From an Internal Revenue Service (IRS) Chief Counsel Advice affecting GRATs to decisions regarding the deduction of business losses, we have recently seen significant developments in estate planning and business law. To ensure that you stay abreast of these legal changes, we have highlighted some noteworthy developments and analyzed how they may impact your estate planning and business law practice.

Donor Did Not Retain Qualified Interest in Grantor Retained Annuity Trust Because Stock Appraisal Did Not Consider Pending Merger

I.R.S. C.C.A. 202152018 (Dec. 30, 2021)

A memorandum released on December 30, 2021, by the Office of Chief Counsel of the IRS addressed a factual situation involving a grantor retained annuity trust (GRAT) funded with the shares of a company founded by a donor. During year one, the donor sought the help of advisors to find an outside buyer for the company. About six months later, in year two, the advisors provided the donor with offers from several corporations. Three days later, the donor contributed shares of the company to a two-year GRAT that appeared to satisfy the requirements for a qualified interest under I.R.C. § 2702 and its corresponding regulations. Pursuant to the terms of the GRAT, the amount of the annuity payment would be based on a fixed percentage of the initial fair market value of the trust’s shares. The value of the shares was based on an appraisal obtained to satisfy the reporting requirements for nonqualified deferred compensation plans under I.R.C. § 409A on December 31 of year one, approximately seven months prior to their transfer to the GRAT. About three months after the initial offers were submitted, several of the corporations submitted final offers. The donor made a gift of company shares to a separate charitable remainder trust, which were valued pursuant to a qualified appraisal as equal to the value of the tender offer accepted by the donor several weeks later—approximately three months after the donor had received the final offers. The merger offer accepted by the donor was for an amount nearly three times greater than the value determined by the appraisal on December 31 of year one.

On December 31 of years two and three, the donor obtained new appraisals for purposes of I.R.C. § 409A, each of which determined an appraised value almost twice the value determined in year one’s § 409A appraisal. In year four, about six months after the end of the two-year term of the GRAT, the purchasing corporation bought the balance of the company’s shares for a price that was nearly twice the value determined in the § 409A appraisals for years two and three.

The Office of Chief Counsel determined that the record supported the proposition that as of the date in year two when the initial offers were submitted to the donor, a hypothetical willing buyer of the company’s stock could have reasonably foreseen the merger and anticipated that the price of the stock would be valued substantially higher than the value determined for the § 409A appraisal in year one. Thus, the hypothetical willing buyer and willing seller of shares in a company would have considered the pending merger in valuing the stock, and the merger bears on the value for gift tax purposes. In addition, citing Atkinson v. Comm’r, 309 F.3d 1290 (11th Cir. 2002), because the donor used the older appraisal, which was outdated and did not take the facts and circumstances of the pending merger into account, the retained interest was not a qualified annuity interest under I.R.C. § 2702. Although the GRAT’s governing instrument appeared to meet the requirements in § 2702 and the corresponding regulations, 

intentionally basing the fixed amount required by § 2702(b)(1) and § 25.2702-3(b)(1)(i) on an undervalued appraisal causes the retained interest to fail to function exclusively as a qualified interest from the creation of the trust. The trustee’s failure to satisfy the “fixed amount” requirement under § 2702 and § 25.2702-3(b)(1)(ii)(B) is an operational failure because the trustee paid an amount that had no relation to the initial fair market value of the property transferred to the trust. I.R.S. C.C.A. 2021-52-018, at 8 (Dec. 30, 2021). 

As a result, the annuity to be paid was less than 34 cents on the dollar than the required amount, resulting in a windfall for the remaindermen.

Takeaways: In a GRAT, the grantor contributes property to a trust and retains the right to be paid an annuity for a specified term of years. The value of the annuity interest retained by the grantor, which is not a taxable gift, is subtracted from the value of the property transferred to the GRAT to determine the amount of the gift. Due to the retained annuity, the GRAT can be structured so there is no gift, or a very small gift, for gift tax purposes. This is referred to as a “zeroed-out GRAT.” At the end of the annu­ity term, the remainder interest, if any, is distributed to the trust beneficiaries. Pursuant to self-adjustment clauses in GRATs, the annuity payments self-adjust if the value of assets held by the GRAT changes upon audit. For example, if the value of the assets transferred to the trust is higher than originally thought, the amount of the annuity would increase by the same percentage. In the Chief Counsel Advice, the self-adjustment mechanism of the GRAT was not respected because the valuation was so much lower than the fair market value that the IRS ultimately determined. Thus, because of the operational failure, the donor was not permitted to reduce the value of the gift by the value of the annuity, likely resulting in unexpected gift tax liability as well as penalties. Although Chief Counsel Advice are not precedential, the memorandum indicates that care in providing accurate appraisals is crucial. For additional explanation and takeaways, view the short video below by Robert Keebler, CPA, MST, AEP (Distinguished).

See what Robert Keebler has to say about the subject by watching the video below!

IRS Extends Electronic Signatures for Forms 706 and 709

The IRS extended its temporary policy allowing taxpayers and representatives to use electronic or digital signatures for certain paper forms that cannot be filed using IRS e-file, including Form 706, U.S. Estate (and Generation-Skipping Transfer) Tax Return and Form 709, U.S. (and Generation-Skipping Transfer) Tax Return, to October 31, 2023. The IRS does not specify the type of technology taxpayers must use for electronic signatures and will accept a wide range of methods.

Takeaways: The IRS’s acceptance of e-signatures on the specified paper-filed forms had previously been set to expire on December 31, 2021, but has been extended to October 31, 2023. The IRS is studying further extensions. The policy seems to allow the electronic signing of the Form 8879 series and the Form 8878 series (for e-file signature authorizations) without knowledge-based authentication.

Debtor’s Tenancy by Entirety Interest Not Exempt from Process by IRS or Claims of Joint Creditors of Debtor and Nonfiling Spouse

In re Morgan, 2021 WL 5498621 (Bankr. M.D.N.C. Nov. 4, 2021)

Ronald Morgan, the debtor, filed for chapter 7 bankruptcy. Morgan listed on his Schedule A/B an ownership interest in a parcel of real property he owned with his nonfiling spouse as tenants by the entirety, claiming it as exempt under 11 U.S.C. § 522(b)(3) and North Carolina law applicable to property owned as tenants by the entirety. Morgan, but not his spouse, owed a priority and general unsecured debt to the IRS, which he listed on his Schedule E/F. Several joint creditors were also listed. The bankruptcy trustee asserted that the real property was not exempt from process by the IRS prepetition and thus was not exempt from bankruptcy to the extent of the IRS debt. In addition, the trustee objected to the exemption to the extent of any joint debts owed by Morgan and his spouse.

The bankruptcy court rejected Morgan’s contention that his entireties interest in the real property was part of the bankruptcy estate, relying on precedent establishing that the bankruptcy estate includes real property held as tenants by the entirety even when only one spouse has filed. In addition, the court also rejected Morgan’s attempt to exempt his tenancy by the entirety interest in the real property pursuant to 11 U.S.C. § 522(b)(3)(B), which allows the exemption of “any interest in property in which the debtor had, immediately before the commencement of the case, an interest as a tenant by the entirety or joint tenant to the extent that such interest as a tenancy by the entirety or joint tenant is exempt from process under applicable nonbankruptcy law.” 

The court looked to both state and federal laws as the applicable nonbankruptcy law. The court noted that under North Carolina law, tenancy by the entirety interests are exempt from the claims of nonjoint creditors. However, applicable federal law—in this case, I.R.C. § 6321—provides that upon a person’s failure to pay any tax after demand, the amount is “a lien in favor of the United States upon all property and rights to such property, whether real or personal, belonging to such person.” Further, the court relied upon United States v. Craft, 535 U.S. 274 (2002), which concluded that despite analogous Michigan state law prohibiting nonjoint creditors from executing on tenancy by the entirety interests, a spouse’s interest in entireties property was subject to attachment of a tax lien under § 6321 for the spouse’s sole tax obligation. As a result, Morgan’s entireties interest was not exempt from process by the IRS and the court disallowed the exemption, but only as to the IRS debt and any joint creditors of Morgan and his spouse.

Takeaways: In the twenty-five states in which it is permitted, ownership of real property as tenants by the entirety is a common estate planning and asset protection strategy. However, In re Morgan provides a reminder that it is not a perfect asset protection tool, particularly in situations involving a federal tax lien. Some commentators have noted that because Morgan’s entireties interest (50 percent) in the real property was not exempt from the bankruptcy estate in In re Morgan, pursuant to 11 U.S.C. § 724, some unsecured priority creditors may be able to receive a distribution that otherwise would have been unavailable to them, with the IRS receiving a distribution only if there are remaining assets. In addition, Morgan may continue to owe money to the IRS even after the bankruptcy case is concluded because the IRS lien had priority status and was not dischargeable. For clients who are concerned about creditors’ claims, especially IRS liens, other mechanisms may provide better protection than tenants by the entirety ownership.

Owners of Self-Directed IRAs Not Permitted to Have Unfettered Control Over IRA Assets

McNulty v. Comm’r, 157 T.C. 10 (2021)

Donna McNulty established a self-directed individual retirement account (IRA) pursuant to I.R.C. § 408 and named Kingdom Trust as the IRA custodian. She instructed Kingdom Trust to use funds held in the self-directed IRA to invest in a single-member limited liability company (SMLLC). Her self-directed IRA was the sole member and she and her husband were the managers. Donna directed the SMLLC to purchase coins, but the shipping labels for the coins identified Donna individually or along with her self-directed IRA as the recipient of the shipments at her personal residence. The coins were stored in a safe at Donna’s residence. Kingdom Trust played no role in the management of the SMLLC, the purchase of the coins, the administration of the SMLLC’s assets, or the self-directed IRA assets.

The Tax Court found that Donna had received taxable distributions from her self-directed IRA when she received physical custody of the coins. Although owners of self-directed IRAs are entitled to direct how its assets are invested without forfeiting the tax benefits of an IRA, they “cannot have unfettered command over the IRA assets without tax consequences.” McNulty v. Comm’r, 157 T.C. 10, at *5 (2021). Independent oversight by a third-party fiduciary such as a qualified custodian or trustee responsible for the management and disposition of property is required for a self-directed IRA. The Tax Court noted that when coins are in the physical possession of the IRA owner rather than a fiduciary, there is no independent oversight to prevent the owner from invading the retirement funds. This lack of oversight is inconsistent with the statutory scheme of IRAs, i.e., encouraging retirement savings and protecting the savings for retirement. Because Donna’s possession of the coins amounted to a taxable distribution, their value was includible in her gross income. In addition, she was liable for accuracy-related penalties due to a substantial understatement of income tax.

Takeaways: Self-directed IRAs provide flexibility unavailable to investors in traditional IRAs. Nevertheless, clients interested in investing in self-directed IRAs should be encouraged to seek the guidance of their attorneys, certified public accountants, and other advisors to avoid costly mistakes.

Owners of Miniature Donkey Farm with Actual and Honest Profit Objective Can Deduct Business Losses

Huff v. Comm’r, T.C.M. (RIA) 2021-140 (Dec. 21, 2021) 

Under I.R.C. § 162(a), taxpayers are generally permitted to deduct all ordinary and necessary business expenses paid or incurred in carrying on a trade or business. However, they may not deduct expenses for activities such as hobbies that are not engaged in for profit. This limitation is overcome if the activity was “entered into with the dominant hope and intent of realizing a profit.” Brannen v. Comm’r, 722 F.2d 695, 704 (11th Cir. 1984).  

In Huff, business-savvy and wealthy parents (the Huffs) established a miniature donkey farm. The Tax Court noted that “[t]he driving factor in deciding to embark on this enterprise was not a late-discovered passion for adorable little animals.” Huff v. Comm’r, T.C.M. (RIA) 2021-140, at 9 (Dec. 21, 2021). Rather, the Huffs’ objective was to turn the business over to their daughter once it was up and running to supplement her income. However, the breeding operation was ultimately less successful than hoped. Some of the foals were delivered stillborn or with deformities, and some of the donkeys “were simply uninterested in the pleasures of the flesh, complicating the breeding process.” Id. at 13.

The business reported losses on all of its partnership returns for tax years 2010 through 2017. The present case addresses only the losses of $87,236 during 2013 and $47,039 during 2014, which the Huffs deducted as ordinary and necessary business expenses incurred in carrying on a trade or business. The IRS disallowed the deductions and determined deficiencies of $37,022 for 2013 and $19,615 for 2014. In addition, the IRS imposed accuracy-related penalties.

The court noted that in determining whether a profit motive exists, greater weight is given to objective facts than to the taxpayer’s statement of intent. See Treas. Reg. § 1.183-2(b) (list of nine objective factors should be considered). Although the business was not profitable, the court found that the Huffs had a business plan, modified their operating methods with an intent to improve profitability, commissioned in-depth research into relevant aspects of running a miniature donkey breeding business, employed competent and qualified people to carry on the business activity, and had a track record of success in other business activities. Further, the court found that Mr. Huff’s testimony that the miniature donkeys were “quite ugly” and looked like a “gigantic hairball” to be credible, demonstrating his absence of personal pleasure or recreation relating to the activity and further indicating the presence of a profit objective. Despite the Huffs’ failure to achieve the success that they had experienced in other business ventures, the court found that the Huffs believed that the breeding operation would eventually become profitable enough to supplement their daughter’s income and that they had pursued this goal using an approach used successfully in their other business ventures. The court ruled that the objective factors demonstrated that the Huffs pursued the miniature donkey farm operation with the primary purpose and intention of making a profit. Therefore, their loss deductions were allowable and they were not liable for the deficiencies or accuracy-related penalties.

Takeaways: Ventures that consistently claim losses for several years risk classification as a hobby by the IRS. Section § 183(d) of the I.R.C. sets forth a presumption that a taxpayer is engaged in the business for profit if the activity is profitable for three of five consecutive taxable years. However, when a business—such as the Huff’s donkey farm—has not been profitable consistently enough to meet the presumption, the business owner must prove an intention to make a profit to claim deductions for their losses if the IRS classifies it as a hobby.

S Corporation Status Could Be Terminated by Acquisition of Shares by Individual Married to Nonresident Alien in Community Property Jurisdiction

I.R.S. P.L.R. 202149004 (Dec. 10, 2021)

In Private Letter Ruling 202149004, the IRS addressed several issues regarding the validity of a company’s S corporation election. I.R.C. § 1361(b)(1) specifies that an S corporation (small business corporation) may not have a nonresident alien as a shareholder. The IRS stated that when a US citizen, who is married to a nonresident alien who is a resident of a country that is a community property jurisdiction, acquires shares of stock in an S corporation, the S corporation will terminate as of the date of the acquisition. In this case, the nonresident alien spouse had signed an agreement transferring her interest in the stock to her US citizen spouse upon learning that the S corporation had an ineligible shareholder. The IRS stated that because the circumstances resulting in the termination were inadvertent within the meaning of I.R.C. § 1361(f), the company would be treated as continuing to be an S corporation.

Takeaways: Shareholders of S corporations should exercise care to avoid inadvertent termination of S corporation status, especially in situations involving shareholders with non–US citizen spouses in community property jurisdictions.