Retirement Planning Strategies under the Scrutiny of the Federal Fisc

OLYMPUS DIGITAL CAMERAPresident Obama’s proposed budget for 2016 shows that some retirement planning strategies have drawn the attention of the Federal government and may be subject to future legislative limitations.

The President’s proposed budget suggests that Roth IRA conversions be limited to only pre-tax contributions. This would effectively eliminate the “backdoor” Roth IRA conversions by which taxpayers whose income is too high to contribute pre-tax money into a Roth IRA instead contribute to a traditional IRA with after-tax money and then quickly convert to a Roth IRA.

Additionally, the proposed budget calls for the elimination of “aggressive” strategies for claiming Social Security benefits. The exact strategies at issue are not specified in the proposed budget, so professionals in the industry and those saving for retirement are left to speculate. Speculation has pointed to two particular techniques as those most likely to be addressed. The first, sometimes called the “claim now, claim more later” strategy involves married couples, often dual-earner couples, one spouse of which chooses to accept spousal benefits at full retirement age (age 66), then later switches to receive his or her own benefits when they max out at age 70. A second approach, sometimes called the “file and suspend” strategy, can be used in conjunction with the first. Because one member of a couple typically must file for retirement benefits in order for his or her spouse to claim a spousal benefit, some couples may have one spouse file for benefits at full retirement age, but then immediately suspend their own benefits, allowing the suspended benefits to grow while their spouse still claims a spousal benefit in the interim.

It should be noted that in the current congressional climate, it is unlikely any such proposals would be codified in the near future. It is also unclear how or if any such proposals could be given retroactive effect if they are implemented.

If you have legal questions about your retirement planning strategies, contact the Private Wealth professionals at BakerHostetler.

IRS Plans to Further Restrict Family Business Valuation Discounts

tax iStock_000006743485_LargeIRS regulations anticipated for release as early as this September may further restrict valuation discounts. The exact scope of the regulations is unknown, but the regulations will likely make it more difficult for taxpayers to discount the value of family business interests.

Valuation Discounts Generally

Valuation discounts in family business interests are often utilized in connection with “estate freezes” that deflect future asset growth from the estate of a senior family member to a younger generation member. Families place restrictions—such as restrictions on the owner’s ability to become a full-fledged voting member or partner of the entity—on interests given to junior family members. Splitting interests and dividing control in this way considerably reduces the value of the transferred interests. The most significant valuation discounts arising from such mechanisms are lack of marketability and lack of control discounts. Thus, when appraisals are done for family business interests with such restrictions placed on them, the transferred interests are valued at significant discounts, and the tax on a transfer may be correspondingly reduced. However, the interests still retain economic benefits for the transferees.

Section 2704 Restrictions Background

In 1990, Internal Revenue Code Section 2704 was enacted to curb the use of such techniques that reduce the value of assets in a taxable transfer. Section 2704 ignores certain “applicable restrictions” when valuing interests in family-controlled entities, such as restrictions that effectively limit the ability of the entity to liquidate and that lapse (or that the family has the power to eliminate) after a transfer is made. However, an exception to Section 2704 provides that restrictions imposed by state or federal law continue to be respected, rather than disregarded, for valuation purposes. In response, many states have changed their laws to provide restrictions that might otherwise be ignored for valuation purposes under Section 2704.

New Regulations on the Way

Section 2704(b) gives the Secretary of the Treasury the power to issue new regulations disregarding additional restrictions if the restrictions reduce the value of the transferred interest but not the value of the interest to the transferee. The IRS has interpreted this grant of power broadly and has long maintained its authority to further restrict valuation discounts.

Since 2003, new regulations under Section 2704 have been on the IRS-Treasury Priority Business Plan, and for several years the Administration included a section in its statement of revenue proposals (commonly known as the “Greenbook”) calling for additional legislation to strengthen the Treasury’s authority to disregard restrictions under Section 2704. However, these revenue proposals were noticeably dropped from the Greenbook in 2014, prompting many to conclude that regulations are now imminent. To confirm this, Cathy Hughes, an Estate and Gift Tax Attorney Advisor at the Treasury Department, spoke at a conference in late April this year, and indicated that new regulations may be released in September of this year.

What might the new regulations look like? The 2013 Greenbook, which was the most recent Greenbook to contain the Section 2704 revenue proposals, provides some clues. The 2013 Greenbook proposed several changes, including the following:

  • The addition of “disregarded restrictions” which are “to be specified in regulations” and may extend beyond the scope of the liquidation restrictions currently addressed by Section 2704.
  • The attribution of the voting power of certain minority interests held by charities or non-family members (to be specified in regulations) to the family for purposes of assessing family control.
  • The addition of safe harbors to permit taxpayers to prepare governing documents for a family-controlled entity so as to avoid the application of Section 2704.

Commentators have also considered a variety of other possibilities for the new regulations. For example, some commentators suggest that the new regulations might distinguish between holding and operating companies and apply more restrictive regulations to the former. Still other commentators believe that the regulations may limit the availability of minority and marketability discounts for transfers involving family-controlled entities, notwithstanding legislative history that clearly indicates that Section 2704 was not intended to affect such discounts.

If you are considering a transfer with valuation discounts, now is the time to act. While the effective date of the looming Section 2704 regulations is unknown, regulations are typically effective prospectively. In the normal course, regulations are issued in proposed form, comments are invited for a period of time, and final regulations are issued thereafter. The effective date of the regulations is typically the date of the final regulations; however, in some cases, regulations have been deemed effective as of the date of the proposed regulations. (Notwithstanding the foregoing, even a transaction completed before the release of the Section 2704 regulations is not guaranteed to avoid scrutiny under the regulations because the IRS could attempt to treat the regulations as interpretive of existing law.)

For more information, please contact Chad Makuch (216-861-7535 or Chad is an associate with BakerHostetler’s Private Wealth team and prepared this blog posting with the assistance of Amanda Tate, a 2015 summer associate in BakerHostetler’s Cleveland office.

The Ohio Supreme Court Places Limitations on the Ohio Bright Line Income Tax Residency Presumption

Ohio Flag Of The State Of OhioOn July 8, 2015, the Ohio Supreme Court found that Ohio nonresidents may not claim the benefit of the Ohio “bright line” presumption of nonresidency for income tax purposes if the taxpayer attests to having a domicile outside Ohio on the required Affidavit of Non-Ohio Domicile and the tax commissioner is in possession of information providing a “substantial basis” that the person is domiciled in Ohio under common law principles. For the tax years at issue, Ohio Revised Code (“R.C.”) §5747.24 provided that if a person maintains a place of abode outside the state of Ohio for the entirety of a tax year, is not present in Ohio for more than 182 contact periods (roughly an overnight period away from home), and timely files an affidavit of non-Ohio domicile with the tax commissioner, the person is irrebuttably presumed a nonresident of Ohio for income and school district income tax purposes, provided the person does not make a “false statement” in the affidavit. For tax years 2015 and later, a person may have no more than 212 contact periods in the state and retain the irrebuttable presumption.

In Cunningham v. Testa, Slip Opinion No. 2015-Ohio-2744, the taxpayer, Mr. Cunningham, argued that although his common law domicile was in Ohio, he was nevertheless irrebuttably presumed a nonresident of Ohio under the Ohio bright line presumption. Mr. Cunningham timely filed the required Affidavit of Non-Ohio Domicile for tax year 2008, which requires the affiant attest to not being domiciled in Ohio at any time during the tax year, and state where he or she was domiciled. Although R.C. §5747.24 does not require a statement of where the affiant was domiciled, this is a requirement on the affidavit form. Mr. Cunningham indicated he was domiciled in Tennessee in 2008, but in January 2008, Mrs. Cunningham filed an application for homestead exemption from property tax on the Cunninghams’ residence in Cincinnati, Ohio, and both Mrs. and Mr. Cunningham signed the application. The homestead exemption application requires the applicant to state, under penalties of perjury, that the residence for which exemption is sought is the applicant’s principal place of residence. Mrs. Cunningham had not filed an affidavit form, and her status as an Ohio resident was not contested before the court.

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Trusts Find Shelter from State Taxes in State Courts

tax iStock_000006743485_LargeIn two recent cases, taxpayers have successfully challenged state taxation of trust income on the basis that the taxing states had a minimal connection to the trust.

In The Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Dept. of Revenue, 2015 WL 1880607 (April 23, 2015), the court ruled that both the North Carolina Constitution and the U.S. Constitution prohibited North Carolina from taxing the income of a trust when the trust’s only connection to North Carolina was the residence of some of its beneficiaries. The trust in question was created by a New York resident with another New York resident as initial trustee, and the trust was governed by New York law. When the trust was divided into separate shares for each of the grantor’s children, one of those children and her descendants lived in North Carolina. The trust for the North Carolinian beneficiaries was discretionary, and they in fact received no distributions from the trust during the taxable years at issue in the case. Further, the custodian of the trust’s investments was located in Boston, Massachusetts; all records were retained in New York; and no trustee was ever a North Carolina resident. The state of North Carolina still assessed taxes of over $1 million on accumulated trust income. A North Carolina statute provided for taxation on the “amount of taxable income of the estate or trust that is for the benefit of a resident” of the state. The Superior Court for Wake County granted summary judgment to the trustee, ruling that the North Carolina statute violated the commerce and due process clauses of both the North Carolina Constitution and the U.S. Constitution.

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Bitcoin and the Like: Further Tax Developments to Monitor

bigstock-Bit-Coin--BTC-54872525Virtual currency developments continue to emerge, including state tax guidance, a court decision on deductibility of losses, and the Uniform Fiduciary Access to Digital Assets Act (the “Act”).

State Tax Guidance

The New Jersey Division of Taxation released Technical Advice Memorandum 2015-1 (the “NJ TAM”). The NJ TAM explains New Jersey’s treatment of virtual currency; that is, New Jersey treats virtual currency as property in conformance with Internal Revenue Service (IRS) Notice 2014-21 (detailed in a previous post). New Jersey takes its guidance two steps further than the federal guidance: (1) sales and use tax, and (2) corporation business tax and gross income tax.

First, a customer who uses convertible virtual currency to pay for property will be viewed as engaging in a barter transaction. In a barter transaction, if what is received in exchange is subject to sales tax, then sales or use tax is due from each party based on the value of the property or services given in a trade. The state statute provides that a sale includes a barter transaction. New Jersey imposes sales tax on the receipts from retail sales of tangible personal property, specified digital products, and enumerated services. The NJ TAM explains how, in a barter transaction, one party must forfeit something of value in order to receive something of value. If a customer purchases a good with convertible virtual currency, sales tax is due on the amount allowed in exchange for the virtual currency, or (put another way) the purchase price of the goods received. The NJ TAM imposes a record-keeping obligation on sellers who accept convertible virtual currency as a form of payment for goods. Among other things, sellers must record the regular selling price of the same or similar product when sold in United States dollars, and the amount of sales tax collected.

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Bitcoin and the Like: Tax Considerations

bigstock-Bit-Coin--BTC-54872525Virtual currency is a new, untested, and unregulated asset. The Internal Revenue Service (IRS) defines “virtual currency” as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. “Convertible virtual currency” is virtual currency that has an equivalent value in real currency, or acts as a substitute for real currency. For simplicity, this post will use the terms virtual currency and convertible virtual currency interchangeably. Virtual currency is held for investment, used to pay for goods and services, and traded through online exchanges. Bitcoins and Ripples are the most well-known types of virtual currency. Bitcoins and Ripples contain their own version of virtual currency and systems, including payment systems. A Bitcoin or Ripple is sent between two accounts, converted into other currency, or used to pay for goods and services. Both Ripples and Bitcoins are finite in number, with only a certain number existing. Virtual currency is volatile, with unpredictable swings in value.

A particular virtual currency’s long-term viability is questionable because virtual currency is far from “mainstream.” Few merchants accept virtual currency for payment. Virtual currency is unregulated and decentralized, meaning there is no bank or governmental oversight. Taxpayers, however, might have to report virtual currency held in foreign exchanges to the IRS. Although the accounts currently are not subject to Report of Foreign Bank and Financial Accounts (FBAR) requirements, commentators opine that, in the future, virtual currency accounts could be subject to FBAR and the foreign exchanges could be subject to reporting under the Foreign Account Tax Compliance Act. Virtual currency is subject to higher scrutiny by law enforcement agencies due to perceived abuses. In law enforcement’s view, because virtual currency transactions are largely anonymous, opportunities exist for money laundering and tax evasion. Continue Reading

Obama Proposes “Middle Class” Tax Increases at Death

The prospects of significant tax legislation this year are low. Nevertheless, when the President proposes “tax reform” it makes headlines. The Obama administration’s latest tax proposals for fiscal year 2016 would increase dramatically both the rates of transfer/income taxation at death and the number of people subject to those higher taxes in the event of a family member’s death.

Since 2011, the lifetime federal estate tax, gift tax, and generation-skipping transfer (“GST”) tax exemption equivalents applicable to each individual have been set at $5,000,000, adjusted each year for inflation ($5,430,000 per person in 2015). For the few individuals who make taxable gifts or who have taxable estates in excess of $5,430,000, the federal estate, gift, and GST tax rates have been set at 40%.

As now in effect, far less than 1% of decedents’ estates are subject to federal estate tax. Thus, under current law, the vast majority of Americans would be able to transfer to their children or other loved ones whatever wealth they may have left at their death, free of any federal estate tax. Continue Reading

Repeated IRS Warnings Haven’t Stopped Telephone Scams

In October 2013, the IRS issued taxpayers a warning about a pervasive telephone scam designed to solicit payments and release of personal information from individuals. The IRS issued a second warning concerning the scam near the end of the 2014 filing season, but the calls have continued into the 2015 filing season with no end in sight.

Scammers have largely targeted elderly persons and recent immigrants. Victims receive calls from people impersonating IRS employees, often complete with false badge numbers and fictitious common names. Some callers are able to mimic the IRS toll-free number on the victims’ caller identification systems and send corroborating e-mails from phony IRS e-mail accounts. The callers generally have very limited information about their victims, though some are able to recite the last four digits of their victims’ Social Security numbers. Callers claim that the call recipients owe the IRS fees or back taxes. Many then try to arrange payments with prepaid debit cards or wire transfers while also soliciting further identifying information from their victims. Callers often threaten arrest, and those targeting recent immigrants may threaten deportation.  Continue Reading

U.S. Supreme Court Agrees to Hear Cases Regarding the Constitutionality of Same-Sex Marriage Bans

The U.S. Supreme Court has agreed to hear four cases from Ohio, Michigan, Kentucky, and Tennessee, respectively, regarding the constitutionality of same-sex marriage bans by the states. While the Court’s decision to hear the cases was anticipated (as previously discussed here), the decision is nonetheless exciting. Arguments are expected to be presented in April of this year, and the U.S. Supreme Court may very well issue a ruling resolving the state-by-state conflict over same-sex marriage by June. Such a resolution to the state-by-state conflict over same-sex marriage would be a welcome development and would bring a great deal more clarity to trust and estate planning for same-sex partners.

For more information, please contact Chad Makuch at (216) 861-7535 or

Still Waiting For Guidance on Material Participation

In March 2014, I commented on the US Tax Court decision in the Frank Aragona Trust case. In that case, the tax court disagreed with the Internal Revenue Service’s arguments that a trust was incapable of providing “personal services” to meet the material participation test under IRC § 469 (c)(7).

In November 2013, when the Service issued the final net investment tax rules, it promised to address the material participation dilemma. To date, no guidance other the Service’s arguments in several court cases have been issued.

Most practitioners take the position that a fiduciary’s participation in the activities in question in any capacity should count for purposes of the material participation determination. The American Institute of CPAs (AICPA) has recommended that when there are multiple fiduciaries, material participation by any one fiduciary should be sufficient for purposes of satisfying the material participation test under IRC § 469 (c)(7). The American Bar Association (ABA), in a recent letter to the Service, urged the Service to allow fiduciaries of a trust or estate to use the same tests that individuals use to establish material participation in a trade or business. The ABA’s letter proposed two alternative tests to determine whether an individual materially participated: an objective hours test and a subjective facts and circumstances test. The hours test would be satisfied on the basis of hours invested by an individual with fiduciary duties to the beneficiaries of the trust or estate, if that individual has the decision-making authority and power to act on behalf of the trust or estate in the trade, business or rental activity. The facts and circumstances test would be satisfied by aggregating the participation of all fiduciaries of the trust or estate, their employees, and agents in the trade, business or rental activity. The Service’s position has been that the activities of a fiduciary’s agents and employees are not considered for purposes of material participation; however, the holdings in the Frank Aragona Trust and Mattie Carter Trust cases, along with continued urging from practitioners, might influence any guidance from the Service on these issues.

The waiting continues.