross estate. In Estate of Bongard v. Commissioner, 124 T.C. 95 (2005), the Tax Court created a three-part test to determine whether I.R.C. § 2036 pulls property back into a decedent’s estate.

In Estate of Strangi v. Commissioner, T.C. Memo. 2003-145, aff’d 417 F.3d 468 (5th Cir. 2005), the Tax Court provided additional guidance for how the court interprets I.R.C. § 2036(a)(1).

In Estate of Nancy H. Powell v. Commissioner, 148 T.C. No. 18 (2017), the court builds on the rationale established by Strangi, but ultimately invokes I.R.C. § 2036(a)(2) to include the transferred assets in decedent’s gross estate. This article: (1) provides an overview of deathbed transfers case law; (2) describes typical such deathbed transfers; (3) outlines the I.R.C. § 2036 statute; (4) discusses the main seminal cases in the area of deathbed transfers, including Estate of Bongard, Estate of StrangiEstate of Powell, and Estate of Moore; (5) synthesizes the case law on I.R.C. § 2036 and analyzers policy considerations regarding such law; and (6) concludes with a summary of the article’s findings.

I. Introduction: Death and Taxes

The only thing more inevitable than taxes and death … is taxes on death. When an individual dies, the person is taxed on the right to transfer property at death under the estate tax. [5] The tax is assessed against the individual’s “gross estate,” which consists of the fair market value of all property and certain interests the person owned at the time of death. [6] Once the gross estate is calculated, certain deductions are applied to arrive at the “taxable estate.” [7] Added to the taxable estate is the value of lifetime gifts subject to the United States Federal Gift Tax (“gift tax”). [8] Instead of being a tax on the transfer of property at death, the gift tax is a tax on an individual’s inter vivos transfer of property where the individual receives nothing, or less than full value, in return. [9] After adding the value of lifetime gifts to the taxable estate, the estate tax is computed. Finally, the tax is reduced by the available Unified Credit. [10]

Despite I.R.C. § 2001(a) imposing the estate tax on the taxable estate of every decedent who is a citizen or resident of the United States, [11] very few people end up paying any tax. Out of the 2.8 million people expected to die in 2020, it is estimated that the estates of only 1,900 people will be taxable—less than 0.1% of decedents. [12] The major reason for this is the Unified Credit. After a series of increases, [13] in 2020, a decedent can exclude up to $11,580,000 from his or her taxable estate before he or she must pay any federal estate and gift tax. [14] While most estates fall within the Unified Credit amount, [15] for those that exceed it, the tax consequences are significant. The current estate tax rate is 40%. [16] Thus, for every $1,000,000 included in the taxable estate, the tax bill rises by $400,000.

With such large amounts of money at stake, it is easy to see why high-net-worth individuals engage in estate planning to reduce estate and gift taxes. While many techniques are used to reduce estate and gift taxes, they center on transferring property out of an individual’s estate prior to death. Because the timing of death is uncertain, the earlier individuals plan their estates, the higher the chance their estate plan will accomplish the tax objectives.

Of course, not all individuals plan their estate well in advance of death. Many begin only after a serious decline in health or when death becomes imminent. These last-minute estate plans, or “deathbed transfers,” and how the court interprets I.R.C. § 2036 [which limits them], is the subject of this article. Part II of this article discusses common deathbed transactions. Part III discusses § 2036. Part IV discusses the line of seminal cases which interpret § 2036. Part V discusses: (1) the rules after the holding in Moore; (2) the policy behind the rules; and (3) the potential future of deathbed transactions.

II. Common Deathbed Transactions

Deathbed transactions take many forms. Typical transactions include outright gifts to loved ones, trust funding for the benefit of children, and asset sales to satisfy debts pre and post death. Most of these transfers are done simply to tie up loose ends before an individual’s death. However, as the estate value approaches and exceeds the estate and gift tax exemption amount, the consideration shifts to the reduction of estate and gift taxes. While multiple options exist to lower estate and gift taxes, the following section focuses on two types of transactions which frequently come under increased scrutiny from the IRS: family limited partnerships and discounted transfers.

A. Family Limited Partnerships

A family limited partnership (“FLP”) is a partnership created to administer a family business where members of the immediate family and close relatives serve as partners. [17] Just as in other limited partnership formats, there are general and limited partners. [18] The general partner is responsible for managing and controlling the assets and receiving and distributing profits. [19] The general partner is legally responsible for losses but does not hold title to the underlying assets of the partnership as an individual. [20] The limited partner shares in the profits of the partnership, but has limited liability and does not control day-to-day operations. [21] Limited partners in FLPs differ from other partnerships entities as FLP limited partners commonly receive an ownership interest without first contributing capital to the partnership. [22] In these instances, the limited partner is gifted the ownership interest based solely on the individual being a member of the family. [23]

Family limited partnerships are a popular vehicle for several reasons. [24] They offer centralized management of assets, ability to pool assets across multiple generations, ease of ownership transfers, asset protection, [25] and avoidance of probate. [26] The potential estate and gift tax savings is a particularly persuasive reason why individuals form FLPs. This option reduces estate and gift tax by transferring an underlying asset from an individual’s estate to an FLP in exchange for a partnership interest. [27] When the individual dies, the value of the partnership interest is included in the gross estate, not the fair market value of the underlying asset. [28] The partnership interest has a value less than the underlying asset because of valuation discounts. [29]

Two valuation discounts commonly apply to FLP interests. One is for “lack of marketability” [30] and the other is for “lack of control.” [31] A lack of marketability discount is applied to reflect that a partnership interest in a closely-held business is less attractive and more difficult to market than a publicly traded business interest. [32] The partnership interest can be harder to sell because the interest is only a minority stake or because of the difficulty of removing an underlying asset from a FLP. [33] The lack of a readily available market to sell the FLP interest, in turn, creates potential short-term liquidity problems and increases the risks of ownership. [34] Thus, courts have allowed a discount for lack of marketability to reflect the difficulties inherent in FLP interest ownership. [35] The lack of control discount is a result of the different rights and different levels of control afforded to general and limited partners. [36] Limited partners “lack control” because they are unable to force distributions or control the daily decisions of the partnership. [37]

Valuation discounts are not uniform. The size of the discount depends on several factors, including the type of asset or assets transferred, market conditions at the time of the transaction, the interest the decedent receives, and restrictions on the transfer of property in the partnership agreement. [38] A lack of marketability discount can range as high as 30-60% of the fair market value of the FLP interest. [39] A lack of control discount can be 25-55% of the pre-discount value of the partnership interest. [40] Overall, valuation discounts applied to FLP interests are such an important estate planning tool because they can reduce the value of an asset that was previously part of the decedent’s estate by 30-60%. [41] This “shrinks” the decedent’s estate and results in significant tax savings.

B. Discounted Transfers

Estate and tax planning opportunities do not end once the initial asset transfer into the FLP occurs. Individuals may receive additional estate reduction by transferring the discounted FLP interest. Common discounted transfers include transfers to children, a Grantor Retained Annuity Trust (“GRAT”), and a Charitable Lead Annuity Trust (“CLAT”). Transfers to children within the family accomplish a multitude of objectives. A transfer to a child of a FLP interest can serve the purpose of giving the child a stake in the family business while teaching the child how to run the business while a parent retains control and management of the business as general partner. [42] Depending on the parent’s goals, the transfer can be structured as a gift or a sale. [43] If the transfer is a gift, the value of the FLP interest is removed from the parent’s estate with the gifted interest’s value counting against the gifting parent’s lifetime exclusion amount. [44] Nonetheless, the valuation discounts reduce the gift tax exclusion amount less than if the underlying assets were transferred outright. [45] If the transfer is structured as a sale, the value of the FLP interest is removed from the parent’s estate and the consideration received for the interest remains. [46] Due to valuation discounts, this amount will be less than an outright sale of the underlying asset. [47]

Another popular discounted transfer to reduce estate and gift tax is the transfer of FLP interests to a GRAT. In this arrangement, a FLP interest is transferred to a GRAT, while the grantor retains the right to the FLP interest’s income stream in the form of an annuity for the term of the GRAT. [48] When the term of the GRAT ends, the FLP interest is transferred to the remainder beneficiary (usually another family member). [49] This allows for an even greater valuation discount because the right to the FLP interest’s stream of income is valued less than the value of the actual FLP interest. [50]

A third common discounted transfer is the transfer of an FLP interest to a CLAT. In this arrangement, the FLP interest is transferred to a CLAT where annuity payments are made to a charity for a certain timeframe. [51] Once the specified period ends, whatever remains in the trust is transferred to or for the benefit of the remainder beneficiary. [52] The remainder beneficiary, importantly, does not have to be a charitable organization. [53] Often, they are the descendants of the CLAT’s grantor. [54] Beyond the benefit of transferring the FLP interest out of the donor’s estate, the donor receives a gift tax charitable deduction for the present value of the lead interest. [55] While the present value of the remainder estate is a taxable gift, steps can be taken to reduce the amount of taxable gift to zero. [56] Thus, successful implementation of a CLAT allows the donor to remove the value of the underlying FLP interest from their estate, receive a gift tax charitable deduction, and transfer the FLP interest to their children or other family members. [57]

III. I.R.C. § 2036

When properly structured and executed, FLPs, discounted transfers, and other vehicles can achieve a significant estate and gift tax reduction. However, the transfers must not fall within the scope of I.R.C. § 2036(a). I.R.C. § 2036(a) is an Internal Revenue Code provision that brings the value of certain transferred property back into the decedent’s gross estate. [58] I.R.C. § 2036(a) provides:

(a) General rule. The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—

(1) the possession or enjoyment of, or the right to the income from, the property, or

(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

Essentially, I.R.C. § 2036(a) includes the value of any transferred property in the decedent’s estate where the decedent either retained: (1) the possession or enjoyment of; (2) the right to possess or enjoy; or (3) the right to designate who shall possess or enjoy such transferred property. The purpose of I.R.C. § 2036 is to “prevent the circumvention of federal estate tax by the use of inter vivos transactions which do not remove the lifetime enjoyment of property purportedly transferred by a decedent.” [59] I.R.C. § 2036 is “part of a Congressional scheme to tax the value of property transferred at death,” whether the decedent “accomplishes the transfer by will, by intestacy, or by allowing his substantial control over the property to remain unexercised until death so that the shifting of its economic benefits to the beneficiary only then becomes complete.” [60] The IRS has increasingly turned to I.R.C. § 2036 in order to pull the value of deathbed transfers back into a decedent’s estate. [61] The following cases explore how the court has interpreted I.R.C. § 2036 and responded to the IRS’s increased use of the provision.

IV. I.R.C. § 2036(a) Deathbed Transfers Seminal Cases

Over the past twenty years, courts have issued a line of decisions providing guidance on the application of I.R.C. § 2036(a) to deathbed transfers. Each of these cases resulted from IRS challenges to decedent asset transfers to an FLP. The IRS increasingly disputes these transfers as they “often view these partnerships as efforts to pass valuable assets to one’s heirs at a discount for lack of marketability and lack of control.” [62]

A. Estate of Bongard

In Estate of Bongard v. Comm’r[63] the United States Tax Court (“USTC”) outlined a general test that has become the standard courts use to determine whether an inter vivos transfer falls within I.R.C. § 2036(a). [64] In Bongard, decedent established Empak, Inc. (“Empak”), an electronics materials packaging company, where decedent served as CEO and sole member of Empak’s board of directors. [65] Decedent and an Irrevocable Stock Accumulation Trust (“ISA Trust”) set up for the benefit of decedent’s children owned all the stock of Empak. [66] On January 30, 1996, WCB Holdings, LLC. (“WCB Holdings”) was established to pool the family members’ ownership interests in Empak in preparation of a corporate liquidity event. [67] On December 28, 1996, decedent and ISA Trust contributed their shares of Empak stock to WCB Holdings in exchange for WCB Holdings Class A and Class B membership units. [68] The following day, decedent and ISA Trust created Bongard Family Limited Partnership (“BFLP”). [69] In exchange for a 99% limited partnership interest in BFLP, decedent transferred all of his WCB Holdings class B membership units to BFLP. [70] ISA Trust received a 1% general partnership interest after transferring a portion of its WCB Holdings class B membership units to BFLP. [71] Subsequent gifts and distributions, including a BFLP 7.72% limited partnership interest gift from decedent to his wife, followed up until decedent’s death. [72] On November 16, 1998, Decedent died unexpectantly. [73]

The IRS argued that decedent’s inter vivos transfers to WCB Holdings and BFLP should be included in the gross estate because I.R.C. §§ 2035(a) and 2036(a) and (b) applied. [74] The estate countered the IRS’s argument on the two transfers, stating that they: (1) were not “transfers” within the meaning of I.R.C § 2036, (2) satisfied the bona fide sale exemption, and (3) did not include decedent’s retention of I.R.C. § 2036 interests. [75] The Tax Court held that: (1) decedent’s transfer of Empak stock to WCB Holdings satisfied the bona fide sale exception of I.R.C. § 2036(a); [76] and (2) the value of decedent’s transfer of WCB Holdings class B membership units to BFLP was includable under I.R.C. § 2036(a)(1). [77] First, the USTC explained I.R.C. § 2036 applies when three conditions are met:

(1) the decedent made an inter vivos transfer of property; (2) the decedent's transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b) in the transferred property which he did not relinquish before his death.

Estate of Bongard v. Comm'r, 124 T.C. No. 8, at *112 (2005). Next, the USTC applied their newly created test. The Tax Court found both of decedent’s transactions to be “transfers” within the context of I.R.C. § 2036 because “transfer” is a broadly defined term [78] and decedent voluntarily made the inter vivos transfers of the property. [79]

For the second condition of the test, the UTSC found decedent’s initial transfer of Empak stock to WCB Holdings did qualify for the bona fide sale exception, [80] while decedent’s subsequent transfer of WCB Holdings class B membership units to BFLP did not. [81] As the United States Court of Appeals for the Fifth Circuit did in Kimbell v. United States[82] the Tax Court broke the bona fide sale exception into two prongs: (1) whether the transaction qualified as a bona fide sale; and (2) whether the decedent received adequate and full consideration. [83] For FLPs, the first prong is satisfied when the objective evidence indicates a “legitimate and significant nontax reason” for the FLP creation and the transferors receive “partnership interests proportionate to the value of the property transferred.” [84]

Decedent’s transfer of Empak stock to WCB Holdings satisfied the first prong of the test because the court found the pooling of decedent’s and ISA Trust’s Empak shares was for the significant nontax reason of attracting potential investors and raising capital for additional growth. [85] Furthermore, the Tax Court determined the second prong was satisfied because both decedent and ISA Trust received interests in WCB Holdings proportionate to the amount of shares each transferred. [86] Thus, the Tax Court determined decedent’s transfer of Empak stock to WCB Holdings satisfied the bona fide sale exception of I.R.C. § 2036(a), and there was no need to determine whether decedent retained an I.R.C. § 2036(a) or (b) interest. [87]

The USTC held decedent's transfer of WCB Holdings class B membership units to BFLP did not satisfy the bona fide sale exception because it failed to exhibit a significant nontax purpose. [88] The USTC rejected the estate’s arguments that BFLP was established to provide additional credit protection and to facilitate decedent’s post-marital agreement with his second wife. [89] The tax court reasoned WCB Holdings already satisfied those objectives. [90] Furthermore, decedent “recycled the value” of the property he transferred to BFLP because BFLP did not perform a management function for the assets received or engage in any businesslike transaction. [91] All decedent did was “change the form” in which he held his interest in the transferred property. [92] Thus, decedent’s transfer of WCB Holdings class B membership units to BFLP did not qualify for the bona fide sale exception. [93]

Finally, the USTC turned to the third consideration of the I.R.C. § 2036 test and held decedent retained an I.R.C. § 2036(a) interest in BFLP. [94] The Tax Court stated a right is retained “if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred.” [95] The USTC concluded there was an implied agreement between the parties that decedent retained the right to control the WCB membership units based on decedent’s ability to decide whether the membership units and underlying Empak stock would be redeemed. [96] After determining decedent retained the enjoyment of the property transferred to BFLP, the USTC concluded the value of the WCB Holdings class B membership units was included in decedent’s gross estate under I.R.C. § 2036(a). [97]

B. Estate of Strangi

While Bongard established a test for courts to use for I.R.C. § 2036(a) inclusion, [98] Estate of Strangi v. Comm’r [99] outlines the application of I.R.C. §§ 2036(a)(1) and (a)(2) to deathbed transfers. In Strangi, decedent transferred 98% of his wealth to Strangi Family Limited Partnership (“SFLP”) two months before his death. [100] On July 19, 1988, decedent executed a power of attorney naming Mr. Gulig, his son-in-law, as his attorney-in-fact. [101] During 1993, decedent underwent surgery to remove a cancerous mass from his back and was diagnosed with a degenerative brain disorder. [102] After attending a seminar discussing the use of family limited partnerships for asset preservation, estate planning, income tax planning, and charitable giving, on August 12, 1994, Mr. Gulig formed SFLP while acting as decedent’s attorney-in-fact. [103] Property of decedent totaling a fair market value of $9,876,929, or 98% of decedent’s wealth, was transferred to SFLP in exchange for a 99% limited partnership interest. [104] Assets contributed to SFLP included the residence occupied by decedent, securities, accrued interest and dividends, insurance policies, an annuity, receivables, and partnership interests. [105] Stranco, a Texas corporation Mr. Gulig created the same day as SFLP, purchased the remaining 1% of SFLP as managing general partner. [106] Stranco was funded by decedent and his four children. [107] Decedent contributed $49,350 in assets for 47% of Stranco’s common stock, while decedent’s children contributed $55,650 for 53% of Stranco’s common stock. [108] Additionally, decedent and decedent’s children were named as the initial five directors of Stranco and Mr. Gulig was hired by Stranco to manage the day-to-day business of the corporation. [109] Decedent died of cancer on October 14, 1994—less than three months after the transfers to SFLP and Stranco. [110]

In the Tax Court, the IRS argued that SFLP should be disregarded because it lacked economic substance and business purpose. [111] After the subsequent approval of a motion to amend its answer, the IRS further argued the full value of the assets decedent transferred to SFLP and Stranco should be included in decedent gross estate because decedent retained a “right” within the meaning of I.R.C. § 2036(a)(2). [112] On its second trip to the Court of Appeals, the Fifth Circuit affirmed the Tax Court’s holding that the value of the assets decedent transferred to SFLP should be included in decedent’s estate under I.R.C. § 2036(a)(1). [113] The Fifth Circuit stated two requirements were needed to trigger I.R.C. § 2036(a)(1). [114] First, the decedent must retain “possession or enjoyment” of the property.” [115] This requirement is met if the decedent retains a “substantial present economic benefit” from the transferred property. [116] For the second requirement, the court used the same “expressed or implied” agreement test used by the court in Bongard[117] The Fifth Circuit concluded that decedent satisfied both requirements based on numerous facts, [118] including: (1) various payments made from the FLP, both before and after decedent’s death, to meet his needs and expenses; (2) decedent’s continued residence in his house after it was transferred to the FLP; (3) his nonpayment of rent to the FLP for three years; and (4) his failure to retain sufficient assets outside the FLP to meet his living expenses for his remaining life expectancy. [119] Based on these circumstances and the inapplicability of the bona fide sale exception, [120] the Fifth Circuit affirmed the Tax Court’s I.R.C. § 2036(a)(1) holding. [121]

Because the Fifth Circuit held the transferred assets were included in the taxable estate under I.R.C. § 2036(a)(1), the Fifth Circuit did not discuss the IRS’s alternative contention for inclusion under I.R.C. § 2036(a)(2). [122] However, the Tax Court’s assessment of the IRS’s I.R.C. § 2036(a)(2) argument is important to discuss as it serves as the basis for later holdings. [123] The Tax Court held, as an alternative to their I.R.C. § 2036(a)(1) holding, that decedent, through Mr. Gulig, retained the “right to designate the persons who shall possess or enjoy the property or its income” within the meaning of I.R.C. § 2036(a)(2). [124] Specifically, the court found Mr. Gulig’s dual roles as decedent’s attorney-in-fact and manager of Stranco problematic. [125] The SFLP partnership agreement named Stranco managing general partner of SFLP and gave the managing partner sole discretion to determine distributions. [126] When Mr. Gulig was hired as Stranco’s manager, this power was then conferred upon Mr. Gulig, [127] placing decedent in a position “to act, alone or in conjunction with others, through his attorney-in-fact, to cause distributions of property previously transferred to the entities or of income therefrom.” [128]

Citing United States v. Byrum[129] the estate argued I.R.C. § 2036(a)(2) was not applicable because decedent’s “rights” were limited by Mr. Gulig’s fiduciary duties to SFLP and Stranco. [130] The court rejected this argument because: (1) Mr. Gulig already owed fiduciary duties to decedent personally as his attorney-in-fact before the formation of SFLP and Stranco; and (2) the fiduciary obligations of Stranco and its directors were duties essentially owed to decedent himself. [131] The Tax Court then rejected the fiduciary duties argument by stating, “[i]ntrafamily fiduciary duties within an investment vehicle simply are not equivalent in nature to the obligations created by the United States v. Byrum . . . scenario.” [132]

C. Estate of Powell

Estate of Powell v. Commissioner [133] builds on Strangi and is a major victory for the IRS in its battle against FLP deathbed transfers. In Powell, decedent’s son, acting under a power of attorney, transferred approximately $10 million of assets from decedent’s revocable trust to an FLP while decedent was hospitalized in intensive care. [134] Decedent received a 99% limited partnership interest, while her two sons contributed an unsecured note in return for a 1% general partnership interest. [135] Notably, the FLP agreement gave decedent’s son sole discretion over the timing and amount of partnership distributions. [136] The agreement also permitted dissolution of the FLP upon written consent of all partners. [137] On the same day cash and securities were transferred into the FLP, decedent’s son, again acting under a POA, transferred decedent’s 99% limited partner interest to a charitable lead annuity trust (“CLAT”) with her two sons receiving the remainder upon her death. [138] Decedent died seven days after the funding of the FLP and same-day transfer of her limited partner interest to the CLAT. [139]

The IRS argued that I.R.C. § 2036(a)(1) and (2) applied to decedent’s transfer of cash and securities to the FLP. [140] The IRS contended that I.R.C. § 2036(a)(1) applied to the transfer because it was subject to an implied agreement under which decedent retained possession or enjoyment of the transferred property or the right to income from that property. [141] The IRS argued that I.R.C. § 2036(a)(2) applied because of decedent's ability, acting with her sons, to dissolve the FLP and thereby designate who could possess the transferred property or the income from it. [142] Finally, the IRS asserted the bona fide sale exception to I.R.C. § 2036(a) did not apply because the estate failed to demonstrate a “significant nontax purpose” for the creation of the FLP and because, in the light of the claimed valuation discount, the transfer was not made for “full and adequate consideration.” [143]

The USTC held for inclusion of the cash and securities under I.R.C. § 2036(a)(2), making it unnecessary to consider the IRS’s I.R.C. § 2036(a)(1) argument. [144] Drawing heavily from Estate of Strangi[145] the Tax Court found decedent’s cooperative ability to dissolve the FLP with her sons constituted a right in conjunction with others to designate the persons who shall possess or enjoy the transferred property within the meaning of I.R.C. § 2036(a)(2). [146] The USTC found the ability to dissolve the partnership problematic because it comes with the ability to direct the disposition of the partnership assets. [147] While the decedent’s ability is in conjunction with her sons, it was enough to trigger I.R.C. § 2036(a)(2) inclusion. [148] Decedent’s ability to determine the amount and timing of distributions through her son’s dual role as managing general partner and her attorney-in-fact constituted a “right” within the meaning of I.R.C. § 2036(a)(2). [149]

In finding this way, the Tax Court echoed Strangi and precluded the “fiduciary duties” argument. [150] The USTC reasoned Mr. Powell owed duties to decedent prior to or upon formation of the FLP. [151] Since decedent held a 99% interest in the FLP, whatever fiduciary duties limited her son’s ability to determine partnership distributions were duties owed “almost exclusively” to decedent herself. [152] Finally, the court found any fiduciary duties Mr. Powell may have owed to decedent as “illusory” because there was no evidence that the FLP was anything but an investment vehicle for decedent and her sons. [153] Since the estate did not argue that the transfer was exempted by the I.R.C. § 2036(a) bona fide sale exception, the USTC concluded the value of the transferred assets was includible in the value of decedent’s gross estate. [154]

D. Estate of Moore

The most recent case in the deathbed transfer inclusion is Estate of Moore v. Commissioner[155] In Moore, decedent built a successful family farm (“Moore Farms”). [156] In 2004, decedent, in his late eighties, began negotiating a sale of Moore Farms to Mellon Farms. [157] In December 2004, before decedent could complete the deal with Mellon Farms, he was rushed to the emergency room with congestive heart failure. [158] After release from the hospital, a hospice doctor gave him less than six months to live. [159] Decedent then began his estate planning. [160] The result was a complex web of entities including a Living Trust (“Living Trust”), a Charitable Lead Annuity Trust (“Charitable Trust”), a Children’s Trust (“Children’s Trust”), a Family Management Trust (“Management Trust”), an Irrevocable Trust (“Irrevocable Trust”), and a Family Limited Partnership (“FLP”)—all created on the same day. [161] Decedent’s estate planning attorney testified that in decedent’s initial call to him, decedent believed his discharge from the hospital was “an extension of his life” and he wanted to wanted to meet with his attorney in order to try to “save the millions of dollars of taxes.” [162] On February 4, 2005, decedent finalized the sale of Moore Farms to Mellon Farms. [163] Decedent continued to live on the farm and made various transfers among and from the trusts and FLP until his death at the end of March 2005. [164]

The IRS argued the majority of the estate plan failed under I.R.C. § 2036 because: (1) decedent lacked a legitimate nontax reason for forming the FLP, thus, the transfer of four-fifths of the farm to the FLP did not qualify for the I.R.C. § 2036(a) bona fide sale exception; and (2) decedent retained possession and enjoyment of Moore Farms even after its sale. [165] The USTC agreed with the IRS and held the transfer of four-fifths of the farm to the FLP did not meet the requirements of the bona fide sale exception [166] and decedent retained possession or enjoyment of Moore farms within the meaning of I.R.C. § 2036(a)(1). [167] The USTC found decedent’s transfer of Moore Farms to the FLP did not qualify for the bona fide sale exception because the formation of the FLP lacked a significant nontax reason. [168] The Tax Court reached this conclusion because: (1) there was no “business” for the family to run after decedent sold the farm within five days of its transfer to the FLP; (2) the business retained significant amounts of capital for any “alleged” creditors who may make claims; (3) decedent began planning his estate only after he faced significant health problems; (4) decedent told his estate planning attorney he wanted to “save millions of dollars of taxes” through his estate plan; and (5) the decedent’s unilateral actions underlined the general testamentary nature of the plan and transfers. [169] Because the formation of the FLP failed to have a significant nontax purpose, the USTC did not consider the issue of value—i.e. whether decedent’s transfer was for adequate and full consideration—and moved to the “retained possession or enjoyment of” the transferred asset part of the analysis. [170]

The USTC concluded decedent retained possession or enjoyment of Moore Farms after he transferred it to the FLP. [171] Applying the two-prong I.R.C. § 2036(a)(1) test from Strangi[172] the USTC found decedent retained a “substantial present economic benefit” from the farm after he transferred it. [173] The Tax Court pointed to several facts to support its conclusion. [174] First, decedent continued to live on the property and run the farm as he did before the sale, and did so up until his death. [175] Second, while decedent retained sufficient assets to support himself unlike the decedent in Strangi[176] he did not draw upon them. [177] Instead, he used FLP assets to pay his personal expenses and make gifts. [178] Finally, despite not holding the controlling general interest, decedent ignored formalities and continued to exercise control over the farm and make unilateral decisions. [179] The USTC reasoned these facts indicated an implicit understanding between Moore and his children that he would continue to use the FLP assets and that his relationship with the transferred assets “changed formally, not practically.” [180] Thus, the Tax Court held the value of the farm should be included in the value of the gross estate under I.R.C. § 2036(a)(1). [181]

V. Analysis

A. The Post-Moore Rules

After Moore, I.R.C. § 2036(a) tends to bring all deathbed property transfers back into the gross estate, [182] unless: (1) the estate can show the sale was a bona fide sale for adequate and full consideration; [183] or (2) the decedent did not retain a right to possession, enjoyment, or rights to the issue of the transferred property. [184] A sale is bona fide, in the family limited partnership context, when the objective evidence establishes the existence of a “legitimate and significant nontax reason” for the creation and transfer of assets to the FLP. [185] A sale is for adequate and full consideration when the decedent receives a “partnership interests proportionate to the value of the property transferred.” [186] Essentially, the bona fide sale prong is a question of motive, while the “for adequate and full consideration” prong is a question of value. [187]

If a transfer does not qualify under the “bona fide sale” exception, the analysis moves to the second exception. A decedent retains the right to possession or enjoyment if the decedent retains “substantial present economic benefit” from the property after transferring it and there is an “express or implied agreement” that the decedent will continue to possess or enjoy the property “at the time of transfer.” [188] While the right to the issue of the transferred property part of the rule is the least developed, the court has held the ability “to act, alone or in conjunction with others,” [189] to cause partnership distributions [190] or dissolve the partnership triggers inclusion under I.R.C. § 2036(a)(2). [191]

B. The Policy Behind these Rules

The policy behind these rules is clear—prevent the circumvention of federal estate tax by including the value of any inter vivos transfer where the decedent retains an interest or right in the transferred property in the decedent’s gross estate. [192] I.R.C. § 2035 works in conjunction with I.R.C. § 2036 to pull the value of any gift transferred or gift taxes paid within three years of the decedent’s death back into the gross estate. [193] The purpose of I.R.C. § 2035 is the same as the purpose for I.R.C. § 2036, except I.R.C. § 2035 focuses on a different method of transfer: a gratuitous transfer versus a transfer for consideration. [194] While the policy for these rules is simple, whether it is correct is a more complicated question.

As a basic tenant of property and trusts and estates law, individuals have the right to transfer property in life or at death. [195] This “right of disposition” is one of the “sticks” in the bundle of rights that accompany property ownership. [196] The issue with I.R.C. § 2036, and by extension I.R.C. § 2035, is that these rules infringe on this right when an individual makes a deathbed transfer. Although the transfer’s substance is respected, I.R.C. § 2036 violates the transaction’s financial effect by pulling the value of the transferred property back into the decedent’s gross estate. If individuals have the right to transfer property, why does sudden illness or other desperate conditions change this right? In the context of deathbed transfers of family limited partnership interests, the IRS could alternatively adjust the valuation discount and then count the value of the transfer against the decedent’s Unified Credit without pulling the full value of the asset back into the decedent’s gross estate. This approach more directly addresses the IRS’s central concern of the size of the valuation discount. Unfortunately, instead of dealing with the issue in a more straightforward manner, the IRS invokes I.R.C. § 2036 and in turn, seems to create a fraudulent transfer statute.

While adjusting the applied valuation discount is a more precise method, the practical reason for applying I.R.C. § 2036 likely boils down to process simplification. When a dispute arises, it is much less complicated for the court to include the full undiscounted value of the transferred FLP interest in the decedent’s gross estate. This also allows the court to avoid having to make difficult judgements regarding the value of an asset. In the court’s opinion, these types of assessments are better left for CPAs and other valuation experts. While an in-depth discussion of the interplay between I.R.C. § 2036 and the consideration offset provisions in I.R.C. § 2043 is beyond the scope of this article, one only has to look at the Tax Court’s discussion in Estate of Moore regarding of the net inclusion amount to get an idea of just how complex valuation and discounting calculations can get. [197]

With the court’s increased use of I.R.C. § 2036 to pull the value of decedent’s deathbed transfers back into the gross estate raises serious concerns, the court’s decisions can be summed up by the saying “bad facts make bad law.” For example, in Estate of Moore, the decedent knew he only had months to live and clearly stated the purpose of his deathbed planning was to “save the millions of dollars of taxes.” [198] Furthermore, the decedent continued to live on the property and run the farm as he did before the sale and continuously used FLP assets to pay personal expenses. [199] Facts such as these made it easy for the Tax Court to hold for inclusion under I.R.C. § 2036. [200] The facts of Estate of Powell tell a similar story. The day before the partnership was funded, two hospital doctors indicated the decedent lacked capacity and “could not act on her own behalf.” [201] Additionally, objective evidence indicated the FLP had no business purpose. [202] It was merely an investment vehicle for the decedent and her two sons. [203]

While the deathbed element does increase the chances that inclusion may occur, simple steps can be taken to avoid triggering I.R.C. § 2036. In order to qualify for the bona fide sale exception to I.R.C. § 2036, individuals should first and foremost establish a nontax motive for creating the FLP. The decedent in Estate of Moore did not fail the bona fide sale exception because he had a tax purpose for the formation for the FLP, he failed the exception because he only had a significant nontax reason for the transfer to the FLP. [204] To provide additional factual support, the nontax reasons for the entity’s formation can be listed in the recitals of the FLP’s partnership agreement. Furthermore, to increase the chances of satisfying the second prong of the bona fide exception, the interest credited to each partner should be proportional to the fair market of the value of the assets each partner contributed to the FLP. Also, the assets contributed by each partner to the FLP should be properly credited to the respective capital accounts. In the case of an IRS challenge, this provides support to the estate’s position that entity formalities were followed.

When it comes to funding and operating the FLP, additional steps should be taken to avoid the perception that a decedent retained an interest or right in the assets transferred to the FLP. As the court in Strangi made clear, [205] the decedent should not transfer all of their assets to the FLP. If the decedent does, the IRS will likely argue there was an implied agreement for the decedent to continue using the assets as they did before the transfer. Additionally, the decedent keeping sufficient assets outside of the FLP avoids the pitfall of the FLP to pay post-death expenses such as funeral costs. In the same vein as keeping sufficient assets outside of the FLP, the decedent should not commingle FLP and personal funds. This was a major factor in the USTC applying I.R.C. § 2036 in both Strangi [206] and Estate of Moore[207] Another important point is to continue or further the entity’s nontax business purpose. This point was highlighted by the first transfer in Estate of Bongard[208] Decedent’s transfer of stock to the holding company did not trigger I.R.C. § 2036 because pooling family assets in the holding company was part of a legitimate nontax business decision to facilitate the sale of the business. [209] This plan to continue legitimate business operations contrasts with the circumstances in Estate of Moore where the decedent sold the farming business days after forming the FLP. [210] Finally, decedents should make sure to divest themselves of any rights they may have alone or in conjunction with another to affect the operations or distribution of partnership assets. Estate of Powell made clear different individuals should act as the decedent’s attorney-in-fact and manager of the FLP. [211]

C. Where We Go from Here

This string of recent I.R.C. § 2036 decisions make it obvious that the law is moving in an ever-more-restrictive direction. The courts historically have not often used I.R.C. § 2036 to pull the value of assets back into a decedent’s estate. However, this is no longer the case. Due to the IRS’s insistence, the courts have increasingly used I.R.C § 2036 as the main weapon against family limited partnerships asset transfers. The IRS often view FLPs “as efforts to pass valuable assets to one’s heirs at a discount for lack of marketability and lack of control.” [212] This seems to reflect that judges may be implying a general-purpose common law that all types of tax planning must get more restrictive if tax reduction is the principle purpose. This could be a result of the numerous income tax economic substance cases over the last two decades. The economic substance doctrine and the “legitimate and significant nontax purpose” requirement of I.R.C. § 2036(a) share a similar rationale and seek to invalidate aspects of tax transactions.

Beyond the reasons for increased use of I.R.C. § 2036, two aspects of the recent court decisions indicate even greater use of I.R.C. § 2036 to restrict the tax benefits of deathbed transfers. The first comes from Estate of Powell. While the case law regarding the bona fide exception and the restriction on the retention of “possession or enjoyment” of the transferred asset of I.R.C. § 2036(a)(1) are fairly well developed, significant questions remain as to what “rights” fall under I.R.C. § 2036(a)(2). While the court found for inclusion under I.R.C. § 2036(a)(1), [213] the reasoning in Strangi regarding I.R.C. § 2036(a)(2) indicated inclusion may be triggered by decedent’s attorney-in-fact also serving as manager of the FLP. [214] Estate of Powell took this retention of a “right” even further by holding decedent’s cooperative ability to dissolve the FLP with her sons, although decedent made no effort to exercise such a right, constituted a right in conjunction with others to designate the persons who shall possess or enjoy the transferred property within the meaning of I.R.C. § 2036(a)(2). [215] Taking these decision together, they seem to indicate that only the possibility—and not the actual execution—of affecting the operation or distributions of the FLP will pull the value of the transferred assets back into the gross estate. With this as the precedent, future decisions will likely hold things such as the retention of minority interest voting rights cause inclusion under I.R.C. § 2036(a)(2).

The second, and likely more important, indication of greater use of I.R.C. § 2036 to invalidate the tax benefits of deathbed transfers is the tone of the Tax Court’s ruling in Estate of Moore. Initially, the Tax Court stated that the three-part test developed in Estate of Bongard was the test that determined whether I.R.C § 2036 recaptures transferred property back into the decedent’s estate. [216] While the elements of the Estate of Bongard test are still present in the Estate of Moore decision, the emphasis has shifted. [217] In Estate of Moore, when discussing the Estate of Bongard test, the Tax Court stated, “[a]nother way of looking at this--and another way we frequently discuss it--is to look at 2036(a) as creating a general rule that brings back all the property that a decedent transfers before he dies, subject to two exceptions.” [218] Instead of the court “not respect[ing] a transfer” if it does not meet the three requirements under the Estate of Bongard test, [219] the transfer is now automatically not respected and the estate must reestablish the transfer’s validity. [220]

As stated above, this seems to indicate judges will apply a general-purpose common law that all types of tax planning (in which the primary purpose is tax reduction) “smell bad” and the decedent’s estate must prove otherwise. This has procedural and practical consequences as it increases the cost and time required to settle a decedent’s estate. As indicated supra Part IV. Section B, forward-looking steps can be taken to significantly reduce the chance transfers to an FLP will not be included under I.R.C. § 2036. The problem with deathbed transfers though is that many of these planning decisions are made in a chaotic and stressful environment. This has the compounded effect of making it more difficult for individuals to plan their estate to avoid inclusion and to produce sufficient evidence that concerns beyond tax savings motivated their formation and transfer of assets to a family limited partnership. With this in mind, it is of the utmost importance for individuals conducting deathbed planning to seek appropriate counsel and avoid the increasing “squeeze” of I.R.C. § 2036.

V. Conclusion

This article discussed the formation and purpose of family limited partnerships. Further, it outlined the advantages of using such as an estate planning vehicle. This article also detailed the requirements of I.R.C. § 2036 and the seminal cases interpreting the statute. Moreover, the present state of I.R.C. § 2036 was reviewed and the article provided recommendations to avoid the value of transferred assets included in the decedent’s gross estate. Finally, this article discussed the implications of the court’s increased use of I.R.C. § 2036 and the likely results of this change in judicial review.

If you have clients in the upper income brackets who share these concerns, the attorneys at Cantley Dietrich would enjoy having a conversation with you about how you can protect them from some of the challenges they will likely face in the next few years.

[1] Prof. Beckett G. Cantley, teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C. Prof. Cantley would like to thank Melissa Cantley and his law clerk, Joshuah C. Miller, for their contributions to this article.

[2] Geoffrey C. Dietrich, Esq. is a shareholder in Cantley Dietrich, P.C.

[3] Estate of Moore v. Comm’r, T.C. Memo. 2020-40, 2020 WL 1685607, at *29 (citing Kimbell v. United States, 371 F.3d 257, 261 (5th Cir. 2004)).

[4] Id. at *30 (citing Kimbell, 371 F.3d at 261).

[5] Internal Revenue Service, Estate Tax, https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax (last visited July 5, 2020).

[6] Id.

[7] Id.

[8] Id.

[9] Internal Revenue Service, Gift Tax, https://www.irs.gov/businesses/small-businesses-self-employed/gift-tax (last visited July 5, 2020).

[10] Internal Revenue Service, Estate Tax, https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax (last visited July 5, 2020).

[11] I.R.C. § 2001(a).

[12] Tax Policy Center, Urban Institute & Brookings Institution, How Many People Pay the Estate Tax? https://www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax (last visited July 5, 2020).

[13] See id.

[14] See I.R.S. Rev. Proc. 2019-44, § 3.41.

[15] See Tax Policy Center, supra note 12.

[16] I.R.C. § 2001(c).

[17] See Nathan H. Bernstein, The Formation of the Family Limited Partnership: Fraudulent Transfer Liability and Other Family Problems, 101 Com. L.J. 26, 27 (1996).

[18] See id. at 27.

[19] See id.

[20] See id.

[21] See id.

[22] See id.

[23] See id.

[24] See Robert G. Alexander & Dallas E. Klemmer, Creative Wealth Planning with Grantor Trusts, Family Limited Partnerships, and Family Limited Liability Companies, 2 Est. Plan. & Cmty. Prop. L.J. 307 (2010); S. Stacy Eastland, Family Limited Partnerships: Current Status and New Opportunities, 2009 A.L.I.-A.B.A. Continuing Legal Educ. 1017.

[25] While certain requirements must be followed to accomplish any of the objectives of a family limited partnership, extra care should be given when setting one up for asset protection. State and federal law impose civil and criminal penalties for fraudulent transfer liability. Fraudulent transfer liability occurs when an individual transfers individually owned assets into a family limited partnership, conceals these assets from creditors, and maintains direct or indirect control over the assets. In these instances, the line between “asset protection” and “fraudulent transfer” is often blurred. Nathan H. Bernstein, The Formation of the Family Limited Partnership: Fraudulent Transfer Liability and Other Family Problems, 101 Com. L.J. 26, 39 (1996).

[26] See Bernstein, supra note 17, at 29-30; Alexander, supra note 24, at 316-17.

[27] See D. John Thorton & Gregory A. Byron, Valuation of Family Limited Partnership Interests, 32 Idaho L. Rev. 345, 347-48 (1996).

[28] See id.

[29] See Matthew Van Leer-Greenberg, Family Limited Partnerships: Are They Still a Viable

Weapon in the Estate Planner's Arsenal , 25 Roger Williams U. L. Rev. 37, 42 (2020).

[30] See Thorton, supra note 27, at 363.

[31] See id. at 364.

[32] Id. at 363.

[33] See Martin A. Goldberg & Cynthia M. Kruth, New Life for Valuation Discounts in Family Entities, 16 Quinnipiac Prob. L.J. 48, 49 (2002).

[34] Thorton, supra note 27, at 363.

[35] Id.

[36] See id. at 3; Nathan H. Bernstein, The Formation of the Family Limited Partnership: Fraudulent Transfer Liability and Other Family Problems, 101 Com. L.J. 26, 27 (1996).

[37] See Van Leer-Greenberg, supra note 29, at 43 (citing Goldberg, supra note 33, at 49).

[38] See id. at 44; Dennis I. Belcher, Valuation Discounts: Theory and Practice, Estate Planning In Depth: ALI-ABA Course of Study 273, 308 (2003).

[39] Id.

[40] See Thorton, supra note 27, at 363. See also, Estate of Maxcy v. Comm’r, T.C. Memo. 1969-158, 1969 WL 1276, 28 T.C.M. (CCH) 783, 793 (1969) (holding minority interest per share value in closely held corporation was 75% of the majority interest, thus, resulting in a 25% discount); Estate of Dougherty v. Comm’r, T.C. Memo. 1990-274, 1990 WL 70915, 59 T.C.M. (CCH) 772, 781 (1990) (allowing a 35% discount in valuing stock of a sole shareholder to reflect lack of marketability, cost of liquidation and diversity of asset management).

[41] See Van Leer-Greenberg, supra note 29, at 42, 44.

[42] See Bernstein, supra note 35, at 27.

[43] See id. at 22, 27.

[44] See Internal Revenue Service, supra notes 9, 10.

[45] See John F. Ramsbacher, John W. Prokey & Erin M. Wilms, Family Limited Partnership:

Forming, Funding, and Defending , 18 Prac. Tax Law 29, 30 (2004).

[46] See id.

[47] See id.

[48] Peter J. Parenti, Designing the Family Limited Partnership or the Family Limited Liability Company - Part 2, 9 J. Pract. Est. Plan. 21, 25 (2007).

[49] Id.

[50] See id. See also, Robert G. Alexander & Dallas E. Klemmer, Creative Wealth Planning with Grantor Trusts, Family Limited Partnerships, and Family Limited Liability Companies, 2 Est. Plan. & Cmty. Prop. L.J. 307, 325-26 (2010) (discussing valuation discounts for GRATs and importance of structuring GRATs so that the growth of GRAT assets exceeds the applicable I.R.C. § 7520 rate).

[51] Mitchell M. Gans and Jonathan G. Blattmachr, Family Limited Partnerships and Section 2036: Not Such a Good Fit, at 3 n.7 (2017). Available at: https://scholarlycommons.law.hofstra.edu/faculty_scholarship/1055. See generally, Jonathan G. Blattmachr, A Primer on Charitable Lead Trusts: Basic Rules and Uses, 134 TR. & EST., Apr. 1995, at 48.

[52] Id.

[53] Id. See generally, Paul S. Lee, Turney P. Berry & Martin Hall, Innovative CLAT Structures: Providing Economic Efficiencies to a Wealth Transfer Workhorse, 37 Actec L.J. 93 (2011) (provides an in-depth discussion of choosing a remainder beneficiary and the associated tax consequences).

[54] Peter Melcher & Matthew C. Zuengler, Maximizing the Benefits of Estate Planning Bet-to-Die Strategies: CLATs and Private Annuities, 9 J. Retirement Plan. 21, 23 (2006). See also, Parenti, supra note 45, at 25.

[55] See Melcher, at 23.

[56] See id. (citing Reg. §25.2522(c)-3(d)(2), Ex. 1).

[57] See id.

[58] I.R.C. § 2036.

[59] Estate of Wyly v. Comm’r, 610 F.2d 1282, 1290 (5th Cir. 1980).

[60] Estate of Lumpkin v. Comm’r, 474 F.2d 1092, 1097 (5th Cir. 1973).

[61] See generally United States v. Byrum, 408 U.S. 125 (1972); Estate of Harper v. Comm’r, 93 T.C. 368; Estate of Thompson v. Comm’r, 382 F.3d 367 (3d Cir. 2004), aff’g T.C. Memo. 2002-246, 2002 WL 31151195; Kimbell v. United States, 371 F.3d 257 (5th Cir. 2004); Estate of Bongard v. Comm’r, 124 T.C. 95 (2005); Estate of Strangi v. Comm’r, T.C. Memo. 2003-145, aff’d 417 F.3d 468 (5th Cir. 2005); Estate of Rosen v. Comm’r, T.C. Memo. 2006-115, 2006 WL 1517618; Estate of Bigelow v. Comm’r, 503 F.3d 955, 969 (9th Cir. 2007); Estate of Stone v. Comm’r, T.C. Memo. 2012-48, 2012 WL 573003, Estate of Powell v. Comm’r, 148 T.C. No. 18 (2017); Estate of Moore v. Comm’r, T.C. Memo. 2020-40, 2020 WL 1685607.

[62] Estate of Moore v. Comm’r, T.C. Memo 2020-40, 2020 WL 1685607, at *13-14.

[63] Estate of Bongard v. Comm'r, 124 T.C. No. 8 (2005).

[64] Id. at *97.

[65] Id. at *130.

[66] Id. at *97.

[67] Id. at *98.

[68] Id.

[69] Id.

[70] Id.

[71] Id.

[72] Id.

[73] Id.

[74] Id. at *113-14.

[75] Id. at *112-13.

[76] Id. at *125.

[77] Id. at *131.

[78] See id. at *113

[79] Id. at *113. (citing Helvering v. Hallock, 309 U.S. 106, n. 7 (1940); Estate of Shafer v. Comm’r, 749 F.2d 1216, 1221-22 (6th Cir.1984), affg. 80 T.C. 1145, 1983 WL 14846 (1983); Guynn v. United States, 437 F.2d 1148, 1150 (4th Cir.1971) (stating that section 2036 “describes a broad scheme of inclusion in the gross estate, not limited by the form of the transaction, but concerned with all inter vivos transfers where outright disposition of the property is delayed until the transferor's death”)).

[80] Id. at *125.

[81] Id. at *129.

[82] 371 F.3d 257, 258 (5th Cir. 2004).

[83] Estate of Bongard v. Comm'r, T.C. No. 8, at *119 (2005) (citing Kimbell v. United States, 371 F.3d 257, 258 (5th Cir. 2004)).

[84] Id. at *117-18 (citing Estate of Stone v. Comm’r, T.C. Memo. 2003-309; Estate of Harrison v. Comm’r, T.C. Memo. 1987-8; Estate of Harper v. Comm’r, T.C. Memo. 2002-121).

[85] Id. at *122, 123.

[86] Id. at *123.

[87] Id. at *125.

[88] Id. at *128-29.

[89] Id.

[90] Id. at *128.

[91] Id. at *128-29.

[92] Id. (quoting Estate of Harper v. Comm’r, T.C. Memo. 2002-121).

[93] Id. at *129.

[94] Id. at *131.

[95] Id. at *129 (quoting Sec. 20.2036–1(a), Estate Tax Regs).

[96] Id. at *131.

[97] Id.

[98] See id.supra note 75.

[99] T.C. Memo. 2003-145, aff’d 417 F.3d 468 (5th Cir. 2005).

[100] Strangi v. Comm’r, 417 F.3d 468, 473 (5th Cir. 2005).

[101] Id.

[102] Id. at 472-73.

[103] Id. at 473.

[104] Id.

[105] Id.

[106] Id.

[107] Id.

[108] Id.

[109] Id. at 474.

[110] Id.

[111] Id. at 475.

[112] Id. at 475, 478 n.7.

[113] Id. at 478.

[114] Id. at 476.

[115] Id. at 478.

[116] Id. at 476 (quoting United States v. Byrum, 408 U.S. 125, 145.)

[117] See Estate of Bongard v. Comm'r, T.C. No. 8, at *113, *131 (2005).

[118] 417 F.3d 468, 477.

[119] Id. at 477-78.

[120] See id. at 478-482.

[121] Id. at 478.

[122] Id. at 478, 478 n.7.

[123] See Estate of Powell v. Comm’r, 148 T.C. No. 18, at *400-05 (2017).

[124] T.C. Memo. 2003-145 (2003), 2003 WL 21166046, at *12, *16.

[125] See id. at *15-16.

[126] Id. at *15.

[127] Id.

[128] Id. at *16.

[129] 408 U.S. 125.

[130] Id. at *14.

[131] Id. at *18.

[132] Id.

[133] 148 T.C. No. 18 (2017).

[134] Id. at *394-95.

[135] Id.

[136] Id. at *395.

[137] Id.

[138] Id.

[139] Id. at *393-95.

[140] Id. at *398.

[141] Id. at *399.

[142] Id.

[143] Id.

[144] Id. at *404.

[145] See T.C. Memo. 2003-145, 2003 WL 21166046, at *12-18.

[146] 148 T.C. No. 18, at *401 (citing I.R.C. § 2036(a)(2)).

[147] Id.

[148] See Id.

[149] Id. at *401-02.

[150] Id. at *404.

[151] Id.

[152] Id.

[153] Id.

[154] Id.

[155] T.C. Memo. 2020-40, 2020 WL 1685607.

[156] Id. at *1.

[157] Id. at *2.

[158] Id.

[159] Id.

[160] Id.

[161] Id. at *3.

[162] Id. at *2.

[163] Id. at *6.

[164] Id.

[165] Id. at *9.

[166] Id. at *12.

[167] Id. at *13.

[168] Id. at *12.

[169] Id. at *11-12.

[170] Id. at *12, *12 n.16.

[171] Id. at *12.

[172] See Strangi, supra notes 116-17.

[173] T.C. Memo 2020-40, 2020 WL 1685607, at *12-13.

[174] Id.

[175] Id.

[176] See Strangi, supra note 119.

[177] Id. at *13.

[178] Id.

[179] Id.

[180] Id. See also, Estate of Thompson v. Comm’r, 382 F.3d 367, 373 (3d Cir. 2004), aff’g T.C. Memo. 2002-246, 2002 WL 31151195 (stating the Tax Court acknowledged the decedent’s transfers altered the “formal relationship” between decedent and his assets, however, as a practical matter, “nothing but legal title changed[]” (quoting T.C. Memo. 2002-246, 2002 WL 31151195, at 387)); Estate of Rosen v. Comm’r, T.C. Memo. 2006-115, 2006 WL 1517618, 91 T.C.M. (CCH) at 1235-36 (explaining given decedent’s old age and poor health, it was implied that decedent’s children would not prevent her from continuing to use her transferred assets).

[181] Id. Because the Tax Court held for inclusion under I.R.C. § 2036(a)(1), the court did not address the Commissioner’s alternative arguments that decedent’s estate plan triggered inclusion under I.R.C. § 2036(a)(2); or that the subsequent transfer of the Living Trust’s assets to the Irrevocable Trust also triggered their inclusion under I.R.C. § 2036. Id. at *13, n.17.

[182] Kimbell v. United States, 371 F.3d 257, 261 (5th Cir. 2004).

[183] Estate of Moore v. Comm’r, T.C. Memo. 2020-40, 2020 WL 1685607, at *10 (citing Estate of Bongard v. Comm’r, 124 T.C. 95, 112 (2005)).

[184] Id. (citing Kimbell, 371 F.3d at 261).

[185] See Estate of Bongard v. Comm'r, T.C. No. 8, at *117-18 (2005) (citing Estate of Stone v. Comm’r, T.C. Memo. 2003-309; Estate of Harrison v. Comm’r, T.C. Memo. 1987-8; Estate of Harper v. Comm’r, T.C. Memo. 2002-121); Estate of Moore v. Comm’r, T.C. Memo 2020-40, 2020 WL 1685607, at *9, *11-12.

[186] Estate of Bongard, T.C. No. 8, at *117-18 (2005).

[187] Estate of Moore, T.C. Memo 2020-40, 2020 WL 1685607, at *10 (citing Estate of Bongard, T.C. No. 8, at *117-18 (2005)).

[188] Strangi v. Comm’r, 417 F.3d at 476 (quoting United States v. Byrum, 408 U.S. 125, 145 (1972)).

[189] Estate of Strangi v. Comm’r, T.C. Memo. 2003-145, 2003 WL 21166046, at *16 (2003).

[190] See id. at *12, *16 (discussing decedent’s ability to act alone, or through his attorney-in-fact, to cause distributions of property previously transferred to partnership triggers inclusion under I.R.C. § 2036).

[191] Estate of Powell v. Comm’r, 148 T.C. No. 18., at *401 (2017).

[192] Estate of Wyly v. Comm’r, 610 F.2d 1282, 1290 (5th Cir. 1980).

[193] I.R.C. 2035; I.R.C. 2036.

[194] Julia Kagan, Three-Year Rule, Investopedia, https://www.investopedia.com/terms/t/threeyearrule.asp (June 20, 2020), (last visited August 1, 2020).

[195] Will Kenton, Bundle of Rights, Investopedia (May 19, 2019), https://www.investopedia.com/terms/b/bundle-of-rights.asp (last visited August 1, 2020).

[196] Id.

[197] See Estate of Moore v. Comm’r, T.C. Memo. 2020-40, 2020 WL 1685607, at *14-19. I.R.C. § 2043 provides for a consideration offset for some lifetime transfers by a decedent that I.R.C. §§ 2035-2038 include in the gross estate resulting in a net inclusion amount. Benjamin A. Cohen-Kurzrock, Estate of Moore: Tax Court Finds Estate Tax Traps in ‘Deathbed’ Plan, Tax Practice: Tax Notes Federal 1359, 1361 (May 25, 2020). In Estate of Powell, the Tax Court stated the net inclusion amount as “equal[ing] any discount applied in valuing the partnership interest the decedent received plus any appreciation (or less any depreciation) in the value of the transferred assets between the date of the transfer and the date of death.” 148 T.C. at 408 n.7. This method for determining the net inclusion amount does have the downside of possibly double counting increases or decreases in transfer tax depending on whether posttransfer valuation increases or declines in the value of the transferred assets are reflected in the value of the closely held interest owned by the decedent. Cohen-Kurzrock, at 1361-62. In order to protect against this possible duplication, the Tax Court in Estate of Moore provided a formula for determining the appropriate inclusion amount and provided four hypothetical examples of its application. See Estate of Moore, at *14-16.

[198] T.C. Memo. 2020-40, 2020 WL 1685607, at *2.

[199] Id. at *13-14.

[200] Id. at *12.

[201] Powell, 2017 WL 2211398, at *2.

[202] Id. at *404.

[203] Id.

[204] See Estate of Moore v. Comm’r, T.C. Memo. 2020-40, 2020 WL 1685607, at *12.

[205] 417 F.3d 468, 477-78.

[206] Id.

[207] T.C. Memo. 2020-40, 2020 WL 1685607, at *12-13.

[208] See Estate of Bongard v. Comm'r, T.C. No. 8, at *122-25 (2005).

[209] Id. at 122, 123.

[210] Estate of Moore v. Comm’r, T.C. Memo. 2020-40, 2020 WL 1685607, at *11.

[211] See Estate of Powell v. Comm’r, 148 T.C. No. 18, at *401 (2017).

[212] Estate of Moore v. Comm’r T.C. Memo 2020-40, 2020 WL 1685607, at *5.

[213] Strangi v. Comm’r, 417 F.3d 468, 478 (5th Cir. 2005).

[214] Id. at *15-16.

[215] Estate of Powell v. Comm’r, at *401 (citing I.R.C. § 2036(a)(2)).

[216] Estate of Bongard v. Comm’r, 125 T.C. 95, 112 (2005).

[217] See Estate of Moore v. Comm’r T.C. Memo 2020-40, 2020 WL 1685607, at *10.

[218] Id.

[219] 125 T.C. 95, 112 (2005).

[220] See T.C. Memo 2020-40, 2020 WL 1685607, at *10.

SSRN - CANTLEY DIETRICH TOP TEN - #1.2

Uncovering Four Ways That Biden’s American Families Plan Attacks Your Wealth

26-Jul-2021

Do the rich pay their fair share? Federal income taxes and adjusted gross income earned in 2018

By:
Beckett Cantley
Geoffrey Dietrich


President Biden sent ripples through the financial world when he proposed a “once-in-a-generation” investment in the foundations of middle-class prosperity [1]  with a tax reform agenda set to neutralize the wealth disparity in our country.

What is the Intent of the Biden American Families Plan? 

The proposed agenda in the American Families Plan (“AFP”) marks an ambitious proposal to reconfigure both how the United States rewards the American Dream and how it proposes to roll out enough social programs to solve what ails our country.  It proposes paying for those programs with an equally ambitious plan to tax the wealthy in ways heretofore unimagined—or if imagined, previously unattainable.

From the outset, it is vitally important to recognize that “tax” is a multi-layered conversation and, depending on the facts used, any conversation about tax will have different outcomes.  This article does not attempt to fully explore all facts. Instead, it seeks to start a conversation and aid in understanding the proposed agenda. Thus, first we will touch on some facts related to the actual amounts of tax paid by the wealthy.  Next, we discus the capital and ordinary income tax proposals raised in the AFP. Finally, we explore some potential outcomes if the AFP is passed into law.

President Biden has said, on several occasions, that America’s wealthy need to “just pay their fair share.”  While we recognize most Americans distrust the tax system (and in many cases, government generally), most Americans do believe they should pay “something” in tax.  After all, this is the greatest nation in the world with access to public services, including free schooling for our children, and rights, such as free speech, which we often take for granted. Most Americans’ views start to differ when “fair share” becomes a rally cry with reports on billionaires qualifying for certain tax credits reserved to the poor.   Again, not to delve into the probably-completely-legal-and-ethical means by which corporations and their owners manage taxation, we present the following graphic from the Heritage Foundation :



As shown above, the “wealthy” (limited to only the top 1%) pay a staggering 40% of all tax revenue, as reported by the IRS.  When you include those Americans making above $200,000 per year as “wealthy,” it becomes 60%.  This is after the 2017 Tax Cuts and Jobs Act “reduced tax bills for the lowest-income Americans by 10% while only cutting taxes for the top 1% by 0.04%” according to the Heritage Foundation. Reasonable minds may differ on what “fair share” amounts to, as—arguably—certain demographics are able to take greater advantage of the tax system than others.

How Does the AFP Tax Plan Attack the Wealthy

The AFP Tax Plan promises to improve life for all Americans with increased taxation on the wealthiest Americans without compliantly reduced taxable income.  It is nearly impossible to keep current with the proposals and all their changes, so we focus on four tax points discussed regularly and the wealth neutralizers “hidden” in plain sight.

  1. First, the Biden Administration proposes raising the top marginal income tax rate from 37% to 39.6%. This would apply to income  over $452,700 for single or head of household filers and $509,300 for joint filers.  This is not good news for well-compensated individuals or joint income families entering the top tax bracket approximately $105,000 sooner than they would otherwise.
  2. Next, the Biden Administration proposes taxing long-term capital gains and qualified dividends at the ordinary income rates for taxpayers with taxable income above $1 million. When combined with the proposed new top marginal rate of 39.6% and the 3.8% Net Investment Income Tax (“NIIT”)—the flat tax affectionately known as the “Obamacare Surcharge”—the  top marginal rate becomes a whopping 43.4% .
  3. We uncover a “hidden” attack on your wealth in the tax on unrealized gains at death above $1 million ($2 million for joint filers, plus the current law capital gains exclusion of $250,000/$500,000 for primary residences).  This is a rally point for the advocates of closing tax “loopholes.”  Sadly, many Americans —especially middle-class taxpayers—pass wealth by transferring appreciated property upon the death of a loved one.  The transfer of a family home, family farms, or other appreciated property with low basis upon the death of a loved one would become a target-rich environment of previously untouchable gains.
  4. The final attack we uncover is hiding in the expansion of previous taxation to which we have already grown accustomed. In addition to the other points previously discussed, the Plan would apply the NIIT 3.8% to  active pass-through business income  above $400,000.  This wealth neutralizer hides in plain sight in a proposal to close perceived “gaps” in the tax law between the FICA and SECA taxes.  There are currently four identified “gaps”:
    1. distributions to active S corporation shareholders;
    2. distributions to active limited partners;
    3. gains from the sale of business property from active non-trading businesses (like an MRI machine used by a radiology practice or a truck used by a construction company) which might not be subject to NIIT for active partners in the business; and
    4. active LLC members.

How Might the AFP Tax Plan Do More Harm Than Good

The Administration makes its projections on eight (or ten) year plans for revenue.  However, the revenue to be raised requires fifteen years to reach its funding goal (in a vacuum).  Thus, the AFP begins with a five-to-seven-year shortfall.  Unfortunately, even if the laws backdate eligibility or claw back income to fall under the future laws, it is unlikely to catch everyone. We wonder how many Fortune-level companies will pay their Big 4 accounting firms to find a way to pay some tax in year one only to plan an escape after that?  If some of the biggest companies do so, the AFP loses tax dollars during the next nine tax years.

Corporations with sufficient revenue at risk are likely to go offshore (again) to take advantage of better tax treaties. Apple’s (and others’) use of the Dutch-Irish Sandwich should provide a good example of the lengths a corporation will go to limit or reduce taxation by even just small percentages.

The truly wealthy are likely to move assets and income to creditor protection jurisdictions and take advantage of legitimate investments with income tax benefits for their investments and wealth. Individuals will find other ways to pass income and transfer wealth or push off selling businesses/stock/houses/etc. The tax on the wealthy may face significant hiccups in tax collection, even with a doubled budget for the IRS.  This could be why the Biden Administration is putting such a priority on global corporate and minimum taxes.  With all the tax minimization options available to wealthy individuals, it is questionable how we will pay for these social programs.

Likely scenarios resulting from Biden’s AFP Tax Plan

The tax starts to trickle down.  We are possibly seeing it now with the lowered upper income bracket.  Increased corporate taxes do not mean less money to the wealthy. It usually means higher prices, increased costs passed on to consumers, and more entry level jobs being handled by robots or self-service kiosks (think Wal-Mart self-check and McDonald’s ordering kiosks).

If you have clients in the upper income brackets who share these concerns, the attorneys at Cantley Dietrich would enjoy having a conversation with you about how you can protect them from some of the challenges they will likely face in the next few years.

Citations

  1. Prof. Beckett Cantley (University of California, Berkley, B.A. 1989; Southwestern University School of Law, J.D. cum laude 1995; and University of Florida, College of Law, LL.M. in Taxation, 1997), teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C. Prof. Cantley would like to thank Melissa Cantley and his law clerk, Reed Green, for their contributions to this article.

  2. Geoffrey Dietrich, Esq. (United States Military Academy at West Point, B.S. 2000; Brigham Young University Law School, J.D. 2008) is a shareholder in Cantley Dietrich, P.C.

  3. https://www.whitehouse.gov/american-families-plan/

Captive Insurance Company FAQs

03-Jun-2021

Captive Insurance Company FAQs

by Beckett Cantley[1] and Geoffrey Dietrich[2]

This article is intended to provide a basic set of frequently asked questions on captive insurance companies. The questions are in no way meant to be exhaustive on the subject, but rather solely cover certain basic uniform questions potential captive insurance company owners need to ask before forming one. Please note that the authors only advise captive owners and advisors on specific issues of captive insurance law and do not form or operate captive insurance companies.

Captive Insurance Company FAQs

What is an IRC § 831(b) Captive Insurance Company?

An Internal Revenue Code (“IRC”) § 831(b) small captive insurance company (“CIC”) is, in essence, a corporation formed to offer insurance to a parent corporation or other affiliated entities.[3] The CIC may offer administrative and tax benefits over self-insurance and commercially available insurance. The questions addressed below briefly discuss the history, the structural details, and the potential benefits.

How Did Captive Insurance Start?

Captives emerged as a planning tool in the 1950’s.[4] Fred Reiss created American Risk Management in 1958 to assist U.S. corporations in establishing their own insurance companies as an alternative to conventional risk management.[5] Due to the peculiarities of state insurance laws at the time, most CICs were formed outside the U.S., often in “debtor havens” where the companies experienced few, if any, local tax consequences.[6] After the U.S. passed tax legislation temporarily eliminating many benefits of CIC insurance arrangements for U.S. companies, Reiss formed International Risk Management in Bermuda.[7] This move precipitated the dominance of offshore domiciles in the CIC market for the remainder of the twentieth century.[8]

Historically, CICs were most often utilized by large U.S. corporations.[9] One common motivation was, and continues to be, a company’s inability to purchase commercial insurance at acceptable premium and coverage levels.[10] The taxpayers in Consumers Oil[11] and Weber[12] had operations in areas prone to flooding and neither taxpayer was able to obtain commercial insurance coverage due to the elevated risk.[13] Similarly, the taxpayers in Gulf Oil[14] and Ocean Drilling[15] operated in high-risk industries and were only able to obtain commercial insurance at prohibitively high prices. The companies formed CICs to provide the coverage they could not otherwise obtain under acceptable terms.

Another common theme is a company’s desire for more administrative control over the insurance policy.[16] Beech Aircraft[17] was unable to obtain commercial insurance that would allow the company to control its legal defense in the event of a claim. [18] The company had been sued under a previous policy, and the jury returned a sizeable verdict against the company, the majority of which was designated as punitive damages.[19] After an investigation, the company was convinced that the verdict was a result of a failure by the insurer’s legal team to adequately prepare and try the case.[20] The company had monitored the activity of the insurer’s attorneys during the course of the trial, and even unsuccessfully filed a motion to have those attorneys removed.[21] To afford itself more control over the administrative terms of the policy, the company formed a wholly owned subsidiary CIC.[22]

Throughout the 1970’s and 1980’s, judicial and executive interpretation identified circumstances under which a CIC insurance arrangement would be respected in the U.S.[23] In general, courts ruled captive structures were valid insurance companies when they either insured a sufficiently large number of the parent company insureds[24] or obtained at least 30% non-parent risk.[25] Increased certainty through pro-taxpayer decisions led to increased utilization of CICs as a risk management strategy by major U.S. corporations.[26] States began passing legislation enabling formation of CICs, and more growth to the domestic sector resulted.[27] A concomitant increase in courtroom activity led to a rise in certainty as judges circumscribed the permissibility of CICs.[28] A critical mass accumulated in the 1990’s, and the CIC industry “exploded” as smaller and even privately-held businesses began to view CICs as an attractive alternative to more common risk management strategies.[29] Today, a majority of states have passed CIC-enabling legislation.[30]

What Can a Captive Do?

Generally speaking, a CIC may offer coverage of virtually any type to the operating business, and the terms of the policy are remarkably flexible.[31] By far the most common arrangement is for the parent company to maintain existing coverage through commercially available policies while having the captive fill policy gaps[32] and provide coverage for stochastic (low frequency, higher payout) risks.[33] Also, Congress has provided a tax incentive for the formation of IRC § 831(b) small CICs. In effect, the tax code helps offset the costs of establishing and operating a regulated, small insurance company.

What are the Benefits of a Captive?

A CIC may afford its owners numerous benefits. A CIC can provide niche coverage for unique or specific risks that would not be otherwise transferrable, or not transferrable at an acceptable cost, in the commercial insurance market. This is especially advantageous to an entity with an above average risk profile that seeks to reduce its exposure in a cost-effective manner. Thus, so long as the policies are commercially reasonable, a CIC owner can “create whatever type of coverage for the operating business [he] can dream up.”[34] In his authoritative book on the subject, Jay Adkisson lists dozens of policy types ranging from the relatively mundane, e.g, errors and omissions, and malpractice, to the somewhat esoteric, e.g., confiscation and expropriation, and weather risks.[35] Moreover, as highlighted by the Beech Aircraft case, the policy terms may be tailored to meet the individual needs of the insured, again, subject to commercial reasonableness.

Also, a CIC may be used as a means of cost stabilization for an insured who has grown weary of premium increases in a hardening commercial insurance market. These increases may be based on market forces or underwriting software rather than the claims experience of the insured entity. For a company with a better than average loss experience, a CIC can save premium dollars that would otherwise be used to subsidize the loss experience of other market members.

Next, a CIC can reduce or eliminate brokerage commissions and marketing and administrative expenses, which are typically wrapped into commercial insurance premiums. Thus, a CIC arrangement allows a business to potentially lower its overhead while leaving more premium dollars in reserve for claims payment and surplus investment. If the CIC “wins its gamble” with the insured, it can generate profit for the parent corporation that would otherwise accrue to the third-1.party commercial insurer. As surplus funds accumulate, the funds can be invested. Moreover, a parent corporation may generally exercise some control over the investment decisions of the CIC.

In addition to these benefits, Congress has provided a tax incentive for CIC formation under IRC § 831(b). In effect, § 831(b) helps offset the costs of establishing and operating a regulated, small insurance company. A valid IRC § 831(b) CIC may allow a parent corporation to manage risk exposure without incurring the income tax problems associated with self-insurance. Whereas contributions to a reserve account for self-insurance are generally not tax deductible, premiums paid to a CIC by its insured entity may be deductible, similar to the deductibility of premiums paid for commercial insurance. IRC § 162(a) provides that “there shall be allowed deductions on necessary and ordinary business expenses incurred in carrying on a business.” Treasury Regulations § 1.162-1(a) states that business expenses include insurance premiums paid on policies covering fire, storm, theft, accident, or similar losses in the course of business. Thus, provided that the CIC is considered an “insurance company,” issuing “insurance” through arrangements that are considered “insurance contracts,” as discussed above, the parent corporation should be able to deduct premium payments to the CIC.

Furthermore, a CIC may earn premiums, within limits, without incurring federal income tax. IRC § 831(a) provides that tax shall be imposed under IRC § 11 on the taxable income of any insurance company other than life insurance companies. However, IRC § 831(b) provides that a non-life property and casualty insurance company, which receives annual premiums not to exceed $2.3 million, can elect to receive these premiums tax-free. Thus, the CIC would incur no tax on underwriting income earned on premiums paid, so long as the aggregate premiums total less than $2.3 million annually.

Notably, the CIC is still taxed on income earned through investment activity. Assuming that the CIC is profitable in its underwriting and investment operations, profits will be distributed to the CIC shareholders in the form of dividends. Alternatively, a CIC shareholder could realize profits through the sale of his shares in the CIC. In either the case of a qualified dividend or sale of stock, the income would be taxed at the long-term capital gains rate, under current law, rather than at the rate applicable to ordinary income.

How is a Captive Owned?

Typically, a CIC is either owned directly by its parent corporation or by the shareholders of the parent corporation. The organizational structure of a CIC closely resembles that of a mutual insurance company, albeit for a more limited number of participants. “CIC” refers to a brother-sister arrangement in the discussion below unless otherwise noted. Without belaboring the details of the day-to-day operation of an insurance company, this discussion seeks to give a brief overview of selected topics. The CIC and its insured should independently operate in an arms-length relationship to the greatest extent possible.[36] Thus, while the CIC should be tightly woven into the parent company’s overall business plan to maximize efficiency, the CIC should maintain its own business goals and plan for success.

Who Manages a Captive?

The ongoing management of the CIC is critical in ensuring the success of the enterprise. The CIC should recruit appropriately credentialed professionals to fulfill management, underwriting, accounting and audit duties. The insurance manager fills the fundamental role of determining which risks to underwrite and drafting the policies that insure the chosen risks. The insurance manager must seek actuarial assistance in evaluating risks and determining premium and reserve levels. Also, it is ultimately the insurance manager’s responsibility to ensure that the CIC complies with its license terms, regulatory requirements, deadlines, and the like.

Are Captives Audited?

Most jurisdictions require annual audits of insurance companies by an accounting firm approved by the Insurance Commissioner. Choosing a firm that is experienced in CIC insurance may help the CIC avoid the myriad pitfalls that await CICs in the IRC.

The CIC should undergo periodic reevaluation to maximize efficiency. Such reevaluation may allow a CIC to underwrite more risk given its capital structure, and the goals of management. Moreover, risks currently underwritten by the CIC may have become more inexpensive to insure in the commercial market, again, subject to management goals. Typically, a CIC must provide notice to the Insurance Commissioner of its jurisdiction when there will be significant changes to its operations or ownership structure.[37]

How are Captive Insurance Companies Formed?

Aside from what structure the CIC will take, many factors must be considered before undertaking the formation of a CIC. First, an experienced attorney or consultant should be engaged to perform a feasibility study.[38] This will provide the prospective owner with an independent, clinical opinion as to whether a CIC is an appropriate vehicle to achieve the desired benefits, given the owner’s business and overall financial plan. This step should also begin to educate the proposed owner of the regulatory and compliance requirements associated with operating an insurance company according to the statutory regime of the licensing jurisdiction.

Also, a detailed actuarial study should be prepared, and, in fact, generally must be submitted with the insurance license application. The actuarial study should determine the amounts and types of coverage that will be underwritten. The study should also include information as to how the premium amounts will be determined and the capitalization requirements associated with the new CIC. There should be no communication between the potential insured, the party supervising the study, and the actuary that attempts to manipulate the numbers to arrive at tax-friendly numbers. Once the feasibility and actuarial studies are completed, the insurance license application can be submitted in the jurisdiction of choice.

Where are Captive Insurance Companies Formed?

A CIC can be formed and licensed pursuant to the laws of a U.S. state, or those of a foreign country. The company will be “domiciled” in the jurisdiction where it was formed. Many factors impact the decision as to whether to form the CIC domestically or offshore and the choice between domiciles in either arena. Those factors include, but are not limited to: (1) the CIC’s exposure to the U.S. tax system; (2) the capitalization burden required at formation; (3) the flexibility the CIC is allowed in investing its resources; and, (4) the asset protection afforded the U.S. shareholders of the CIC.[39]

The tax and compliance burdens imposed by U.S. law on a CIC and its U.S. shareholders may be a consideration in deciding whether to form a CIC domestically or offshore. Notably, an organization in an offshore jurisdiction will not preclude the IRS from assessing and collecting U.S. income tax. Therefore, the decision as to whether to form a CIC in a domestic or offshore jurisdiction should be made based on the local reporting requirements and taxation to which a CIC would be subject, accepting as fact that the IRS is quite capable of visiting federal income taxation on an offshore CIC.[40]

Both domestic and offshore CICs are subject to U.S. income taxation. A foreign CIC may elect to be taxed as a domestic entity under IRC § 953(d).[41] A company making such an election directly subjects all income earned globally to U.S. federal income tax, rather than indirectly through its U.S. shareholders under IRC subchapter F.[42] The benefits to a U.S.-owned offshore CIC making an IRC § 953(d) election include exemption from the federal excise tax (“FET”), simplified compliance and administration and, at least theoretically, communication to the IRS that the CIC need not be subjected to heightened scrutiny by virtue of its offshore domicile.[43] An IRC § 953(d) election is irrevocable absent IRS consent.[44]

A CIC that chooses not to make an IRC § 953(d) election could find itself categorized as a controlled foreign corporation (“CFC”) if more than 25% of its shares are held by U.S. owners.[45] A CFC classification would render the CIC income currently taxable its U.S. shareholders. Under these circumstances, the U.S. shareholders of the CIC would be required to currently include all CIC profits not directly allocable to insurance contracts issued on risks outside the U.S. in the CIC owner’s taxable income, irrespective of the timing of the distributions.[46]

What are the Disadvantages of Forming a Captive Insurance Company Offshore?

The disadvantages of forming a CIC under the laws of a foreign country potentially include subjecting the policy premiums to the FET and increasing the compliance burden of the CIC by exposing the company to a greater risk of an intrusive audit.[47] Policy premiums paid to an offshore CIC by a U.S. insured may be subject to the FET if the IRS views the arrangement as an “importation” of a foreign service. Foreign services imported to the U.S. are subject to the FET. Specifically, property/casualty premiums paid to an offshore CIC by a U.S. insured are subject to a FET of 4% for original insurance and 1% for reinsurance.[48] Because the offshore CIC provides insurance, actuarial, and management services to its U.S. shareholders, the IRS may view the arrangement as an “importation” of foreign services, thus exposing its U.S. shareholders to the increased U.S. tax burden of the FET. While some domestic jurisdictions charge premium taxes, shareholders of a domestic CIC can generally avoid the additional tax liability in the form of premium taxes by simply choosing to organize the CIC in a state that does not require premium taxes.[49]

An otherwise compliant CIC should have nothing to fear from the mere fact that it is domiciled offshore. However, that offshore domicile alone may be enough to subject the company to an “ever-changing and perilous compliance burden” and a risk that the company will be swept up in the increasing number of IRS audits of offshore entities.[50] Around 2005, the Senate Permanent Subcommittee on Investigations (“PSI”), under the leadership of Senator Carl Levin, began to view U.S. taxpayers’ offshore holdings with increasing suspicion.[51] This sentiment grew out of the government’s reduced ability to monitor its citizens’ offshore holdings. When PSI investigations began to uncover empirical evidence supporting this suspicion, Congress, the Department of Justice, and the IRS became engendered with a belief that U.S. holdings in offshore arrangements were potentially abusive and evasive. Congress has enacted and continues to propose, numerous legislative schemes to assist the IRS in enforcing U.S. tax laws offshore. Without addressing the details of the various enacted or proposed legislation, it is sufficient to say that organizing a CIC offshore to reduce one’s exposure to U.S. tax laws is by no means a foolproof strategy.

How are Captives Capitalized?

The capitalization burden, or the sum of money required under local law to be contributed to a reserve account upon formation, will likely affect whether one decides to organize a CIC domestically or offshore, and the choice of domicile within these categories. Domestic jurisdictions have historically required between $300,000 and $300 million capitalization to form a CIC, depending on such factors as the type of CIC, the proposed coverage offered by the CIC, and the relationship between the CIC and the insured. Laypeople, and indeed some tax and insurance professionals, have long espoused the relaxed offshore regulatory environment as a benefit of organizing a CIC offshore. This perception arises in part from the lower minimum capital contributions typically required in offshore jurisdictions and the less restrictive rules and regulations many offshore jurisdictions impose on insurance and financial institutions. For example, offshore regulators generally rely on independent CPA verifications, whereas domestic regulators typically require examinations by state regulatory bodies and state-approved audit firms.

While the local regulatory environment is important in choosing a jurisdiction in which to found a CIC, a planner must not overlook the requirements superimposed on all insurance companies by the IRS The IRS must consider the CIC an insurance company for premiums to be deductible under IRC § 162, and for a CIC to receive the tax benefits of IRC § 831(b), and the policies issued must reflect an insurance arrangement. To consider a policy an insurance arrangement, the IRS must find that the risk of economic loss was shifted from the parent-insured to the CIC, i.e. “risk shifting”. Without adequate capitalization, the CIC may have insufficient reserves to cover its insureds’ current and anticipated claims. Because an insured would bear the entire risk of loss if his insurer failed to satisfy the insured’s claim, adequate capitalization factors heavily in determining whether risk has shifted between an insured and a CIC. Therefore, any CIC seeking to participate in the benefits bestowed upon insurance companies by the IRC may be subject to substantially higher capitalization requirements than those imposed by the offshore jurisdiction.

Notably, some U.S. states have made their minimum capitalization requirements more palatable in recent years. For example, Delaware reduced its requirement to $250,000 combined capitalization among separate CIC entities formed and administered as part of the same series. Under such an arrangement, a group of individual CIC entities may share the same capitalization. Thus, provided that all other CIC law is strictly observed, the individual entities can maintain the reserves necessary for proper risk-shifting while keeping their individual capitalization requirements reasonably low. Such domestic options at least warrant a second look from a prospective owner seeking to minimize his initial capital contribution without inviting IRS scrutiny.

What Investments Can a Captive Insurance Company Make?

One consideration in choosing whether to organize a CIC domestically or offshore is the investment flexibility a jurisdiction affords a CIC with respect to its surplus. Surplus is the income that a CIC retains in excess of the funds needed to satisfy its current claims. Some foreign jurisdictions permit a CIC to invest its surplus in any investment vehicle, provided the investment does not impair the capital base or run afoul of the foundational requirements of the insurance arrangement, including making investments so unreasonably illiquid as to potentially prevent the payment of its actuarially anticipated claims.[52] Because the primary responsibility of an insurance company is to pay claims as they arise, a CIC that fails to abide by its solvency requirements would not be considered a valid insurance company for any purpose. As such, while a foreign jurisdiction may permit a CIC greater investment flexibility, the CIC is still subject to the IRC requirements applicable to all insurance arrangements. A CIC not primarily engaged in the business of underwriting insurance or reinsurance activities would not be considered an insurance company.[53] Thus, CIC compliance with the regulations of the foreign jurisdiction is significant in assessing whether a CIC is primarily engaged in the business of insurance, but the controlling factor in analyzing whether a CIC qualifies as an insurance company is the nature of the business transacted in the taxable year.

IRS pronouncements warn that certain arrangements where an insurance company’s insurance business is outweighed by its investment activities may not withstand this analysis. While some of this guidance appears in the context of life insurance, which a CIC may not insure, the issues raised with respect to life insurance companies should apply with equal force to companies that insure risks other than life. IRS Notice 2003-34 warned taxpayers that investing in certain U.S. shareholder-owned offshore purported life insurance companies to defer recognition of ordinary income, or to re-characterize ordinary income as capital gains, may present a compliance risk. The IRS recognized that arrangements of this type are used to invest in hedge funds or those investments in which hedge funds ordinarily invest, typically resulting in a relatively small proportion of genuine insurance activities in comparison to the offshore entity’s investment activities.

These arrangements result in the offshore entity earning investment income substantially in excess of the entity’s ordinary insurance business needs. Shareholders often eschew any current distribution, claiming that since the appreciation arises from the conduct of insurance business rather than passive investment income, the appreciation constitutes capital gain instead of ordinary income. The IRS recognized that operating an insurance company will almost certainly involve investment activity. However, genuine insurance companies use the returns from their investments to satisfy claims, underwrite more business, and fund distributions to the company’s shareholders. A foreign jurisdiction’s certification of an entity as an insurance company under the jurisdiction’s local rules does not necessarily equate to IRS recognition of the entity as an insurance company, especially where the entity is not primarily occupied in the issuance or reinsurance of insurance or annuities. For federal income tax purposes, an entity is only considered an insurance company when it primarily employs its capital in the pursuit of income from underwriting additional insurance risks. In making this determination, the IRS will analyze an entity’s aggregate operations and sources of income.

The IRS may determine that an offshore CIC is not an insurance company for federal income tax purposes if the CIC is predominantly used as a conduit for hedge fund investment. Under such circumstances, the IRS could impose current taxation on those U.S. persons earning passive income through the offshore entity under the Passive Foreign Investment Company (“PFIC”) rules.[54] Under IRC § 1279(a), a foreign corporation is a PFIC if (1) 75% or more of the entity’s gross income is passive income, or, (2) at least 50% of the entity’s assets produce, or are held for the production of, passive income. Corporations engaged primarily in the active conduct of insurance business are outside the purview of the PFIC rules, as they are subject to federal income taxation under the IRC subchapter L U.S. life insurance company rules. IRS Notice 2003-34 stated that the IRS will challenge the validity of these types of investment schemes, through the application of the PFIC rules, on a finding that a foreign corporation is not an insurance company for federal tax purposes. Thus, the latitude a foreign jurisdiction gives a CIC with respect to investing its surplus may be significantly circumscribed, at least to the extent that the entity’s investment activities may not exceed its insurance activities, lest the CIC find itself challenged as a PFIC.

Does a Captive Insurance Company Provide Asset Protection?

Adding a layer of asset protection may enter into the calculus when deciding whether to organize a CIC domestically or offshore. Various offshore jurisdictions claim that their regulators hold information about CIC assets in strict confidence, allowing a CIC to be organized and operated in secrecy. Many people also believe that disclosure of the identity of the parent entity to the IRS can be avoided through a valid IRC § 953(d) election, on the rationale that the CIC itself is the U.S. taxpayer and owner of all CIC assets. Avoiding disclosure to both foreign and domestic authorities may seem a beneficial attribute of offshore CIC organizations. Such secrecy may render a creditor unable to follow the money, leaving him less enthusiastic about the prospect of costly, protracted litigation, given the uncertainty as to whether the debtor is “judgment proof.”

Moreover, an IRC § 953(d) election could force a creditor to file suit against the CIC in the courts of the offshore domicile, effectively allowing the CIC to choose both the venue and the controlling law. Such a result is possible because a valid IRC § 953(d) election applies only to the IRC, and not to any other titles of the U.S. Code, including the Federal Rules of Civil Procedure. Thus, a creditor would be unable to argue that the CIC was domiciled in the U.S. and would have to prove that the U.S. court had personal jurisdiction over the CIC. A U.S. court could only exercise personal jurisdiction over the corporation on a showing that the corporation had the requisite minimum contacts with the jurisdiction or had purposefully availed itself of the U.S. court’s jurisdiction. An offshore CIC that collects substantial premiums from a U.S. insured in exchange for insurance may indeed have sufficient contacts to fall within the U.S. court’s jurisdiction. However, assuming a U.S. court could not exercise personal jurisdiction over a foreign CIC, creditors would effectively be forced to bring suit against the CIC in the foreign domicile’s courts, under the foreign domicile’s laws. Creditors may be unwilling to undertake such a daunting task, particularly where the offshore domicile has strict asset protection and account secrecy laws. Furthermore, even if U.S. courts are able to exercise personal jurisdiction over the CIC, and a creditor secures a judgment against the corporation, the foreign jurisdiction may be unwilling to enforce the U.S. judgment. Such a blow could be fatal to a creditor in the case of a debtor who has few assets outside the offshore jurisdiction.

If a creditor secures a judgment against a U.S. citizen, a U.S. court may very well declare a transfer offshore illegal or invalid at its source. The Court may be hesitant to relinquish jurisdiction over a transfer it perceives as a fraudulent attempt to evade the transferor’s creditors, especially if the creditor successfully maneuvers the transferor into a bankruptcy action. U.S. bankruptcy courts have broad powers to invalidate transfers that hinder or delay satisfaction of a creditor’s claim, and often use these powers to frustrate offshore asset protection arrangements. A hypothetical debtor could transfer significant assets offshore and outside the debtor’s control and beneficial enjoyment in the form of premium payment to a foreign CIC in an effort to become insolvent. Once found insolvent, creditors could position the debtor into bankruptcy, and the bankruptcy trustee would take control of the debtor’s estate. The trustee may be able to force a waiver of the attorney-client privilege, and obtain any information provided to the debtor by an asset protection attorney. This would likely allow the bankruptcy trustee to uncover documents and information revealing the location of the debtor’s offshore assets. In the case of a CIC, this information would likely include the non-public records of where the CIC assets are located. Once the bankruptcy trustee uncovered this information, it would be an easy task to unwind an asset protection arrangement designed to render the debtor insolvent. Then, the bankruptcy trustee could reclaim the assets, or repatriate premiums paid to the CIC or assets purchased with those premiums to satisfy creditor claims.

U.S. courts have declared that it is against public policy to enforce the laws of a foreign jurisdiction where those laws violate established principles of U.S. law. Foreign jurisdictions that are known for asset protection often intentionally draft legislation to circumvent the laws of other jurisdictions, including the U.S. As such, a U.S. judge may be loath to apply a foreign law that is unlikely to withstand an attack on public policy grounds. Thus, if a U.S. court finds that foreign laws are being used in contravention of public policy, the Court may unwind an offshore CIC.

A creditor may successfully void a transfer of funds from a U.S. party to an offshore CIC if the creditor can convince the Court that the transfer was made for improper asset protection purposes. Thus, a court may rule that capitalization or premium payments made to an offshore CIC by a U.S. shareholder or insured are void ab initio, especially if the debtor is before the U.S. bankruptcy court, as discussed above. Moreover, if the IRS and DOJ suspect that a CIC was formed for asset protection, they may question whether the CIC is being primarily operated as an insurance company, irrespective of creditor claims.

How Do Captive Insurance Companies Operate?

A CIC is, first and foremost, an insurance company, and must be operated in a manner consistent with being predominantly in the business of insurance. To avail itself of the favorable tax treatment the IRC bestows upon insurance companies, a CIC must, of course, meet the definition of “insurance company.”[55] Failure to meet this requirement could result in the exposure of all of the entity’s income to C corporation double taxation. Treasury Regulations § 1.801-3(a) provide that an insurance company is one whose primary and predominant business activity is the issuance of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. Under IRC § 816(a), an “insurance company” is any company more than half the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by an insurance company.

Captives must also comply with the “Harper Test,” so named because it is based on three factors outlined in the Harper case.
The three factors are:
(1) Whether the arrangement involves the existence of an “insurance risk”;
(2) whether there was both risk-shifting and risk distribution; and
(3) whether the arrangement was for “insurance” in its commonly accepted sense.[56]

“Insurance risk” requires the insurance company to specifically define the risk, which is contained in the policy. In addition, the insured must be able to demonstrate a premium was paid and the insurance company issued an insurance policy. Risk shifting and distribution are covered below.

Insurance in its commonly accepted sense requires the transaction to comply with generally accepted industry practice.

The Harper court found adequate capital and arms-length premiums determinative, as was the existence of regulatory authority (here, the Hong Kong government). Other IRS documents have discussed the need for the captive to comply with the state law definition of an insurance company and the existence of standard insurance company documentation.[57]

If a CIC charges commercially unreasonable premiums and/or otherwise engages in non-arms-length transactions, the IRS may not respect the CIC as a legitimate insurance company. While arms-length dealing and separate management fees alone are not sufficient to prove that an entity is an insurance company, such conduct telegraphs the existence of a bona fide “insurance company.” As discussed above, any CIC hopeful of recognition as an “insurance company” must otherwise operate as an “insurance company,” employ professionals with the appropriate credential to fill critical roles within the company and comport with local licensing and capitalization requirements.

Also, an “insurance company” must provide “insurance” through “insurance contracts.”[58] Unfortunately, the IRC provides little guidance in defining these terms. In general, an agreement must transfer the risk of economic loss, contemplate the occurrence of a stated contingency, and comprise something more than a mere business or investment risk to receive insurance treatment for federal income tax purposes.[59] Insurance Services Offices often provide policies for captives.[60] A CIC must show that it has adequately shifted the risk of economic loss from the insured to the insurer (“risk shifting”), and that the insurer has adequately spread that risk among various insurance companies or other unrelated entities such that no single entity bears the entire risk of economic loss (“risk distribution”).[61] A CIC may accomplish this goal using IRS safe harbors or otherwise.

What is Risk Shifting?

In Helvering v. LeGierse, the United States Supreme Court (“Supreme Court”) analyzed the risk-shifting issue. In LeGierse, an elderly, uninsurable taxpayer purchased a life insurance policy and a life-only annuity contract one month before her death.[62] By purchasing the annuity contract from the same insurer, without which the insurer refused to issue the life insurance policy, the taxpayer neutralized the insurer’s risk with respect to the life insurance policy. The taxpayer purchased the life insurance policy primarily to take advantage of favorable estate tax treatment available, and the arrangement had a little net effect on her economic position. The Court held that because the life insurance policy and the annuity contract offset one another, there was no risk shifting from insured-to-insurer.

Risk shifting is only present when a party facing the risk of economic loss transfers some or all of the financial consequences of that potential loss to an insurer.[63] Risk shifting generally requires an enforceable written insurance contract, with premiums negotiated and actually paid at arms-length, and the insurance company to be a discrete entity capable of satisfying its obligations and properly formed under the laws of the applicable jurisdiction. The thrust of the risk-shifting analysis is whether the premium-paying party has truly transferred the economic impact of the potential loss to the insurer.[64]

The Humana[65] court held that an arrangement solely between a parent company and a subsidiary CIC could not be considered insurance for federal income tax purposes because it failed to shift risk from the insured to the insurer. Humana paid premiums on its own behalf to a wholly-owned CIC in exchange for coverage. The Court noted that the similarities between such an arrangement and a reserve account for self-insurance, contributions to which are not tax-deductible, were impossible to ignore. The underlying rationale for the Court’s decision was that Humana did not truly transfer any risk of loss to the CIC, since any loss incurred by the CIC would ultimately be absorbed by Humana as the sole owner of the CIC. Nonetheless, the Humana court held that an arrangement between a subsidiary CIC and several dozen other subsidiaries of the parent entity did satisfy the risk-shifting element. The Court reasoned that a loss incurred by the CIC would not directly transfer to the sibling subsidiaries in the same way a loss would transfer between a wholly-owned subsidiary CIC and its parent.

Notably, the Court stated that the doctrine of substance over form, discussed in greater detail in another of our FAQ articles, could be invoked to challenge the existence of separate and distinct entities, which are required to show the existence of risk shifting. However, the Court went on to state that the doctrine would only be applicable where no valid business purpose exists for the transactions or where a clear Congressional intent to curtail such transactions can be shown. The Humana court concluded that Congress had not yet manifested any intent to disregard the separate corporate entity in the context of CICs and respected the separate identities of the entities.

With proper planning and execution, a CIC should have no trouble showing a valid business purpose for maintaining separate corporate entities. Thus, a substance over form argument employed to challenge the existence of risk shifting should be ineffective unless the transaction is found to lack economic substance aside from mere tax benefits (discussed further, below).

Since Humana, the IRS has provided broad “safe harbor” rulings. In the main “safe harbor” provision, found in Revenue Ruling 2002-90, the IRS explained that an arrangement of at least twelve subsidiaries paying premiums to an affiliated CIC constitutes effective risk-shifting where each subsidiary has no more than 15% and no less than 5% of the total risk insured and none of the claimed twelve subsidiaries are disregarded entities.

Since the promulgation of the “safe harbor” provisions, the IRS appears eager to challenge a CIC on the grounds of risk-shifting in only the most egregious and abusive of circumstances. This underscores the importance of adhering to the general guidelines discussed above. Risk shifting may be questioned where guarantees exist to neutralize a CIC risk of loss and where contracts are not entered into at arms-length. Other factors the IRS may consider in a risk-shifting challenge include: whether the insured parties face a genuine hazard of economic loss in an amount which justifies premium payments made at commercially reasonable rates; whether the validity of insurance claims was investigated and established before the claims were paid; and, whether the CIC business operations and assets are maintained separately from the business operations and assets of the parent entity.

What is Risk Distribution?

Risk distribution is also required for an arrangement to be considered insurance. Risk distribution involves the pooling of insurance premiums from separate insured entities so that an individual insured is not paying for a significant portion of its own risk. Rather, the risks, and claims, of an individual insured would be subsidized in large part by the premiums paid by other insured entities in the pool.[66] The law of large numbers dictates that the likelihood of a single claim exceeding premium payments for a given period of time decreases as the length of time and number of insureds in a given pool increase.

A risk distribution analysis is broader in focus than that of a risk-shifting analysis. The risk distribution analysis looks to whether an insurer has distributed the risk of an individual insured over a larger group of entities, rather than strictly between the insurer and the single insured. Unfortunately, authority adequately discussing what constitutes risk distribution where risk shifting is found to exist is scarce. However, the Humana[67] court found that an arrangement where a CIC insured multiple sibling subsidiaries from an affiliated group constitutes valid risk distribution since the premiums paid by each insured could offset the CIC losses as a whole. While decisions have never established the minimum quantity of unrelated business sufficient to constitute risk distribution, courts have ruled that 30% is sufficient and 2% is not.

The IRS has issued several Private Letter Rulings that outline two different risk distribution models. In the first, the insured pays a premium to an insurance company, which then cedes risk back to the insured’s captive. For example, the insured pays a premium of $100,000 to an insurer, which then cedes a percentage of the risk (anywhere between $30,000 and $90,000) back to the captive. Here, the risk distribution occurs within the financial accounts of the insurance company, as the insured's premium is combined with those from other, unique insureds.

In the second, the insured pays the full premium to his captive, which then cedes at least 50% of its risk to a pool where other, unique insureds do the same. Then, after an insured’s pool contribution is mixed with other, unique insureds, the pool cedes most of the original contribution back to the insured.
For example, an insured pays $100,000 to his captive, which then cedes at last $50,000 of its premiums to a pool, which in turn returns a majority of the original funds to the captive.

In summary, to be treated as an insurance company for federal income tax purposes, a Captive Insurance Company must show that its insureds have adequately shifted their risk of loss to the CIC and that the CIC has adequately distributed that risk over various diverse entities. A CIC maintaining its own arms-length operational identity and conducting its business in a manner consistent with standard insurance industry norms will also support such treatment. If a CIC can meet these requirements, many advantages may be available to the CIC and its owner.

  • [1] Beckett G. Cantley, Esq. (University of California, Berkley, B.A. 1989; Southwestern University School of Law, J.D. cum laude 1995; and University of Florida, College of Law, LL.M. in Taxation, 1997) teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C.
    The author may be reached for comment at bgcantley@cantleydietstg.wpengine.com.
  • [2] Geoffrey C. Dietrich, Esq. (United States Military Academy at West Point, B.S. 2000; Brigham Young University Law School, J.D. 2008) is a shareholder in Cantley Dietrich, P.C.
  • [3] Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012).
  • [4] Beckett Cantley, F. Hale Stewart, Current Tax Issues with Captive Insurance Companies, Bus. L. Today, February 2014, 1.
  • [5] Jay D. Adkisson, Adkisson’s Captive Insurance Companies: An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. xiii.
  • [6] Id.
  • [7] Id.
  • [8] Id. at xiv.
    Beckett Cantley, F. Hale Stewart, Current Tax Issues with Captive Insurance Companies, Bus. L. Today, February 2014, 1.
  • [10] F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 5-6.
  • [11] Consumers Oil Corporation of Trenton v. United States, 166 F. Supp. 796, 797-798 (N.J. 1960).
  • [12] United States v. Weber Paper Co., 320 F.2d 199, 201 (8th Cir. 1963).
  • [13] Stewart, supra at 6.
  • [14] Gulf Oil Corp. v. C.I.R., 914 F.2d 396 (3d Cir. 1990).
  • [15] Ocean Drilling and Exploration Co. v. United States, 988 F.2d 1135 (Fed. Cir. 1993).
  • [16] F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 5-6.
  • [17] Beech Aircraft Corp. v. United States, Civil No. 82-1369, 1984 WL 988, *1 (D. Kan. 1984).
  • [18] Beech Aircraft Corp. v. United States, Civil No. 82-1369, 1984 WL 988, *1 (D. Kan. 1984).
  • [19] Id.
  • [20] Id. at *3.
  • [21] Id.
  • [22] Id. at *4.
  • [23] Id.
  • [24] Humana, Harper, Amerco
  • [25]
  • [26] Id.
  • [27] Id.
  • [28] Id.
  • [29] Id.[30] Id.
  • [31] Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. 56.
    [32] Donald S. Malecki, CGL Commercial General Liability, © 2005 The National Underwriter Company, (For example, the commercial general liability policy usually excludes coverage for product recall and damage to “your product.” A captive could write a “difference in conditions” or DIC policy to specifically fill all gaps in the third party policy.)
  • [33] Like commercially available insurance, captives have menu of standard coverages such as administrative actions, legal liability, product liability, product recall, pollution liability, etc…
  • [34]Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006), 56.
  • [35] Id. at 56-68.
  • [36] Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. 2.
  • [37] Id. at 54-55.
  • [38] F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 31.
  • [39] Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012), 227.
  • [40] Id. at 269.
  • [41] See IRC § 953(d).
  • [42] Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012), 269.
  • [43] Id.
  • [44] Id.
  • [45] Id. at 268.
  • [46] Id.
  • [47] Id.
  • [48] See IRC § 4371.
  • [49] Id. at 269-70.
  • [50] Id. at 251-52.
  • [51] Id. at 242.
  • [52] Id. at 272.
  • [53] Treas. Reg. § 1.801-3(a).
  • [54] IRC§§ 1291-98.
  • [55] Beckett Cantley, The Forgotten Taxation Landmine: Application of the Accumulated Earnings Tax to I.R.C. § 831(b) Captive Insurance Companies, 11 Rich. J. Global L. & Bus. 159, 160 (2012), 163.
  • [56] Harper Group and Subsidiaries v. C.I.R., 96 T.C. 45, 58 (T.C. 1991)
  • [57] by F. Hale Stewart and Beckett Cantley, Captive Guidance After The ‘Dirty Dozen’ Listing, Tax Notes, June 8, 2015, p. 1191
  • [58] IRC § 816(a).
  • [59] Helvering v. LeGierse, 312 U.S. 531, 542 (1941); Rev. Rul. 89-96, 1989-2 C.B. 114 (1989).
  • [60] See http://www.verisk.com/iso.html
  • [61] Humana, Inc. v. C.I.R, 881 F. 2d 247, 251 (6th Cir. 1995) (citing Helvering, 312 U.S. at 539).\
  • [62] Helvering v. LeGeirse, 312 U.S. 531, 539 (1941).
  • [63] Bobbe Hirsh & Alan S. Lederman, The Service Clarifies the Facts and Circumstances Approach to Captive Insurance Companies, 100 J. Tax’n 168, 169 (Mar. 2004).
  • [64] Clougherty Packing Co. v. C.I.R., 84 T.C. 948, 959, aff’d, 811 F. 2d 1297, 1300 (9th Cir. 1987).
  • [65] Humana, Inc. v. C.I.R, 881 F. 2d 247, 251 (6th Cir. 1995) (citing Helvering v. LeGierse, 312 U.S. at 539).
  • [66] See Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42, 53 (Fed. Cl. 1997) dismissed, 194 F.3d 1330 (Fed. Cir. 1999).
  • [67] Humana, Inc. v. C.I.R, 881 F. 2d 247 (6th Cir. 1995).

The Biden Administration Takes Aim at Wealth: 10 Proposed Tax Hikes Targeting Corporations and The Wealthy

29-Apr-2021

Biden’s Proposed Increase to Corporate Tax Rate

Biden’s Proposed Increase to Corporate Tax Rate

A look at some of the Biden administration's tsunami of proposed tax hikes targeting corporations and the wealthy.

Here is a quick high-level overview of what you should be thinking about considering the Biden administration's tsunami of proposed tax hikes that would target corporations and the wealthy.

I will cover proposed Biden plans to tax wealth in America, including:

  • Increases to the Corporate tax rate 
  • Increases to the Global Minimum Tax
  • Increases to the Top Persona Income Tax Rate
  • Increases to the Capital Gains Tax Rate
  • Increases to Social Security Taxes for Employers and Employees
  • Reducing the Benefit of Itemized deductions 
  • Elimination of Like-Kind Exchanges

I will also cover many other areas that could have a significant impact on high-net-worth individuals. If you are someone with significant assets, say, $2 million or more in net worth, keep reading.

#1 - Biden’s Proposed Increase to the Corporate Tax Rate

OK, so first let us talk about the corporate tax rate changes. The Biden administration recently announced The American Jobs Plan, which is an infrastructure bill aimed at spending trillions of dollars on roadways, bridges, etc. The bill also includes a lot of other priorities that the Biden administration thinks are important. To offset the high price tag, they have proposed a significant number of corporate income tax rate changes that should raise a lot of revenue over a decade.

First, they have proposed raising the corporate income tax rate from 21% to 28%. While that seems like a significant rise in rates -- and it is -- the reality is that when President Trump came into office, the tax rate was 35%. So, it is still significantly lower than it was when President Trump came into office, should they get the entire increase passed through legislation and signed into the tax code.

#2 - Biden’s Proposed Increase to the Global Minimum Tax

Another proposal is a 21% global minimum tax calculated by each country by country. US corporations would pay 21% on overseas income in each country in which they do business. In addition, they proposed an alternative 15% corporate minimum tax on corporations with a global book income of $100 million or more. Many large corporations would end up paying at least a 15% tax rate on the book income that they show to investors.

If you are a corporate taxpayer and you are facing these kinds of significant rate hikes, what can you do about it? Well, the only thing that makes common sense would be to defer your taxes to later years when hopefully we will have folks that decide to reduce rates again. These kinds of high rates do not tend to stay around for a very long period of time. You would want to outlast the government by creating a deferral.

#3 - Biden’s Proposed Elimination of the IRS Section 199A Deduction

Another code section that the Biden administration is seeking to change is the recently enacted Section 199A deduction. This deduction provides for a 20% passive deduction for qualified business income. The Biden administration is proposing phasing it out for taxpayers who make more than $400,000 of adjusted gross income.

If you are making more than $400,000, then you're going to eventually end up not being able to take advantage of this Trump-era provision. The 199A deduction is a below-the-line deduction available to owners of Sole Proprietorships Partnerships, S-Corps, and some trusts and estates engaged in a qualified business.

The only solution for a phase-out of the 199A deduction would be to be creative in locating additional deductions that could create the same kind of offset so that your taxes remain stable.

#4 - Biden’s Proposed Increase on the Top Persona Income Tax Rate

The Biden administration is also raising the top personal income tax rate. The current rate of 37% will be raised to 39.6 % for people making more than $1 million. This is not a massive increase in actual rates, but it will raise a significant amount of revenue.

The only solution for the high-end taxpayers would be to undertake a strategy for deferring the income to later years when, hopefully, the rate will decrease; or doing a conversion strategy which would take some of the ordinary income and turn it into a capital gain. The idea would be to defer the income until capital gains rates are low again, given that the Biden administration is also proposing raising the capital gains rate significantly.

#5 - Biden’s Proposed Increase on the Capital Gains Tax Rate

The Biden administration is going to propose a capital gains tax rate increase that's very significant. Currently, capital gains are taxed at a preferred rate of 20%. The Biden administration would like to raise that to the top income tax rate currently at 37%. They have also proposed, of course, that the rate increases to 39.6% for taxpayers making more than $1 million in income.

The capital gains tax rate is a preferred rate in which assets that are sold at a gain that have been held for more than a year are taxed at a preferred rate of 20%. The Biden administration is proposing that the rate for people that make more than $1 million in income rise to the top level of taxation for that class. For example, right now, the top tax rate is 37%. The Biden administration is proposing it be raised to 39.6%. If it were successful, capital gains for this class of taxpayer would be at 39.6% rather than the 20% it is today. That is an incredibly significant increase.

#6 - Biden’s Proposed Increase on Social Security Taxes for Employers and Employees

The Biden administration is also proposed raising the Social Security tax rate for employers and employees. Currently, Social Security taxes are applied to the first $137,700 of wages/income, and that number is inflation-indexed each year. The Biden administration is planning on over $400,000 being taxed at an additional 12.4%. In application, this means there is no Social Security tax on the income between the current cap on Social Security, which is $137,700, and the $400,000 in which the new tax rate would apply.

#7 Biden’s Proposed Reduction on Itemized Deduction Benefits

The Biden administration is also proposing reducing the benefit of itemized deductions such that nobody receives a benefit of more than 28%. Itemized deductions are things like:

  • medical,
  • dental,
  • real estate taxes,
  • state taxes,
  • home mortgage interest,
  • mortgage insurance,
  • charitable gifts,
  • casualty theft losses, etc.

In application this is a reintroduction of the “Pease” limitation on itemized deductions, reducing itemized deductions by 3% for each dollar of income in excess of $400,000.

"The  Pease Limitation put a cap on how much certain taxpayers could claim in the way of itemized deductions before it was repealed when President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) into law on December 22, 2017."

Bird, Beverly. “How Did the Pease Limitation Work (and Why Was It Repealed?).” THE BALANCE [New York, NY], 17 Sept. 2020, www.thebalance.com/the-pease-limitation-and-why-it-was-repealed-4163498.

#8 - Biden’s Proposed Steep Reduction for Estate Tax Exemption

The Biden administration has also made significant proposed changes to the estate tax code. For example, the estate tax exemption is being proposed to be reduced from $11.58 million to $3.5 million. That is a giant reduction in the estate tax exemption. That will bring an enormous amount of estates into the estate tax world, wherein most estates were not previously. It increases the top tax rate for estates to 45%.

#9 - Biden’s Proposed Elimination of The Step-Up-In-Basis Benefit to value assets in the estate.

Most importantly, there are proposals both in the House and the Senate right now to eliminate the Step-Up-In-Basis for beneficiaries who receive $1 million in either income or benefit or property during the year that the descendant passes away. Today, when someone passes away the value of the assets in the estate that a beneficiary receives is "stepped up" to the current fair market value of the asset.

So, for example, if you own some investment property that is worth $1 million, but only costs you $500,000, you have a $500,000 gain in that property if you sold it. But because the descendant passes away, it's treated as though it has stepped up to the full $1 million. You pay no tax on what would otherwise be a capital gain, the capital gains to the sale of the asset.

Now that we understand what the step-up in basis is, let us look at the proposal that the Biden administration has on the table in the Senate and in the House. They are proposing that beneficiary's making $1 million dollars in the year of the date of death of the descendant do not get the step-up-in-basis and instead must pay tax on the assets as though they were sold on that date in the amount of the difference, between the basis of the descendant and the amount that is a fair market value of the asset.

If you combine this step-up-in-basis elimination with the higher capital gains rate that the Biden administration is proposing, there could be as much as an $80 billion increase in annual taxes.

#10 - Biden’s Proposed Elimination of Like-Kind Exchanges

The Biden administration has also proposed changing the rules with respect to Like-Kind exchanges. These exchanges are typically where you have property held for business, often real property, and you have a sale of a one piece of property and a purchase of a like-kind piece of property on the other side. And you do not end up paying capital gains tax or you do not end up paying income tax on the sale of the asset.

It rolls into the new property and you take the same lower basis that you would have in the initial property that was sold into the new property that is acquired. The Biden administration has decided to propose that taxpayers making more than $400,000 can no longer make use of like-kind exchanges.

That is a quick look at some of the tax proposals on the table that could have a huge impact on your wealth. In future blogs, we will start to look at each of the areas that give you some wealth protection strategies to think about.

If you are a high net worth individual or advisor and looking for tax strategies and tax law insights for protecting your wealth, contact us at CantleyDiectrich.com.

Written by Beckett Cantley Author, Professor of Tax Law, and Senior Partner at the Cantley Dietrich law firm.

Ground Zero: A comprehensive review of the IRS Attack on Syndicated Conservation Easement

23-Apr-2021

What is a Syndicated Conservation Easement - The Cantley Dietrich Blog

What is a Syndicated Conservation Easement?

Authored by Beckett G. Cantley and Geoffrey C. Dietrich

What is a Syndicated Conservation Easement - The Cantley Dietrich Blog

A "syndicated" conservation easement is a transaction whereby the promoter organizes a group of investors together in an entity, uses the investors' cash contributions to the entity to purchase land, and places a conservation easement on the land restricting the private use of it. When you place a valid conservation easement on a parcel of land, you are reducing the value of the property by making a charitable donation of the perpetual use of the land to a charitable land trust. The IRS is challenging many syndicated conservation easements because, among other things, they take the position that the value of the conservation easement is being overstated when taking the charitable deductions generally allowed under Section § 170 of the Internal Revenue Code. The purpose of the deduction is to encourage the preservation of land. The amount of the deduction is generally equal to the difference between the value of the land at its "highest and best use" and the value of the land after the conservation easement is executed.

On June 25, 2020, the IRS announced a settlement initiative (“SI”) to certain taxpayers with pending docketed cases involving syndicated conservation easement (“SCE”) transactions. The SI is the current culmination of a long series of attacks by the IRS against SCE transactions. The IRS has recently found success in the Tax Court against syndicated conservation easements, but the agency’s overall legal position may be overstated. It is possible that the recent SI is merely an attempt to capitalize on leverage while the IRS has it. Regardless, the current state of the law surrounding SCEs is murky at best. Whether a taxpayer is contemplating the settlement offer, is currently involved in an unaudited SCE transaction, or is considering involvement in an SCE transaction in the future, the road ahead is foggy and potentially treacherous.

This article attempts to shed light on the obstacles that face syndicated conservation easement (SCE) transactions, including:

(1) an overview of syndicated conservation easement transactions and the main attacks against them; 

(2) analysis of the IRS’ main attacks and the relevant issues that arise; 

(3) illustrations of the relevant pro-taxpayer and anti-taxpayer cases on each issue; 

(4) subsequent considerations that taxpayers need to take into account and the future outlook of syndicated conservation easement; and 

(5) a summary of syndicated conservation easement key findings.

What is a Conservation Easement?

Under Section § 170 of the Internal Revenue Code, taxpayers are allowed to take a deduction for donating a conservation easement on their land.[3] The purpose of the deduction is to encourage the preservation of land.[4] The amount of the deduction is generally equal to the difference between the value of the land at its “highest and best use” and the value of the land after the conservation easement is executed.[5] To take advantage of this deduction, many taxpayers have created transactions that are now referred to as syndicated conservation easement transactions.[6] Typically in these cases, investors form and contribute funds to a partnership. The partnership then buys another partnership containing a tract of land that has been held by it for more than one year. The partnership obtains an appraisal of the land’s “highest and best use” which is considerably higher than the amount the land-owning partnership paid for the land. Then the partnership donates a conservation easement over the land to a local conservancy. Finally, the partners take large deductions (usually far more than their initial investment in the partnership) based on the new valuation of the land for their charitable contribution under Section 170.[7]

The IRS is challenging many syndicated conservation easements as abusive tax shelters. The Internal Revenue Service (“IRS”) became suspicious of conservation easements in 2016, when it first designated syndicated conservation easement (“SCEs”) transactions as “listed transactions.”[8] In 2019, the IRS announced a “significant increase in enforcement actions” related to SCE transactions as SCEs made the IRS’ “Dirty Dozen” list of tax scams.[9] This increase in enforcement actions has primarily resulted in IRS victories in the Tax Court.[10] Thus, the IRS recently announced a Settlement Initiative (“SI”) to leverage its favorable outcomes against the taxpayers.[11] Some critics are skeptical of the SI, claiming the IRS only wins SCE cases on technical grounds and the IRS does not hold as strong of a position as it claims on the true issues surrounding conservation easements.[12] Accordingly, many suggest that few taxpayers will take part in the SI.[13]

In the Tax Court, the IRS is fighting the entire deduction, which many argue cuts against congressional intent.[14] In the cases where the taxpayers prevail, the IRS is typically still able to reduce the value of the easement.[15] There is virtually no case[16] where the taxpayers get to keep the entire deduction. Despite their recent success in the Tax Court, the IRS is far from an outright victory in the war on conservation easements. The determinative issues in these cases are temporary roadblocks for SCE transactions. Eventually, taxpayers will figure out how to structure their SCE transactions to avoid the pitfalls of recent cases. For example, the IRS recently convinced the Tax Court that certain taxpayers’ easement deeds violate the perpetuity requirement of conservation easements because the extinguishment clause of the deed provides the one with a fixed value instead of a “proportionate value” upon extinguishment.[17] Going forward, those drafting SCE deeds will make sure that the extinguishment clause complies with this requirement. Additionally, many conservation easements struck down in the Tax Court found much more favorable outcomes upon appeal.[18] In fact, the most influential recent case is likely to be appealed in the 6th Circuit.[19] The Tax Court avoids circuit precedent when possible,[20] but as the number of cases rises the Tax Court may not be able to hide much longer. The IRS may eventually have to concede that SCEs are technically valid conservation easements. When that happens, the IRS will fall back on one of its original arguments—conservation easements overvaluation. Thus, valuation is the real issue and it is extremely fact-intensive and differs from case to case.

Currently, The IRS’ primarily attacks SCE’s by arguing that the taxpayers did not make a “qualified conservation contribution.”[21] This is required for the taxpayers to receive the deduction for donating a conservation easement.[22] There are three necessary requirements for a contribution to be considered a “qualified conservation contribution”: 

  1. The contribution must be of a qualified real property interest (“QRPI”).
  2. The contribution must be made to a qualified organization.
  3. The contribution must be “exclusively for conservation purposes.”[23]

The qualified organizations requirement is rarely litigated. This article shall discuss the relevant pro-IRS and pro-taxpayer cases on the other requirements below. Further, this article discusses the current state of the law surrounding syndicated conservation easements and the factors taxpayers will need to consider as they make decisions in this area.

Qualified Real Property Interest: Section 170(h)(2)© of the IRS Code

The determinative issue in some conservation easement cases has been whether a QRPI was contributed as a part of the deal. At its core, this attack on the easement deed is an attack on the perpetuity on the conservation easement. While the perpetuity of an easement is typically challenged under the “exclusively for conservation purposes” element, the QRPI argument still rears its head every now and then. This is evidence that the IRS is looking to exploit even the slightest of deficiencies in easement deeds.[24] However, the decline in recent cases decided on this issue may be due to transaction organizers adapting to adverse case law in their drafting.

Section 170(h)(2) defines a QRPI as: “. . . a restriction (granted in perpetuity) on the use which may be made of the real property.”[25] The applicable regulation[26] provides that a “perpetual conservation restriction” is a qualified real property interest. A “perpetual conservation restriction” is a restriction granted in perpetuity on the use which may be made of real property—including, an easement or other interest in real property that under state law has attributes similar to an easement (e.g., a restrictive covenant or equitable servitude).[27] It is critical that conservation easement exists in perpetuity. There is only one, extremely narrow exception to the perpetuity of such easements.[28] As we will see in Part III, the Treasury Regulations provide for the judicial extinguishment of conservation easements in situations where the conservation purpose becomes either impossible or impracticable to carry out.

The seminal case on the issue of QRPI and perpetuity in the context of conservation easements is Belk v. Commissioner.[29]  In Belk, the taxpayers purchased a 410-acre tract of land, then transferred such land to their own limited liability company.[30] The taxpayers then developed the land to include a golf course surrounded by residential lots.[31] A few years later, the taxpayers executed a conservation easement over the portion of the tract which included the golf course.[32] The easement was granted in perpetuity, but was subject to certain “reserved rights.”[33] One of those rights, the centerpiece of the case, essentially allowed the taxpayers to modify which parcels of land were or were not covered by the conservation easement, as long as the change was proportionate and did not adversely affect the conservation purpose of the easement.[34]

The Tax Court held, and the Fourth Circuit affirmed, that the taxpayers had not donated a QRPI.[35] Therefore, they lost the entire deduction.[36] The Tax Court reasoned that because the conservation easement allowed the taxpayers to change the boundaries of the easement, the easement was not granted in perpetuity.[37] The taxpayers contended that since the provision required them to maintain a certain proportion of land within the conservation easement, the value of the easement does not change—thus, it exists in perpetuity.[38] The Fourth Circuit rejected this argument by emphasizing the plain language of the statute: “a [QRPI] includes a restriction (granted in perpetuity) on the use . . . of the real property.”[39] The Fourth Circuit held that the perpetuity of a restriction is inevitably attached to the real property originally designated as a conservation easement.[40] “Thus, while the restriction [in this case] may be perpetual, the restriction on ‘the real property’ is not.”[41] Therefore, the taxpayers had not donated a QRPI and the easement did not qualify as a “qualified conservation contribution.”[42]

Conservation Easement Pro-Taxpayer Cases

While Belk continues to spearhead the dismantling of many conservation easements, some cases have come out in the taxpayers’ favor as the courts wrestle how to interpret and distinguish Belk. In 2013, the Tax Court decided Gorra v. Coissioner.[43] In Gorra, the taxpayers donated a conservation easement on the façades of a townhouse in New York.[44] The Commissioner contended that the easement was not perpetual because “there are facts to indicate that the [one] was willing to terminate the [e]asement upon [the taxpayers’] request.”[45] The court ignored this argument—focusing exclusively on the language of the easement deed. Accordingly, the court differentiated this case from Belk because the deed clearly defined the property donated under the easement and restricted the easement to that property in perpetuity.[46] Thus, the taxpayers had donated a QRPI and the easement donated qualified as a “qualified conservation contribution.”[47]

Importantly, the court affirmed that the term “QRPI” includes the perpetuity requirement.[48] In other words, for a parcel of land to be considered a QRPI for purposes of a conservation easement, the interest must be set aside in perpetuity.[49] The taxpayer cannot switch what land is protected and what is not—that would violate perpetuity.[50] Additionally, it is important to note that although the taxpayers prevailed in securing their deduction, they ultimately lost on valuation.[51] The court held that the easement was overvalued by over 400%.[52] Therefore, the taxpayers lost over 80% of their deductions and were also assessed the maximum accuracy-related penalty of 40%.[53]

A couple of years later, the Tax Court decided Bosque Canyon Ranch, LP v. Comm’r.[54] In this case, two related partnerships sold a tract of land to its partners for the purposes of development and conservation.[55] Part of the land was developed, while the other was donated as a conservation easement to a charity one land trust.[56] Crucially, the easement deed allowed the partners to slightly modify the easement boundaries by mutual agreement with the one.[57] The Tax Court agreed with the IRS that this provision was similar to the provision in Belk.[58] Therefore, the Tax Court held that the taxpayers had, in turn: violated perpetuity, not donated a QRPI, and not made a “qualified conservation contribution.”[59]

Interestingly, the 5th Circuit reversed in Tax Court’s decision two years later in favor of the taxpayers.[60] The 5th Circuit held that the instant case was different from Belk because the easement could only be modified if it left the original exterior boundaries intact and if the total acreage of the easement remained the same.[61] To illustrate, picture of a slice of Swiss cheese.[62] The piece of cheese is the tract of land and the holes represent the parts of the land that the easement does not cover. In this case, the 5th circuit is saying that the sizes of the holes can change as long as the total amount of cheese remains constant (i.e. when one hole gets bigger, another hole or holes must get smaller to compensate) and the external square shape of the slice also stays intact.[63] Additionally, the court recognized that the modifications at issue were “de minimis at most.”[64] Finally, although the taxpayers won at the appellate level, the case was remanded to the Tax Court for valuation analysis.[65] The dispute overvaluation is ongoing.

Anti-Taxpayer Conservation Easement Cases

Gorra and Bosque Canyon Ranch are unique cases. Belk is typically interpreted by the Tax Court to leave no room for error regarding the QRPI requirement. In 2015, the Tax Court decided Balsam Mountain Investments, LLC v. Commissioner.[66] In that case, the taxpayers executed a conservation easement with a provision allowing the taxpayers to shift the easement boundaries up to five percent in the first five years of the easement’s existence.[67] The court held that while this provision was slightly different and much less dramatic than the provision in Belk, the difference is not enough for the easement to qualify.[68] The court held that the taxpayers had not contributed a perpetual QRPI sufficient to receive the desired deduction.[69] Importantly, the court further asserts that under Section 170(h)(2)© there must be an “identifiable, specific piece of real property.”[70]

The most recent case on the QRPI issue is Pine Mountain Preserve, LLLP v. Commissioner.[71] The easement deed in Pine Mountain is similar to the deed in Bosque Canyon Ranch in that it permitted slight changes to the interior boundaries of the easement, but not to the total acreage or exterior boundaries of the easement.[72] The court explicitly acknowledged that the facts in this case are similar to those in Bosque Canyon Ranch, but chose not follow the 5th Circuit’s precedent because this case was not appealable in the 5th Circuit.[73]

The court uses the Swiss Cheese analogy from the dissent in Bosque Canyon Ranch to illustrate its decision and how it believes this case, along with Bosque Canyon Ranch, should be treated the same as Belk.[74] The court claimed that Belk and Bosque Canyon Ranch are the same in that they make new holes in the cheese.[75] Regardless of whether or not the acreage proportion is the same, creating new holes or changing the sizes of each hole is not permissible under Belk and violates perpetuity.[76] Accordingly, the court held its ground on the QRPI issue in this case.[77]

Qualified Real Property Interest Case Analysis

While the issue of whether a QRPI is contributed is not usually the main issue in conservation easement cases, taxpayers (and drafters) should take a second look at their deeds to make sure that they are truly contributing a QRPI in perpetuity given recent caselaw. These cases reveal multiple key insights to help with this analysis. First, for the Tax Court, there must be an “identifiable, specific piece of real property” that is restricted and perpetual in size and shape.[78] Additionally, the Tax Court is very skeptical of any provision in the easement deed which allows for modifications of the easement boundaries.[79] The appellate courts might be more taxpayer friendly.[80] However, the court also noted in Pine Mountain (and affirmed in Oakbrook)[81] that the retained powers of all parties to change contractual terms does not by itself deprive a deed of easement of its required perpetuity.[82]

Conservation Easement Cases Primarily center on “Exclusively for Conservation Purposes”

The majority of conservation easement cases center on whether the contribution is “exclusively for conservation purposes.” There are three main categories of challenges by the IRS under this issue: environmental/wildlife, exchange, and perpetuity.

Section §170(h) of the IRS code defines “conservation purpose” as:

  1. the preservation of land areas for outdoor recreation by, or the education of, the general public,
  2. the protection of the relatively natural habitat of fish, wildlife, or plants, or similar ecosystem,
  3. the preservation of open space (including farmland and forest land) where such preservation is—
  4. for the scenic enjoyment of the general public, or
  5. pursuant to a clearly delineated Federal, State, or local governmental conservation policy, and will yield a significant public benefit, or
  6. the preservation of a historically important land area or a certified historic structure.[83]

Conservation Easements:  Environmental & Wildlife Protection

IRS Cases Challenging conservation easements

The IRS has challenged conservation easements on section §170(h)(ii), “the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem.”[84] The regulations add the word “significant” before the word “relatively.”[85] Thus, to the extent the Code allows, the protection at issue must be “significant.”[86] Significance is subjective and is typically decided on a case by case basis.

The most recent case challenging the significance of the protection of environmental and wildlife interests is Champions Retreat Golf Founders, LLC v. Commissioner.[87] In that case, the taxpayers bought a 463-acre tract of land in 2002.[88] Two-thirds of the parcel was used as a golf course.[89] The other third was either used for homesites or was undeveloped.[90] In 2010, the taxpayers executed a conservation easement on a 348-acre portion of the land including the undeveloped land and the golf course.[91] The easement land “is home to abundant species of birds, some rare, to the regionally declining fox squirrel, and to a rare plant species, the dense flower knotweed.”[92] 

The issue in the case was whether the taxpayers contributed the easement for “the protection of a [significant][93] relatively natural habitat of fish, wildlife, or plants, or similar ecosystem,” or for “the preservation of open space . . . for the scenic enjoyment of the general public [that] will yield a significant public benefit.”[94] The Tax Court held that it did. The 11th Circuit reversed.[95] The 11th Circuit took a broad approach to the regulations, ultimately deciding that at least part of the easement was exclusively for conservation purposes and that it protected both a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem and open space for scenic enjoyment under §170(h)(ii) and (iii).[96] The IRS argued that the presence of a golf course on most of the easement property prohibited the land from being considered “natural.”[97] The court rejected this argument, saying that what matters under the regulation is not that the land is natural, but that the habitat is.[98] Thus, the court acknowledged that the taxpayers are entitled to a deduction if the easement is made to protect the habitat of a “rare, endangered, or threatened species.”[99] Since the easement includes the habitat of some rare, endangered, and threatened species of plants and animals, the court found that the Tax Court’s finding otherwise was clearly erroneous and wrong as a matter of law.[100] Additionally, the court found that but for the golf course being built on the property, the easement would clearly be the preservation of open space for public enjoyment.[101] Again, while the taxpayers prevailed on appeal, the case has been remanded to the Tax Court for valuation analysis.[102]

Analysis of Tax Court rulings on conservation easements

In general, the Tax Court will be much more hesitant to find that easements are made exclusively for conservation purposes. As seen in Champions, the Tax Court relies on the term “significant” in the relevant regulation to justify its analyses. The Tax Court seems to want to weigh the particular facts and circumstances for itself in each case. However, the Tax Court fails to create any sort of identifiable or objective framework for deciding what is “significant” under the regulation. Accordingly, it seems like that Tax Court’s standard for what is “exclusively for conservation purposes” is both high and unpredictable. 

Although circuit courts, like the 11th Circuit in Champions, have generally been more sympathetic to taxpayers and have interpreted the applicable regulations quite broadly, the Tax Court has resisted at every point that it can.[103] The Tax Court has insisted on construing the regulations narrowly. Any ground given up on the regulations is given to the IRS by deference to the administrative agency. Additionally, the Tax Court’s eagerness in Pine Mountain voice its disagreement with the 5th Circuit’s Bosque Canyon opinion shows how strongly the Tax Court feels about its positions regarding conservation easements. That is not likely to change soon. Thus, it is likely that if a case like Champions came through the Tax Court from outside the 11th Circuit, the Tax Court would maintain its position against the taxpayer. Perhaps most importantly, even if taxpayers win on this issue, valuation remains a significant hurdle going forward.

Exchange or Gift: exclusively for conservation purposes

To be exclusively for conservation purposes, the taxpayer can receive no other consideration from the donee and can place no conditions on the gift. While this argument is not usually made within the context of Section §170(h), it is implicit in the analysis. Section §170(c) defines a charitable contribution as a contribution or gift to or for the use of various specified entities or other types of entities for certain approved purposes.[104] This means a charitable contribution—eligible for a deduction—cannot include a quid pro quo arrangement.[105] A few conservation easements have been defeated in cases where the donor conditioned the gift or received something in return. For example, in Pollard v. Commissioner, the Tax Court denied a deduction related to a conservation easement because the taxpayer had given the conservation easement to the county in exchange for a subdivision exemption.[106] The court held that there was a quid pro quo arrangement and therefore there could be no deduction for a charitable contribution.[107]

Moreover, in Graev v. Commissioner, the taxpayer made a side deal with the donee which placed a condition on the conservation easement.[108] The side deal provided that in the event the IRS disallows the taxpayer’s charitable deduction, the taxpayer would recoup his investment and both parties would work together to extinguish the conservation easement.[109] The court pointed to Reg. §1.170A-1(e) which “clarifies that . . . no deduction for a charitable contribution that is subject to a condition . . . is allowable, unless on the date of the contribution the possibility that a charity’s interest in the contribution [would be defeated] is “negligible”.[110] The court held that since the possibility of the donee’s interest in the land being defeated was not “so remote as to be negligible.” Thus, the taxpayer’s deduction is not allowable.[111]

Therefore, while contributions of conservation easements do not usually run into this issue, it is important to note that for a contribution to be considered a “qualified conservation contribution,” it must first be a charitable contribution.[112] Only under rare circumstances can a charitable contribution be subject to a condition and remain charitable.[113] If a contribution is not charitable, it cannot be a “qualified conservation contribution” because it would not be “exclusively for conservation purposes.”[114]  Therefore, taxpayers with conservation easements that are subject to one or more conditions or are a product of a quid pro quo arrangement are likely to lose their entire deduction if challenged.

Perpetuity: core aspect of what makes a conservation easement work

Conservation easements, to be made exclusively for conservation purposes, must exist in perpetuity.[115] Perpetuity is the core aspect of what makes a conservation easement work and it is central to the policy considerations that underlie its existence.[116] This is the most common way the IRS targets deductions attached to conservation easements. It is their recent victories on this issue that have prompted the recent SI.[117]

There are over twenty cases that have been decided on the issue of perpetuity, and of those cases, the taxpayers prevail in only three.[118] This disparity shows the importance of perpetuity as the cornerstone of conservation easements. It also displays the painstaking determination IRS and the Tax Court have to make sure that conservation easements are truly perpetual in existence if they are to allow accompanying deductions. The IRS and the Tax Court have demonstrated their willingness to go great lengths to find that a certain aspect of a conservation easement deed violates perpetuity.[119] Once they have this hook into perpetuity, they can drag the entire deduction down.

Pro-Taxpayer Cases: conservation easements have to be perpetual in order to be valid

Two of the three pro-taxpayer cases on this issue,  Gorra  and  Bosque Canyon Ranch, have already been discussed in the context of QRPIs.[120] This is because perpetuity applies to both the first and third elements of a “qualified conservation contribution.” We have seen how a QRPI necessarily includes a restriction in perpetuity.[121] However, outside of the QRPI issue, recent cases simply recognize that conservation easements have to be perpetual in order to be valid.[122] If they are not perpetual, they are not “exclusively for conservation purposes.”

The other pro-taxpayer case is Irby v. Commissioner.[123]Irby was a unique case decided in 2012.[124] In that case, the IRS tried to challenge the extinguishment clause of the conservation easement deed, claiming the conservancy would not get its fair share upon extinguishment.[125] Thus, the deed was “superficial” and not exclusively for conservation purposes.[126] Unlike the other extinguishment clause cases discussed below, this clause provided for the donee (a government funded organization) to repay the government upon extinguishment of the easement.[127] The IRS argued that this deprived the donee of their proportionate share under the regulation.[128] However, the court reasoned that this situation was different because the donor would not receive a windfall as a result of the extinguishment of the easement.[129] Thus, what happens to the donee’s proportionate share apart from the donor is beyond the scope of the regulation.[130] Therefore, the court disagreed with the IRS and upheld the clause and the easement.[131]

Conservation Easement IRS Anti-Taxpayer Cases

The most influential conservation easement case as of late is Oakbrook Land Holdings, LLC v. Commissioner.[132] While this case is currently on appeal in the 6th Circuit, it has been used to strike down many conservation easements in the past couple months.[133] In Oakbrook, the taxpayers bought a 143-acre piece of land.[134] The taxpayer set aside 37 acres for development, and donated the remaining 106 acres to a local conservancy.[135] The IRS took issue with the extinguishment clause of the easement deed.[136] Extinguishment clauses are commonly found in conversation easement deeds.[137] These clauses outline the division of hypothetical proceeds from a future hypothetical extinguishment of the easement.[138] To understand how these clauses work, a closer look at the regulations is helpful.

Although conservation easements must exist in perpetuity, the law does provide a very limited avenue to dissolve them. The relevant regulation provides:

If a subsequent unexpected change in the conditions surrounding the property that is the subject of a donation under this paragraph can make impossible or impractical the continued use of the property for conservation purposes, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the donee's proceeds . . . from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution.[139]

The following section governs how the proceeds of the extinguishment are distributed between the parties:

 . . . for a deduction to be allowed under this section, at the time of the gift the donor must agree that the donation of the perpetual conservation restriction gives rise to a property right, immediately vested in the donee organization, with a fair market value that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time. . . . For purposes of this paragraph (g)(6)(ii), that proportionate value of the donee's property rights shall remain constant. Accordingly, when a change in conditions give rise to the extinguishment of a perpetual conservation restriction under paragraph (g)(6)(i) of this section, the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction, unless state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior perpetual conservation restriction.[140] (Emphasis added).

In other words, even though conservation easements with extinguishment clauses may not be perpetual in fact, they can be “treated as protected in perpetuity” if the extinguishment clause complies with the regulations.[141] Accordingly, the regulations provide that upon extinguishment, the donee is entitled to a “proportionate share” of the subsequent proceeds.[142] In Oakbrook, the IRS argued that the deed’s extinguishment clause did not provide for the donee to get their “proportionate share.”[143]

The easement deed in  Oakbrook  provided that upon extinguishment and subsequent sale, the donee “shall be entitled to a portion of the proceeds equal to the fair market value of the [c]onservation [e]asement.”[144] The IRS argued that this provision did not comply with the regulation because the donee should get a “proportionate share”—a fraction, not a fixed value.[145] The taxpayers argued that the regulation says “value” not “share.”[146] Therefore, the whole number they provided for in their deed is permissible.[147]The court ruled that the IRS interpretation is correct without relying on deference to the agency’s interpretation.[148] Thus, the regulation prohibits any scenario in which a donor gets to recover compensation other than a proportionate share (a fraction) of the proceeds, with the proportion defined by the easement’s FMV over the FMV of the unencumbered and unimproved property.[149]

In sum, the court disallowed the deduction because the extinguishment clause in the easement deed did not comply with the applicable regulations.[150] Because the clause existed (jeopardizing the perpetuity of the conservation easement) and did not comply with the regulations, it cannot be treated as protected in perpetuity as the regulation permits.[151] Thus, a small defect in the easement deed cost the taxpayers lost their entire deduction.

This case is likely to be appealed to the Sixth Circuit, and the outcome is uncertain based on 6th Circuit precedent. There are two relevant cases in the 6th Circuit: Hoffman Properties II, LP v. Commissioner[152] and Glass v. Commissioner.[153]Glass was decided in 2006, in favor of the taxpayers.[154] In Glass, the court affirmed the Tax Court’s decision that the easement in that case was protected in perpetuity, but offered little analysis on the issue.[155] In April of 2020, the court decided Hoffman in favor of the IRS.[156] In that case, the easement deed gave the donor the ability to make changes to the easement as donee permits.[157] Thus, the circuit court affirmed the Tax Court’s decision that this provision defeated the perpetuity of the conservation easement.[158]

Although appellate courts have generally been more sympathetic towards taxpayers, the 6th Circuit has typically deferred to the Tax Court on these issues.[159] Additionally, neither of these cases made a sincere attempt to analyze the relevant regulations and apply them to the easement deed.[160] Further, neither of these cases involved an extinguishment clause.[161] Thus, an appellate decision in Oakbrook is a wild card. Nonetheless, many cases have come out of the Tax Court in the past month following Oakbrook and striking down conservation easements over defective extinguishment clauses.[162] Even if the 6th Circuit reverses Oakbrook, the Tax Court is likely to maintain course in cases ineligible for appeal in the 6th Circuit.

Analysis: conservation easement deductions

Right now, the IRS is hanging its hat on improper extinguishment clauses, which render conservation easement deductions wholly invalid.[163] Some believe the IRS is engaging in scare tactics by issuing a SI before the courts have truly settled these issues, but the IRS also knows that it has valuation as a backstop.[164] Moreover, Oakbrook differs from Irby in that the issue in Irby was how the donee’s “proportionate share” was allocated after distribution.[165] However, in Oakbrook, the issue was whether the donee received their “proportionate share.”[166] In Oakbrook, the court was worried about the donor obtaining a windfall upon extinguishment.[167] Conversely, in Irby, the donor would never receive a windfall from the extinguishment of the easement because the donee would be repaying the government, not the donor.[168]

Finally, it is also worth noting the Tax Court’s approach to the applicable regulations in Oakbrook. The court recognized that both parties’ interpretations of the regulation at issue were not plain readings of the text.[169] The court also acknowledged that the 5th Circuit previously found the regulation to be ambiguous.[170] The 5th Circuit recognized that when a regulation is ambiguous, courts should defer to the agency that issued it.[171] However, the Tax Court in Oakbrook specifically concluded that this type of deference was unwarranted in this case.[172] Curiously, the court asserts that although the Commissioner’s interpretation is “not a plain reading,” it is the correct conclusion based on “traditional tools of construction.”[173] Thus, the court held that deference to the agency was unnecessary.[174] Interestingly, this is not the first time in which a circuit court deferred to the IRS while the Tax Court did not.[175]

In recent cases, the Tax Court seems almost merciless their insistence that the IRS wins even without any deference to the IRS. The Tax Court appears to be almost an IRS ally in the war on SCE transactions.[176] However, speculation and technicalities seem insignificant when taxpayers realize that even if they win on these issues, the dispute over valuation lurks around the corner.

Valuation: IRS’ attack on SCE deductions

Once the dust settles on the IRS’ attack on SCE deductions, taxpayers are still not in the clear. It now seems like the imperfections in the various deeds from these cases can be fixed and adjusted by those still seeking to create a SCE transaction. Future drafters now know the pitfalls to avoid. For example, do not allow changes to the easement boundaries and make sure any extinguishment clause complies with the Treasury Regulations. Assuming this happens, there will likely be a time where the IRS can no longer win these cases on such technicalities—disallowing entire deductions. However, when that time comes, the IRS will likely turn to valuation as the main issue. Objectively, this is the real reason why the IRS dislikes SCE schemes. In fact, the IRS said they don’t care if they lose on everything else—they believe they will win on value.[177] The IRS has no issue with conservation easements or the conjunctive deductions. The IRS is targeting those it believes to be abusing conservation easements for large tax savings.[178]

The valuations of SCEs are problematic because they directly relate to the amount of the subsequent deductions—which is arguably the main goal of SCE transactions. Thus, there is an incentive for taxpayers to obtain an inflated valuation. The value of a conservation easement is the difference between the fair market value of the land before the easement and the fair market value of the land after the easement.[179] Theoretically, this value should reflect the forgone value of development rights on the land. It is standard practice to value property at its most valuable reasonably probable use—or “highest and best” use.[180] However, such a determination is highly subjective and thus highly contestable.

The IRS must believe the taxpayers in these cases have no reason to pursue a conservation easement other than tax savings. If not, the IRS would not have attempted to disallow the entire deduction in recent cases. The IRS would have gone straight to disputing the valuation. However, assuming certain fact patterns in which taxpayers would prevail on the “qualified conservation contribution,” the IRS will have to settle for arguing for a reduced valuation. In that case, the outcome of each case will truly depend on its own facts and circumstances. Unfortunately, the Treasury Regulation does not provide helpful guidance on the valuation of conservation easements.[181] In short, the regulation states that 1) the value of the easement is the fair market value, 2) if there are relevant comparable transactions, the fair market value should be based on those, 3) if there are no relevant comparable transactions, the fair market value equals the difference between the value before the easement and the value after the easement, and 4) that this value is the value of the deduction.[182]

A new methodology has emerged by those appraising SCEs which has not yet seen significant challenge by the Tax Court.[183] This methodology applies four main criteria pulled from the Uniform Standards of Professional Appraisal Practice:[184] what is legally allowable, physically possible, financially feasible, and maximally productive.[185] The “maximally productive” element is the most controversial.[186] The regulations require an “objective assessment” of such development’s likelihood.[187] Critics suggest that many SCE valuations do not contain this “objective assessment” to substantiate their valuation.[188] Thus, typical SCE valuations reflect a hypothetical value derived from inappropriate assumptions about the land’s maximum productivity.[189] Thus, a discounted cash flow analysis will project a value which no buyer would ever pay.[190] This directly conflicts with the definition of fair market value—which requires a willing buyer and seller.[191]

Recently, the Tax Court has seldom addressed the issue of valuation as it has found other ways to extinguish these conservation easements completely.[192] However, many of the cases pending and those remanded from the appellate level are currently being decided on the issue of valuation.[193] Past results in the Tax Court have varied. In most cases, the court leans toward the valuation of the IRS which is usually far less than the taxpayers’ valuation. There are a couple of favorable outcomes for taxpayers, but far from an outright victory on valuation. Therefore, even if taxpayers successfully retain their deduction, they face an uphill battle on the amount of such deduction. Adding insult to injury, taxpayers could still face a hefty penalty for overvaluing their deduction. Altogether the return on investment for those involved in SCE transactions seems bleak.

Conservation Easement: Penalties and the IRS Settlement Initiative

Generally, there is a 10%-20% penalty applied to gross misstatements of deductions.[194] The IRS routinely goes for the maximum of 40% in conservation easement cases.[195] It is either all or nothing. In most of the cases, the Tax Court has upheld the 40% penalty.[196] However, there is a considerable amount of circumstances, like Oakbrook, in which the court disallows the entire deduction but does not impose a penalty at all.[197] This is based on the reasonableness of the taxpayers’ actions and assumptions.[198] If the court decides the taxpayers acted reasonably, then no penalty will be assessed.[199] However, in most cases in which the Tax Court invalidates a conservation easement and decides the partners acted unreasonably, the court imposes the 40% maximum penalty.[200] This might be different for cases in which valuation is the only issue. Since the taxpayers would be overvaluing a deduction rather than claiming one they do not have, the penalty might be less severe—like the typical 10%-20%.

The uncertainty regarding penalties is a crucial issue for those contemplating the recent SI offer. There are four key terms of the settlement agreement—one condition and three effects.[201] To accept the settlement, “[a]ll partners must agree to settle, and the partnership must pay the full amount of tax, penalties, and interest before settlement.”[202]  Once the taxpayers accept the offer:

  1. The deduction for the conservation easement is disallowed in full;
  2. “Investor” partners can deduct their cost of acquiring their partnership interests and pay a reduced penalty of 10% to 20% depending on the ratio of the deduction claimed to partnership investment;
  3. Partners who provided services in connection with any SCE transaction (promoters) must pay the maximum penalty asserted by the IRS (typically 40%) with no deduction for their costs.[203]

The settlement offers only the 10-20% penalty and gives a deduction for the partner’s initial investment. This might be intriguing, but the promoters get nothing and are subject to the maximum 40% penalty.

At the end of the day, the SI pits investor partners against promoters.[204] This puts additional pressure on taxpayers because participation in the SI requires the unanimous consent of all partners. Litigation promises only uncertainty, but settlement might only offer minimal relief for investors while ensuring disappointment for promoters. Taxpayers should carefully consider the strength of their cases, the durability of their valuations, the penalties at stake, and the costs of litigation as they contemplate the SI offer.

Although the IRS’ legal position on conservation easements is questionable, it may not be worth the fight. Those taxpayers with subpar easement deeds[205] or extremely inflated valuations will likely find the SI to be an attractive option. However, those taxpayers who are confident in the viability of their conservation easements and believe their valuation is accurate enough for them to break-even on their investments might resist folding to the IRS’ demands.

Furthermore, appraisers themselves are currently at a heightened level risk of being assessed a penalty for their valuation of conservation easements.[206] Normally, appraisals are a matter of judgment guided by certain valuation procedures and standards such as the Uniform Standards of Professional Appraisal Practice mentioned in Part IV.[207] Such judgment is typically subject to a review process before an IRS penalty is applied.[208] This process would usually include input from at least five experienced opinions from IRS employees and a second opinion from another appraiser.[209] However, the IRS recently eliminated this review process entirely.[210] Thus, “under the revised IRS procedure, a single IRS employee, who may have no background whatsoever in the land appraisal, could advance a penalty assessment.”[211] This action destroys all checks and balances in the review process, meaning appraisers now have little ability to defend their valuations.[212] In the end, the IRS gets to make an arbitrary decision on the validity of valuations. 

Such an aggressive regulatory change tips the IRS’ hand. It seems that the IRS may not actually care about the true valuation of conservation easements. Rather, it seems the IRS would prefer to eliminate the deduction for conservation easements entirely. However, as the saying goes, “deductions are a matter of legislative grace.”[213] The IRS does not have the right to decide what deductions a taxpayer is entitled to.[214] It may disagree with the value, but not with the deduction itself.[215] Effectively, this is what the IRS is attempting to do. The agency does not like the way taxpayers and appraisers are playing under the statutory and regulatory rules, so it simply changes the rules to stack against the taxpayer. The commandeering of authority on conservation easement valuations shows that the IRS cares more about winning on all SCE audits than it does about solely targeting abusive SCE transactions.

Conclusion: The IRS is waging war on SCE transactions

The IRS is waging war on SCE transactions. Moreover, the Tax Court seems skeptical—if not hostile—towards these transactions as well. The two main attacks on SCEs are (1) that they do not contribute a “qualified real property interest”[216] and (2) that they are not made “exclusively for conservation purposes.”[217] Both of these are required for the donation of a conservation easement to be considered a “qualified conservation contribution.”[218] If there is no “qualified conservation contribution,” there is no deduction allowed for the donors.[219] While some taxpayers have been able to fend off these attacks, the IRS has mostly been successful in these attacks in the Tax Court. Appellate courts have been more sympathetic towards taxpayers, but the Tax Court has maintained course when possible.[220]

Taxpayers will eventually figure out how to construct their easement deeds to avoid the pitfalls of the recent cases (e.g. extinguishment clauses). When that happens, valuation will be the main issue. Unfortunately for taxpayers, the road gets even foggier at this point as it is difficult to predict how the courts will come out on valuation. Regardless, we do know that such a determination is extremely fact intensive and will vary from case to case. On top of everything else, taxpayers must worry about the possibility of significant penalties if they lose their cases.

For those contemplating the current settlement offer, they likely cannot do anything about issues with their deeds, if they have them, considering  Oakbrook. Since those taxpayers are facing a likely disallowance of the entire easement, the SI is probably a better deal even without considering the possibility of a 40% penalty. However, there could easily be multiple scenarios where there is a proper extinguishment clause and where the rest of the deed complies with the regulations. In those cases, valuation will be the key issue. If so, the decision on whether to take the SI offer becomes more complicated than it already is—considering litigation fees and the strength of the taxpayers’ valuation.

The evidence is mounting that the IRS’s attack on SCEs is overly aggressive. The cumulative effect of recent IRS actions such as eliminating the appraisal penalty review process, attempting to completely strike down conservation easements, and offering a one-sided SI, has the effect of heavily discouraging the donation of conservation easements. This cuts against congressional intention to incentivize the conservation of land and it is arguably a regulatory over-step by the agency. The IRS is demanding surrender on syndicated conservation easements. They may or may not be well-positioned to make such demands. Regardless, the battle ahead for taxpayers is long, treacherous, and unforgiving. Some might lose their entire deduction. Some of those might wind up paying an additional 40% penalty. Others might successfully defend their deduction, but many of those will lose on valuation. The likelihood of a taxpayer escaping with their full deduction is slim to none. The last time that happened was in 2009, before the dramatic rise of SCE transactions.[221] The fate of SCE transactions will be revealed in due time. For now, taxpayers have a difficult decision to make—potentially premature surrender or a tedious gamble.

Interested in what Cantley Dietrich can do for you? Click here to contact us today.

[1] Beckett G. Cantley, Esq. teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C. Prof. Cantley would like to thank Melissa Cantley and his law clerk, Austin Young, for their contributions to this article.

[2] Geoffrey C. Dietrich, Esq. is a shareholder in Cantley Dietrich, P.C.

[3] See 26 USCA § 170 (West).

[4] See id. at § 170(h).

[5] 26 CFR § 1.170A-14.

[6] Guinevere Moore, IRS Settlement Program For Syndicated Conservation Easements Announced, Forbes (Jun. 26, 2020, 12:23 PM), https://www.forbes.com/sites/irswatch/2020/06/26/irs-settlement-program-for-syndicated-conservation-easements-announced/#33ea36f7e3cf.

[7] IRS News Release IR-2020-130 (Jun. 25, 2020) (hereinafter “IR-2020-130“).

[8] Listing Notice--Syndicated Conservation Easement Transactions, 2017-4 IRB 544 (2016).

[9] IRS News Release IR-2019-182 (Nov. 12, 2019).

[10] See e.g. Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018); see also Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 TCM (CCH) 1352 (TC 2020).

[11] IR-2020-130.

[12] Kaustuv Basu and Aysha Bagchi, IRS Land Deal Offer Has Little to Entice Challengers to Settle, Bloomberg Law (Jul. 9, 2020, 3:46 PM), https://news.bloombergtax.com/daily-tax-report/irs-land-deal-offer-has-little-to-entice-challengers-to-settle.

[13] Id.

[14] Nancy Ortmeyer Kuhn, INSIGHT: Charitable Conservation Easements—IRS and Tax Court Act To Shut Them Down, Bloomberg Law (Jul. 22, 2020, 3:01 AM), https://news.bloombergtax.com/daily-tax-report/insight-charitable-conservation-easements-irs-and-tax-court-act-to-shut-them-down.

[15] See, e.g., Gorra v. Comm'r, 106 TCM (CCH) 523 (TC 2013).

[16] In 2009, the taxpayers won a near outright victory. Kiva Dunes Conservation, LLC v. Comm'r, 97 T.C.M. (CCH) 1818 (T.C. 2009).

[17] See Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (T.C. 2020).

[18] See, e.g., Champions Retreat Golf Founders, LLC v. Comm'r of IRS, 959 F.3d 1033 (11th Cir. 2020) (remanded to Tax Court for valuation).

[19] See Oakbrook.

[20] See, e.g., compare Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018), with BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).

[21] 26 USCA § 170(h) (West).

[22] See §170(f)(3)(B)(iii).

[23] See §170(h).

[24] Kuhn, supra note 14.

[25] 26 USCA § 170(h)(2) (West).

[26] 26 CFR § 1.170A-14

[27] Id.

[28] See infra Part III(C).

[29] Belk v. Comm'r, 774 F.3d 221 (4th Cir. 2014).

[30] Id. at 223.

[31] Id.

[32] Id.

[33] Id.

[34] Id. at 223-24.

[35] Id. at 230.

[36] See id.

[37] Id. at 225-26.

[38] Id.

[39] Id.

[40] Id.

[41] Id.

[42] Id.

[43] Gorra v. Comm'r, 106 T.C.M. (CCH) 523 (T.C. 2013).

[44] Id. at 1.

[45] Amended Reply Brief for Respondent at 93, Gorra v. Comm'r, 106 TCM (CCH) 523 (TC 2013) (No. 15336-10).

[46] Gorra at 9.

[47] Id.

[48] Id.

[49] Id. at 8-9.

[50] Id.

[51] Id. at 24-25.

[52] Id.

[53] Id. at 25.

[54] BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).

[55] Id. at 549-51.

[56] Id.

[57] Id. at 552.

[58] Bosque Canyon Ranch, LP v. Comm'r, 110 TCM (CCH) 48 (TC 2015), vacated and remanded sub nom. BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).

[59] Id.

[60] BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).

[61] Id. at 552-53.

[62] See id. at 562.

[63] See id. at 552-53.

[64] Id. at 554.

[65] Id. at 560.

[66] Balsam Mountain Investments, LLC v. Comm'r, 109 TCM (CCH) 1214 (TC 2015).

[67] Id. at 2.

[68] See id. at 3.

[69] Id.

[70] Id.

[71] Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018).

[72] See id. at 256-60.

[73] See id. at 272-73.

[74] See id. at 273-74.

[75] Id.

[76] Id.

[77] Id.

[78] Balsam Mountain Investments at 3.

[79] See Balsam Mountain Investments; see also Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018).

[80] See BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).

[81] Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (T.C. 2020).

[82] See Pine Mountain.

[83] 26 USCA § 170(h)(4)(A) (West).

[84] Id. at (ii).

[85] 26 C.F.R. § 1.170A-14(d)(3)(i).

[86] See id.

[87] Champions Retreat Golf Founders, LLC v. Comm'r of IRS, 959 F.3d 1033 (11th Cir. 2020).

[88] Id. at 1034-35.

[89] Id. 

[90] Id. 

[91] Id.

[92] Id. at 1034.

[93] The word “significant” is added to account for the regulation; see supra note 80.

[94] See generally, Champions.

[95] See Champions.

[96] See id 1036-38.

[97] Id. at 1038.

[98] Id. 

[99] Id.

[100] Id. at 1039.

[101] Id. at 1041.

[102] Id.

[103] See, e.g., Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018).

[104] See 26 U.S.C.A. § 170(c) (West).

[105] Pollard v. Comm'r, 105 T.C.M. (CCH) 1249 (T.C. 2013).

[106] Id.

[107] Id.

[108] Graev v. Comm'r, 140 T.C. 377 (2013).

[109] Id.

[110] Id.; 26 C.F.R. § 1.170A-1(e).

[111] Graev at 409.

[112] See 26 U.S.C.A. § 170 (West).

[113] 26 C.F.R. § 1.170A-1(e).

[114] 26 U.S.C.A. § 170(h)(5) (West).

[115] Id.

[116] See Ann Taylor Schwing, Perpetuity Is Forever, Almost Always: Why It Is Wrong to Promote Amendment and Termination of Perpetual Conservation Easements, 37 Harv. Envtl. L. Rev. 217, 221 (2013). There is only one limited exception to perpetuity, discussed infra note 131 and accompanying text.

[117] See IR-2020-130.

[118] See, e.g., BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017); Gorra v. Comm'r, 106 TCM (CCH) 523 (TC 2013).

[119] See, e.g. Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (TC 2020).

[120] See infra Part II(A).

[121] Id.

[122] See, e.g. Oakbrook.

[123] Irby v. Comm'r, 139 TC 371 (2012).

[124] Id.

[125] Id. at 380. As we will see later, this is a typical IRS argument on this issue

[126] Id.

[127] Id. at 376-77.

[128] Id. at 380.

[129] Id. at 380-85.

[130] Id.

[131] Id.

[132] Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (T.C. 2020).

[133] See, e.g., Plateau Holdings, LLC v. Comm'r of Internal Revenue, TCM (RIA) 2020-093 (TC 2020); Lumpkin HC, LLC v. Comm'r of Internal Revenue, TCM (RIA) 2020-095 (TC 2020).

[134] Oakbrook at 3.

[135] Id. at 5.

[136] Id. at 11.

[137] Id. at 2.

[138] Id.

[139] 26 C.F.R. § 1.170A-14(g)(6)(i) (emphasis added).

[140] 26 C.F.R. § 1.170A-14(g)(6)(ii) (emphasis added).

[141] See id. at (i) and (ii).

[142] Id.

[143] Oakbrook at 11.

[144] Id. at 6-7.

[145] Id. at 21-22.

[146] Id.

[147] Id. In a companion case, Oakbrook challenged the validity of the regulation and failed.

[148] Id. at 25.

[149] Id.

[150] See id.

[151] See id.

[152] Hoffman Properties II, LP v. Comm'r of Internal Revenue, 956 F.3d 832 (6th Cir. 2020), reh'g and suggestion for reh'g en banc denied, No. 19-1831, 2020 WL 3839687 (6th Cir. June 17, 2020).

[153] Glass v. Comm'r, 471 F.3d 698 (6th Cir. 2006).

[154] Id.

[155] Id.

[156] Hoffman Properties II.

[157] Id.

[158] Id.

[159] See Glass; Hoffman Properties II.

[160] See id.

[161] See id.

[162] See, e.g., Plateau Holdings, LLC v. Comm'r of Internal Revenue, TCM (RIA) 2020-093 (TC 2020); Lumpkin HC, LLC v. Comm'r of Internal Revenue, TCM (RIA) 2020-095 (TC 2020).

[163] See Oakbrook; see also IR-2020-130.

[164] Kristen A. Parillo, Criticism of Easement Settlement Deal Doesn’t Worry IRS, taxnotes (Jul. 15, 2020), https://www.taxnotes.com/tax-notes-today-federal/charitable-giving/criticism-easement-settlement-deal-doesnt-worry-irs/2020/07/15/2cqf4.

[165] See Oakbrook; Irby v. Comm'r, 139 T.C. 371 (2012).

[166] See Oakbrook.

[167] See Oakbrook.

[168] See Irby.

[169] Oakbrook at 23.

[170] Id. (citing PBBM-Rose Hill, Ltd. v. Comm'r of Internal Revenue, 900 F.3d 193, 205-07 (5th Cir. 2018).

[171] Id.

[172] Id. at 25.

[173] Id.

[174] Id.

[175] See, e.g., Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012); PBBM-Rose Hill, Ltd. v. Comm'r of Internal Revenue, 900 F.3d 193, 205-07 (5th Cir. 2018).

[176] See Kuhn, supra note 14.

[177] Parillo, supra note 164.

[178] See IR-2020-130.

[179] 26 C.F.R. § 1.170A-14(h)(3)(i).

[180] See Frazee v. Comm'r, 98 TC 554, 563 (1992).

[181] See 26 C.F.R. § 1.170A-14(h)(3)(i).

[182] See id.

[183] William E. Ellis, Syndicated Conservation Easements, Valuation Abuse, and Penalties, taxnotes (July 27, 2020) https://www.taxnotes.com/tax-notes-federal/appraisals-and-valuations/syndicated-conservation-easements-valuation-abuse-and-penalties/2020/08/03/2csc2.

[184] Id.

[185] Id.

[186] Id.

[187] Id.

[188] Id.

[189] Id.

[190] Id.

[191] Id.

[192] See, e.g., Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (TC 2020).

[193] See, e.g., Champions Retreat Golf Founders, LLC v. Comm'r of IRS, 959 F.3d 1033 (11th Cir. 2020).

[194] 26 U.S.C.A. §6662(a) (West).

[195] 26 U.S.C.A. §6662(h) (West).

[196] See, e.g., Gorra v. Comm'r, 106 T.C.M. (CCH) 523 (T.C. 2013).

[197] See Oakbrook.

[198] See id. 

[199] See id.

[200] See e.g., Plateau Holdings, LLC, Waterfall Development Manager, LLC, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, T.C.M. (RIA) 2020-093 (TC 2020).

[201] IR-2020-130.

[202] Id.

[203] Id.

[204] Moore, supra note 6.

[205] For example, those deeds that will lose in the Tax Court following Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (TC 2020).

[206] Jeff Kauttu, Conservation Easements at Risk Because of IRS Appraisal Penalties, taxnotes (Aug. 12, 2020) https://www.taxnotes.com/tax-notes-federal/appraisals-and-valuations/conservation-easements-risk-because-irs-appraisal-penalties/2020/07/27/2cqkj.

[207] Id.

[208] Id.

[209] Id.

[210] Internal Revenue Service, Memorandum for All LB&I and SB/SE Employees (Jan. 22, 2020) https://www.irs.gov/pub/foia/ig/lmsb/lbi-20-0120-0001.pdf.

[211] Kauttu, supra note 206.

[212] Id.

[213] New Colonial Ice Co. v. Helvering, 292 US 435, 440 (1934).

[214] See id.

[215] Id.

[216] See, e.g., Belk v. Comm'r, 774 F.3d 221 (4th Cir. 2014).

[217] See, e.g., Champions Retreat Golf Founders, LLC v. Comm'r of IRS, 959 F.3d 1033 (11th Cir. 2020); see also Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 TCM (CCH) 1352 (TC 2020).

[218] 26 USCA § 170(h) (West).

[219] Id.

[220] See, e.g., Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018).

[221] See supra, note 16.

Risks You Can Avoid by Using Attorney Paymaster Services

24-Nov-2020

Attorney paymaster services

Anyone who is conducting business internationally or making large transactions should be aware of attorney paymaster services. These services are designed to protect you and others involved in your high-dollar transaction from fraud, and to offer legal protections by ensuring that all the proper steps are followed to comply with financial regulations, including KYC, AML, CDDand EDD. Beloware just a few of the risks that an attorney paymaster can protect against. Attorney paymaster services

Fraud

Whenever you conduct high-dollar transactions (such as real estate, jet fuel or precious diamonds and metals), or work with an overseas buyer or seller, there is a risk that you could be participating in a fraudulent transaction. This is especially true in transactions in which you may have never met the person face to face or talked to them except electronically. With an attorney paymaster acting as an escrow account, you can hold funds in the reserve account until you verify that the transaction is legitimate. This is prudent on both the buyer’s and the seller’s side—if you are selling goods, the attorney paymaster can confirm that payment is made before you release the items. If you are buying, the attorney paymaster can release your funds to the seller and track the shipment of goods.

Money Laundering

Another potential risk that people face when they are doing business with entities or individuals they have never met is inadvertently becoming a participant in a money laundering transaction. Your attorney paymaster can help you verify the person or entity on the other end of the transaction using KYC (know your customer), CDD or EDD (customer due diligence or enhanced due diligence) and AML (anti-money laundering) verifications. It is often easier for an attorney paymaster to perform these checks than it would be for you, as they can be time-consuming and difficult if you don’t have experience in these areas. These checks are also required by law, so it’s important that you have them done by someone who knows how to do it right.

Clerical Errors

Even legitimate transactions with buyers who have checked out through KYC, CDD and AML can run into issues when it comes to the paperwork. A lot of information must be confirmed, filled out, filed with various regulatory bodies and shared in the process of your transaction. Missing a key piece of information or filling out some of the forms incorrectly can still land you in trouble or significantly slow down a transaction. Working with an attorney paymaster service ensures that all the i’s are dotted and t’s are crossed, so you can move forward confidently in your transaction. Cantley Dietrich is available to provide attorney paymaster services for your high-value domestic or international transactions. Contact us today to learn more.

Why Privacy Matters in Asset Protection Strategies

06-Nov-2020

asset protection strategies

High-net-worth individuals have a lot to consider when it comes to asset protection, but one important factor that not everyone thinks to take into account is how well your asset protection strategy protects your privacy. How does your attorney or financial advisor work to protect your privacy? If you’re not sure, you could be putting yourself at unnecessary risk. asset protection strategies

Most Info Is Just a Click Away

The internet provides us with a lot of connectivity tools, and nowhere has it had more of an impact than on privacy. Sensitive information is easily available with just a few website clicks. In fact, people with high net worth might be at even higher risk for the exposure of personal information. This is because they are more likely to have transactions recorded that can be traced electronically through the internet than someone who has lower net worth and fewer assets (property ownership, public salary information, asset registrations, etc.). Even information you would prefer to keep private is more accessible than ever, which can make financial planning more difficult without the right strategies and tools.

Opportunistic Plaintiffs Can Make Life Harder

When financial information is readily available online, it can make you the target of an opportunistic plaintiff looking to make a quick buck from a frivolous lawsuit. With so much information available online about assets, properties, bank accounts, salaries, net worth and more, anyone who is wealthy could quickly find themselves embroiled in a lawsuit or on the receiving end of demands for money. Information that is readily available about your net worth or the extent of your assets could also come back to harm you in civil or personal cases—for example, a divorced spouse or an ex-business partner who decides to sue. You never know who might be keeping tabs on your overall net worth online, so the more privacy you can get, the better.

Commercial or Business Interests

The more public your financial information, the more likely you will be exposed to commercial sales calls, business propositions and other unwanted requests as well. While not as troublesome as lawsuits, it is certainly an inconvenience when you are constantly interrupted by phone calls, emails or even in-person solicitations for donations. For all these reasons, it’s important to work with an attorney and financial advisor who understands the tools available to protect your assets, and the importance of protecting your privacy in the process. Find out how Cantley Dietrich can help by contacting us about your asset protection and financial planning needs today.