Newsletter-Supreme Court 090704 by Don Fitch CPA CITP (877)CPA-Help or (877)272-4357 Website www.Paylesstax.com

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04/26/2009

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Articles (see detail below)

1) IMPORTANT ***** Supreme Court Sides With Retirees; Plan Amendment Violates ERISA. This recent Supreme Court decision could affect millions of retirees.

2) Fifth Circuit Decision Provides Road Map for Estate Planners.

3) Electronic Filing Available Until October 15.

4) Figurehead President Is a Responsible Person for Employment Tax Penalties.

5) Court Chastises KPMG for Using a Misleading Log to Claim Privilege.

United States v. Rutherford, No. 03-10158 (9th Cir. 6/10/04): The Ninth Circuit reversed a district court and held that the district court applied the wrong legal standard in determining whether a large number of IRS and other government agents, who sat directly behind the prosecution table, intimidated jurors in the taxpayers' trial for tax evasion. Code Section 7203.

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1) Supreme Court Sides With Retirees; Plan Amendment Violates ERISA. This recent Supreme Court decision could affect millions of retirees.

A recent Supreme Court decision could affect millions of retirees. In Central Laborers' Pension Fund v. Heinz, the Supreme Court affirmed the Seventh Circuit and held that an employer could not change its pension plan rules to retroactively deny benefits to two employees who had retired early with full pension benefits and taken new jobs in the same industry.

Background

Thomas Heinz and Richard Schmitt are participants in a multi-employer pension plan administered by Central Laborers' Pension Fund. Both Heinz and Schmitt, who were 39 years old when they retired in 1996, qualified for and began receiving monthly benefit payments under a "service-only pension," which was available to participants who retired at any age if they had earned 30 or more pension credits. The monthly payments available under the service-only pension were the same as those available at normal retirement age; that is, the benefits were not actuarially reduced to take into account that payments began at an earlier age and would continue over a longer period.

Under the plan, monthly benefit payments for those retiring before age 60 were subject to suspension for periods during which the participants worked in certain "disqualifying employment." When Heinz and Schmitt retired in 1996, the plan defined "disqualifying employment" as any job as a union or non-union construction worker. After their retirement, Heinz and Schmitt obtained jobs as supervisors in the construction industry, which was not disqualifying employment under the existing definition.

In 1998, the plan was amended and the definition of disqualifying employment was expanded to include any job in the construction industry. The pension fund construed this amended definition as covering Heinz and Schmitt's supervisory work and suspended their monthly benefit payments.

Heinz and Schmitt sued the pension fund, arguing that a pension plan amendment that expands the types of post-retirement employment that trigger mandatory suspension of early retirement benefits violates ERISA's "anti-cutback" rule when applied to suspend the benefits of individuals who retired before the amendment. ERISA's anti-cutback rule generally prohibits any pension plan amendment which has the effect of eliminating or reducing a participant's early retirement benefit or a retirement-type subsidy with respect to benefits attributable to service before the amendment.

The Lower Courts' Rulings

A district court held for the pension fund. According to the court, the anti-cutback rule does not apply to suspensions of early retirement benefits payments triggered by disqualifying employment. Further, the court determined that the pension fund's interpretation of the amended definition of disqualifying employment to include supervisory work was not arbitrary and capricious. In reaching its decision, the district court relied on the Fifth Circuit's interpretation of ERISA's anti-cutback rule. Heinz and Schmitt appealed.

The Seventh Circuit reversed the district court and held that the plan amendment violated the anti-cutback rule. In so doing, the court rejected the Fifth Circuit's interpretation of ERISA's anti-cutback rule. The court concluded that Heinz and Schmitt lost a valuable right they had earned before the amendment – the right to continue to work in the industry while receiving monthly benefit payments – and that the loss was permanent. In the court's judgment, this was a reduction of early retirement benefits within the plain meaning of the anti-cutback rule. The pension fund appealed, arguing that the anti-cutback rule should apply only to amendments directly altering the monthly payment's nominal dollar amount and not to a suspension when the amount that would be paid is unaltered.

Supreme Court Rejects Plan Amendment

The Supreme Court agreed with the Seventh Circuit and held that ERISA's anti-cutback rule prohibits a plan amendment expanding the categories of post-retirement employment that triggers suspension of the payment of early retirement benefits already accrued. According to the Court, the anti-cutback provision is crucial to ERISA's central objective of protecting employees' justified expectations of receiving the benefits that they have been promised. The question in this case is whether the plan's amendment had the effect of eliminating or reducing an early retirement benefit. The Court found that it was clear as a matter of common sense that a benefit had suffered under the amendment. Heinz and Schmidt accrued benefits under a plan allowing them to supplement their retirement income and they reasonably relied on that plan's terms in planning their retirement. The 1998 amendment undercut that reliance, paying benefits only if they accepted a substantial curtailment of their opportunity to do the kind of work they knew.

The Supreme Court concluded that there was no way that, in any practical sense, this change of terms could not be viewed as shrinking the value of Heinz's and Schmidt's pension rights and reducing their promised benefits. The court rejected the pension fund's argument as overly technical, holding that its constricted reading of the anti-cutback rule missed the point. According to the Court, while ERISA permits conditions that are imposed up-front as elements of the benefit itself, the issue in this case was whether a new condition may be imposed after the benefit has accrued. The right to receive certain money on a certain date, the court stated, may not be limited by a new condition narrowing that right.

OBSERVATION: The court's interpretation of this provision is important because, under Code Section 411(d)(6), the same rules apply in the qualified plan area.

2) Fifth Circuit Decision Provides Road Map for Estate Planners

A recent Fifth Circuit decision is good news for estate tax planners. In Kimbell v. United States, the court details actions estate planners can take to prevent the value of assets transferred to a partnership from subsequently being included in a transferor-decedent's estate. In doing so, the court rejected the lower court's finding that (1) family members can not enter into a bona fide transaction, and (2) a transfer of assets in return for a pro rata partnership interest is not a transfer for full and adequate consideration.

Facts

Ruth Kimbell died in 1998 at age 96. In the years before her death, Mrs. Kimbell transferred a large portion of her estate in a series of transactions to three entities: (1) a revocable living trust administered by her and her son, David, as co-trustees; (2) a Texas limited liability company (LLC) that was 50 percent owned by the living trust and 50 percent owned by David and his wife, and of which David was the sole manager; and (3) a Texas limited partnership that was created two months before her death by the trust and LLC.

In forming the partnership, the trust contributed approximately $2.5 million in cash, oil and gas working interests and royalty interests, securities, notes and other assets for a 99 percent pro-rata limited partner interest. The oil and gas properties were a continuation of an oil and gas business that Mrs. Kimbell's late husband had founded in the 1920's. The LLC contributed approximately $25,000 in cash for a 1 percent pro-rata general partner interest. At inception, approximately 15 percent of the assets of the partnership were oil and gas working (11 percent) and royalty (4 percent) interests. As a result of these transfers, Mrs. Kimbell, through the trust and the LLC, owned 99.5 percent of the partnership. David managed his mother's business interest before and after the creation of the LLC and the partnership. Not all of Mrs. Kimbell's assets were conveyed to the LLC and the partnership. She retained over $450,000 in assets outside of the LLC and the partnership for her personal expenses.

Under the partnership agreement, the purposes of the partnership were to: (1) increase family wealth; (2) establish a method by which annual gifts could be made without fractionalizing family assets; (3) continue the ownership and collective operation of family assets and restrict the right of non-family members to acquire interests in family assets; (4) provide protection to family assets from claims of future creditors against family members; (5) prevent the transfer of a family member's interest in the partnership as a result of a failed marriage; (6) provide flexibility and continuity in business planning for the family not available through trusts, corporations or other business entities; (7) facilitate the administration and reduce the cost associated with the disability or probate of the estate of family members; (8) promote the family's knowledge of and communication about family assets; (9) provide resolution of any disputes which could arise among the family in order to preserve family harmony and avoid the expense and problems of litigation; and (10) consolidate fractional interests in family assets. The term of the partnership was 40 years.

The LLC, as general partner, managed the partnership and had exclusive authority to make distributions. The partnership agreement provided that the general partner owed no fiduciary duty to the partnership or to any partner but owed a duty of loyalty and a duty of care to the partnership. The trust, as limited partner, had no right to withdraw from the partnership or receive a return of contributions until the partnership was terminated, which could occur only by unanimous consent of the partners. The partnership agreement provided that 70 percent in interest of the limited partners had the right to remove the general partner. A majority in interest of the limited partners had the right to elect a new general partner.

In 1998, the estate filed its federal estate tax return. At the time of Mrs. Kimbell's death, the value of the partnership assets was approximately $2.4 million. On the return, the estate claimed a 49 percent discount on the value of Mrs. Kimbell's interest in the partnership and her interest in the LLC for lack of control and lack of marketability of the partnership interest. It reported her 99 percent interest in the partnership as having a fair market value of approximately $1.2 million and her 50 percent interest in the LLC as having a fair market value of approximately $17,000.

After auditing the estate, the IRS concluded that the value of the assets transferred to the partnership and the LLC, rather than Mrs. Kimbell's interest in these entities, was includible in the gross estate and increased the tax due accordingly. The estate paid the additional tax and then filed for a refund, claiming that the IRS overvalued Mrs. Kimbell's interests in the partnership and the LLC.

Recapturing Assets for Estate Tax Purposes

Under Code Section 2036(a), a decedent's gross estate includes the value of all property in which the decedent has at any time made a transfer in which he or she retained for life (or for any period not ascertainable without reference to his or her death or for any period that does not in fact end before death): (1) the possession or enjoyment of, or the right to the income from, the property, or, (2) the right to designate, either alone or with others, the persons who shall possess or enjoy the property or its income.

There are two exceptions that will allow a transfer to escape the operation of Code Section 2036(a). First, if the transfer is a bona fide sale for full and adequate consideration, then Code Section 2036(a) does not apply. If the transfer is not a bona fide sale for full and adequate consideration, then the transfer may still be excluded from the estate of the decedent under the second exception, if the decedent did not retain either the (1) possession, enjoyment or rights to the transferred property, or (2) the right to designate the persons who would possess or enjoy the transferred property.

The District Court's Decision

A district court held that the estate was not entitled to a refund. According to the court, the transfer of assets by Mrs. Kimbell into the partnership did not fall under either of the exceptions to Code Section 2036. The court noted that there was no credible evidence that the formation of the partnership was the product of an arm's length transaction. Indeed, the court found that Mrs. Kimbell not only stood on both sides of the transaction, but, for all intensive purposes, was both sides of the transaction. Moreover, the court stated, even if the partnership was the result of a bona fide sale, the executor (her son, David) failed to establish that Mrs. Kimbell received adequate and full consideration for the sale.

With respect to the retained income or rights exception, the court stated that the partnership agreement gave the limited partner (i.e., Mrs. Kimbell) the right to designate and remove the general partner. According to the court, by retaining the power to designate the general partner, Mrs. Kimbell retained the power to either personally benefit from the income of the partnership or to designate the persons who would benefit from the income of the partnership. The court rejected the executor's argument that Mrs. Kimbell had irrevocably transferred her assets to the partnership.

The district court also concluded that Code Section 2036(a) was applicable to Mrs. Kimbell's 50 percent interest in the LLC, including her indirect 0.5 percent interest in the partnership assets resulting from the LLC's ownership of the 1 percent general partner interest in the partnership. The estate appealed.

IRS Arguments on Appeal

On appeal, the IRS adopted the district court's position and argued in addition that it was inconsistent for the estate to assert, on one hand, that the value of Mrs. Kimbell's interest in the partnership was worth only 50 percent of the assets she transferred (as discounted for lack of control and marketability), and on the other hand claim that the partnership interest Mrs. Kimbell received in exchange for the assets transferred was adequate and full consideration for the transfer.

The Fifth Circuit Reversal

The Fifth Circuit vacated and remanded the district court's decision, concluding that the lower court erred in finding as a matter of law that (1) family members can not enter into a bona fide transaction, and (2) a transfer of assets in return for a pro rata partnership interest is not a transfer for full and adequate consideration. The district court also erred in failing to consider uncontroverted evidence to support the taxpayer's position that the transfer was a bona fide sale.

According to the Fifth Circuit, what is required for the transfer by Mrs. Kimbell to the partnership to qualify as a bona fide sale is that it be a sale in which the decedent/transferor actually parted with her interest in the assets transferred and the partnership/transferee actually parted with the partnership interest issued in exchange. In order for the sale to be for adequate and full consideration, the exchange of assets for partnership interests must be roughly equivalent so the transfer does not deplete the estate. In addition, when the transaction is between family members, the court observed, it is subject to heightened scrutiny to insure that the sale is not a sham transaction or disguised gift. However, that scrutiny is limited to the examination of objective facts that would confirm or deny the taxpayer's assertion that the transaction is bona fide or genuine.

The Fifth Circuit rejected the district court's finding that the transfer by Mrs. Kimbell of assets to the partnership in exchange for pro-rata partnership interest was not a bona fide sale. That conclusion, the court observed, ignored circuit precedent and was based on the district court's erroneous assumption that an arm's length transaction, defined as one between persons who are not related, was a requirement of this exception. According to the court, the district court's analysis ignored evidence in support of the estate's position that the transaction was entered into for substantial business and other non-tax reasons.

The court noted that the following objective facts supported the estate's position that the transfer to the partnership was a bona fide sale: (1) Mrs. Kimbell retained sufficient assets outside the partnership for her own support and there was no commingling of partnership and her personal assets; (2) partnership formalities were satisfied and the assets contributed to the partnership were actually assigned to the partnership; (3) the assets contributed to the partnership included working interests in oil and gas properties which do require active management; and (4) several credible and unchallenged non-tax business reasons were advanced for the formation of the partnership that could not be accomplished via Mrs. Kimbell's trust.

The Fifth Circuit noted that the Tax Court has expressly rejected the argument that a discounted valuation of a pro rata partnership interest precludes a finding that the interest is adequate consideration for the assets transferred. With respect to the IRS's inconsistency argument, the Fifth Circuit observed that it is a classic mixing of apples and oranges: The IRS is attempting to equate the venerable "willing buyer-willing seller" test of fair market value (which applies when calculating gift or estate tax) with the proper test for adequate and full consideration under Code Section 2036(a).

According to the court, this argument misses the mark: The business decision to exchange cash or other assets for a transfer-restricted, non-managerial interest in a limited partnership involves financial considerations other than the purchaser's ability to turn right around and sell the newly acquired limited partnership interest for 100 cents on the dollar. Investors who acquire such interests do so with the expectation of realizing benefits such as management expertise, security and preservation of assets, capital appreciation and avoidance of personal liability. Thus there is nothing inconsistent in acknowledging, on the one hand, that the investor's dollars have acquired a limited partnership interest at arm's length for adequate and full consideration and, on the other hand, that the asset thus acquired has a present fair market value, i.e., immediate sale potential, of substantially less than the dollars just paid – a classic informed trade-off.

The proper focus on whether a transfer to a partnership is for adequate and full consideration, the court stated, is: (1) whether the interests credited to each of the partners was proportionate to the fair market value of the assets each partner contributed to the partnership; (2) whether the assets contributed by each partner to the partnership were properly credited to the respective capital accounts of the partners, and (3) whether on termination or dissolution of the partnership the partners were entitled to distributions from the partnership in amounts equal to their respective capital accounts. In the instant case, the court stated, the answer to each of these questions is yes. Mrs. Kimbell received a partnership interest that was proportionate to the assets she contributed to the partnership. There was no question raised as to whether her partnership account was properly credited with the assets she contributed. Also, on termination and liquidation of the partnership, the partnership agreement required distribution to the partners according to their capital account balances.

The court concluded that the partnership assets qualify for exclusion from Mrs. Kimbell's estate under the exception for bona fide sales. The district court's application of Code Section 2036(a) to the LLC transfer, the court stated, was erroneous. Even if the transfer did not constitute a bona fide sale for full and adequate consideration, Mrs. Kimbell did not retain sufficient control of the assets transferred to the LLC to make her transfer subject to Code Section 2036(a). Her interest in the LLC was only a 50 percent interest, and her son had sole management powers over the LLC. Thus, the court found, Mrs. Kimbell did not retain the right to enjoy or designate who would enjoy the LLC property.

3) Electronic Filing Available Until October 15

The IRS announced that its e-file service will be available through October 15, 2004, and that it expects about 10 million taxpayers to file their tax returns electronically after April 15, 2004. Among these are taxpayers who received an automatic four-month filing extension, taxpayers in certain hardship situations who are eligible for an additional two-month extension, and late filers who did not receive an extension.

IR-2004-72 (5/26/04).

4) Figurehead President Is a Responsible Person for Employment Tax Penalties

A recent case illustrates the pitfalls that can result when an individual agrees to serve as a company's figurehead president. In United States v. Marino, the taxpayer agreed, at the behest of her son's friend, to serve as president of a mortgage lending company. She was not involved in the day-to-day operations of the corporation nor did she participate in corporate decisions. However, when the company did not pay its employment tax obligations, she was the one left holding the bag.

Facts

In 1995, Daniel Myers asked James Kunkle, son of Ellen Marino, to incorporate SUSA/U.S. Financial, Inc. (SUSA), a licensed correspondence mortgage lender. Myers could not serve as an officer of the corporation due to past credit problems. In late 1996 or early 1997, Myers asked Marino to become president, sole shareholder, and mortgage lender license holder for SUSA. Marino agreed and remained president and sole shareholder of the corporation until it ceased operating in 2001. As president, Marino received a salary in 1999 and 2000. In addition, over the course of her presidency, Marino – again at the request of Myers – opened and closed corporate bank accounts, and signed corporate checks. Marino also approved the making and usage of a signature stamp, which Myers used as he desired. Despite her position, Marino had little contact with the business or its employees and took no active role in the corporation's daily operations. In fact, Myers ran the day-to-day affairs of the corporation from its inception until it ceased operations.

In 1999, SUSA sought to expand its business and, as a result, suffered financially. At Myers' request, Marino made a capital contribution of $46,000, and helped to obtain a line of credit for SUSA of $50,000. Later that year, IRS letters began to arrive at Marino's house. Marino learned that SUSA had some tax problems but she relied on Myers' representation that he and the company accountant would handle them.

The following year, the IRS served Marino a summons because SUSA had failed to provide requisite information to the IRS. By this time, the IRS had levied SUSA's accounts. Later that year, Marino, on behalf of SUSA, signed an installment agreement with the IRS to pay the trust fund taxes. The installment agreement provided that SUSA would make monthly payments of increasing amounts to the United States. SUSA defaulted on the installment agreement and filed for bankruptcy. Marino also filed for bankruptcy.

Responsible Person Penalty

Under Code Section 6672, a penalty equal to 100 percent of amounts withheld from the compensation of an employee is imposed if the withheld amounts are not remitted to the United States. The penalty often is referred to as the 100 percent or responsible person penalty. It is imposed on responsible persons, who generally are officers or employees of the entity responsible for remitting the withheld taxes. Responsible persons are subject to the penalty if they willfully fail to collect, account for, and pay employee withholding taxes.

Bankruptcy Court Decision

A bankruptcy court was asked to decide whether Marino was, under Code Section 6672, a responsible person for purposes of SUSA's employment taxes and whether she was liable for the related trust fund penalty. The court held that Marino was not a "responsible" person who "willfully" failed to pay over withheld employment taxes. Specifically, the bankruptcy court noted that Marino lacked any authority or power over the management of SUSA. According to the court, her position as president was in title only and she did not have control over the financial affairs, disbursement of corporate funds, or the ability to hire or fire employees. Myers, the court concluded, had complete decision-making authority over SUSA. The IRS appealed.

District Court's Reversal

A district court reversed the bankruptcy court decision and held that Marino was a responsible person for purposes of the penalty under Code Section 6672. According to the court, a responsible person is a corporate officer or employer who has a duty to collect, account for, or pay over the withheld tax. Responsibility is a matter of status, duty, and authority, rather than knowledge. To determine if a party is responsible, a court may look to several indicia, including: holding corporate office, control over financial affairs, authority to disburse corporate funds, ownership of stock, and ability to hire and fire employees.

The district court found that the bankruptcy court erred by giving too much weight to the undisputed fact that Marino did not actually exercise control over the daily operations and decisions of the corporation. Although Marino did not involve herself in the day-to-day operations of the corporation, the court concluded that by virtue of her position as president, sole shareholder, and sole officer with authority to sign corporate checks, she could have taken an active role in the company. In the eyes of the law, the court concluded, this authority and status is enough to render Marino responsible under Code Section 6672.

5) Code Section 7525 Court Chastises KPMG for Using a Misleading Log to Claim Privilege

KPMG was misrepresenting its unprivileged tax shelter marketing activities as privileged communications and must release the names of clients who have participated in potentially abusive tax shelters. United States v. KPMG LLP, No. 02-0295 (D. D.C. 5/4/04).

As part of an IRS examination of KPMG's promotion of and participation in transactions that the IRS contends are tax shelters, the IRS issued nine summonses requesting information relating to transactions marketed by KPMG. According to the IRS, although KPMG produced many boxes of records in response to the summonses and produced individuals who provided sworn testimony in response to the summonses, it failed to fully comply with the summonses. The IRS also claimed that despite granting KPMG additional time to comply with the summonses, KPMG failed to produce much of the requested material.

Instead KPMG withheld certain documents from the IRS on grounds that the documents were privileged, and KPMG provided the IRS with a privilege log of those documents. Despite the privilege log, however, the IRS argued that the withheld documents were not in fact privileged. In the instant case, the court was asked to decide (1) whether KPMG must release the identity of clients who allegedly participated in tax shelters, and (2) issues surrounding the Code Section 7525 confidentiality privilege.

A district court held that KPMG must identify the individuals who are clients of KPMG and who have participated in potentially abusive tax shelters. The court also concluded that KPMG was misrepresenting its unprivileged tax shelter marketing activities as privileged communications, and claims of privilege under Code Section 7525 were unsupportable for documents that had been reviewed by the court. The court stated that it had lost confidence in KPMG's privilege log since it had been shown to be inaccurate, incomplete, and even misleading regarding a very large percentage of documents. After reviewing the entire record of the case, the court concluded that KPMG had taken steps since the IRS investigation began that were designed to hide its tax shelter activities. In doing so, the court stated, KPMG had cast doubt over its privilege assertions.

CPA Loan Confirmation Letters "New Service"

Q. A potential borrower provided self prepared tax returns with their loan package. What would Don Fitch Accountancy do with them?

A. Don Fitch Accountancy would reconcile and confirm via letter and/or fax that the presented tax returns with the IRS and the related state. This procedure is intended to confirm via a disinterested 3rd party "Don Fitch" that real returns with real numbers are in fact the same returns on file with the IRS and state.

Q. How long will this confirmation procedure take?

A. A. Usually the same day.

Q. Q. How much does this procedure cost either the Lender and/or the borrower?

A. A $300 fixed fee that includes one state. Each additional state costs would cost an additional $50.

Q. Explain Don Fitch Accountancy’s guarantee.

A. A 100% refund of any and all fees paid to Don Fitch Accountancy in the event the lender and/or the borrower is not satisfied with the professional services provided.

GUARANTEED IRS Wage Levy Release Program

Q. The IRS just levied my wages, what does this mean?

A. When the IRS issues a wage levy, your payroll department is required to withhold most of your paycheck (the amount depends on your filing status and exemptions). For most people, this means it is a struggle to pay rent and buy groceries.

Q. Q. How long will the wage levy last?

A. A. The wage levy will last until the tax liability has been satisfied.

Q. What will Don Fitch Accountancy do for me?

A. After receiving your signed Don Fitch Accountancy Agreement and personally prepared financial statement, your own tax manager at Don Fitch Accountancy will step in and negotiate an IRS wage levy release, on your behalf.

Q. Explain Don Fitch Accountancy’s guarantee.

A. A 100% refund of any and all fees paid to Don Fitch Accountancy in the event the wage levy is not released within 30 days after you have provide the required financial information to Don Fitch Accountancy.