Happy Mother's Day! Son Tries to Deduct Over $1MM in Legal Fees to Parents

So how much would you pay to have your child take care of you when you’re old and infirm?

According to one tax attorney, $1.2 million. At least that is the take away from Estate of Olivo v. Commissioner.

"The court considered whether mom’s estate could deduct $1,240,000 for son’s services before mom died. Tax lawyer Anthony Olivo worked in law firms from 1976 to 1988, then opened his own practice.

Yet by 1994, he was devoting so much time to his parents and their health problems that it was hard to maintain his practice. He lived with his parents and gave them round-the-clock care. That left little time to practice law, so from 1994 through 2003, he earned almost nothing from his practice.
So when they died he figured the estate should pay him all those lost wages. Hey, it’s deductible, he said. The court had to decide whether the estate could deduct the $1,240,000. On top of that was the $44,200 administrator’s commission Anthony received, not to mention $55,000 in accountant’s and attorney’s fees.
The court was careful to say that Anthony rendered extraordinary care. Hey, this was a doting son. His efforts were commendable. However, mom’s estate couldn’t prove that Anthony was entitled to any pay or how much his services were worth.
There was no contract, no invoice, and no evidence the family agreed to pay him anything. Sure, Anthony gave round-the-clock care. The family would have hired round-the-clock nurses if he hadn’t been there.
But he was, and the fact that a nurse would have been paid didn’t mean pay to Anthony was deductible. Anthony even considered billing the estate for his legal services.
After all, apart from his personal care and for administering the estate, he performed legal work too. He filed the estate tax return, handled an IRS audit and the estate’s Tax Court petition.
But here again, Anthony was out of luck. He didn’t keep time records, prepare invoices, or establish the value of what he did. He merely estimated his hours at a $150 hourly rate. That kind of loosey-goosey estimate wasn’t enough for a deduction.
The biggest lesson? Contracts, invoices, and good record-keeping are as important with family or related parties as anywhere else. In fact, perhaps there’s a bigger reason for being scrupulous with family and related parties: to save yourself headaches with the IRS. Happy Mother’s Day, Mom."

(Hat Tip:  Attorney Robert Wood of Forbes)

Year-End Gift Planning: How Valuation Clauses Can Get Around a Late Appraisal

With the abnormally high gift/estate tax exemption amounts of $5.12 million set to sunset at the end of this year, many attorneys, CPAs and tax-advisors are rushing to help their clients take steps to make significant gifts.  For those who wish to take advantage of this unique opportunity, the clock is winding down.  For the gifts to be effective this year, the transfer must be completed by December 31.

Unfortunately, many planners are now realizing that scheduling appraisals this late in the year means that they will likely not have the appraisal figures back until next year.  Thus, a donor is left to wonder, if I want to make a gift of say, exactly $5.12 million to my children, how do I know how many shares of stock or LLC units to transfer this year if I won't know the value until next year.

Fortunately, due to the availability of defined value clauses and some recent Tax Court cases, the donor (and his/her advisers) can make large gifts with confidence.

In short, a donor need not specificy the exact number of LLC units given, all that needs to be specified is that value to be transferred, expressed in a mathematical formula.

A good example of such a formula clause is found in the recent Wandry decision, and reads as follows:

I hereby assign and transfer as gifts, effective as of January 1, 2004, a

sufficient number of my Units as a Member of Norseman Capital,

LLC, a Colorado limited liability company, so that the fair market

value of such Units for federal gift tax purposes shall be as follows:

                   Name                             Gift Amount

                   Kenneth D. Wandry        $261,000

                   Cynthia A. Wandry           261,000

                   Jason K. Wandry              261,000

                   Jared S. Wandry               261,000

                   Grandchild A                     11,000

                   Grandchild B                     11,000

                   Grandchild C                     11,000

                   Grandchild D                     11,000

                   Grandchild E                     11,000

                                                          1,099,000

Although the number of Units gifted is fixed on the date of the gift, that

number is based on the fair market value of the gifted Units, which

cannot be known on the date of the gift but must be determined after

such date based on all relevant information as of that date.

Furthermore, the value determined is subject to challenge by the

Internal Revenue Service (“IRS”). I intend to have a good-faith

determination of such value made by an independent third-party

professional experienced in such matters and appropriately qualified to

make such a determination. Nevertheless, if, after the number of gifted

Units is determined based on such valuation, the IRS challenges such

valuation and a final determination of a different value is made by the

IRS or a court of law, the number of gifted Units shall be adjusted

accordingly so that the value of the number of Units gifted to each

person equals the amount set forth above, in the same manner as a

federal estate tax formula marital deduction amount would be adjusted

for a valuation redetermination by the IRS and/or a court of law.

In short, while it would be preferrable to get the value before making the gift, a formula clause like the above gives the donor, and other professionals some breathing room.

Of course, one big caveat is to ensure that when the gift tax return is filed that the language on the return matches the language on the gift.  If the return just lists the exact number of shares, units, or percentage interest transferred the donor exposes himself to a potential challenge from the IRS alleging that a formula clause was not utilized. 

Tax Court Rejects The "TurboTax" Defense

In an argument that reminds me of Tim Geithner's painful Senate hearings, a taxpayer claimed that her failure to account for all of her taxable income was the result of "honest mistakes" resulting from her lack of familiarity with the TurboTax progam.  Unfortunately for her, the Tax Court did not buy it, Bartlett v. Commissioner, T.C. Memo. 2012-254 (Sept. 4, 2012):

Petitioner claims she used the audit portion of the TurboTax program, believing the audit portion would catch any mistakes she otherwise might make. ...It is apparent that a portion of the information petitioner entered into the TurboTax program was incorrect; hence the mistakes made (which resulted in the underpayment) were made by petitioner, not TurboTax. TurboTax is only as good as the information entered into its software program. See Bunney v. Commissioner, 114 T.C. 259, 267 (2000). Simply put: garbage in, garbage out.

Hat Tip (Tax Prof Blog)

Do My Gifts of Limited Partnership Interests Qualify for the Annual Exlusion?

Under current law, a person has a right to give away $13,000 of assets to as many people as they see fit--free of gift tax.  This is commonly referred to as the "annual exclusion". 

One question that has developed over the years has been whether annual gifts of a family limited partnerships are eligible to qualify for the annual exclusion.  The hiccup was that in order to be considered a gift eligible for the annual exclusion, the gift has to be a gift of a present interest, and not just some future right or benefit. (Reg. 25.2503-3(b).)  The courts have held that in order to qualify as a present interest, the gift must confer a present economic benefit by reason of the use, possession, or enjoyment  i) of property or ii) of income from the property.

The tricky part with gifts of family limited partnership interests is that most of their partnership agreements provide restrictions on transfers--so as to ensure the business interests remain in the family.  The only problem is that the courts view these transfer restrictions as precluding the donees from having the right to use or enjoy the interest in a meaningful way.  Thus, courts are left to consider whether there is income that is of use or benefit to the donee.

The recent case of the Estate of George  H. Wimmer, TC Memo 2012-157, recently considered such a question and reiterated that for gifts of limited partnership interest to qualify for the annual exclusion under the argument that the donee received income, they must prove three things:

1. That the partnership would generate income,
2. That some portion of the income would flow steadily to the donees, and
3. That a portion of the income could be readily ascertained. 

Often, partnership agreements contain language granting the general partners full discretion as to whether or not distributions will be made to the partners--which would not appear to satisfy the second requirement.  In Wimmer, the Court noted that the general partners owed fiduciary duties to the donee limited partners, and that because the donee limited partners were actually irrevocable trusts, the only way such trusts would be able to pay their share of income tax would be for the partnership to make a distribution of income.  Based on these unique facts, the court held that the income would in fact flow steadily to the donees.

In short, before deciding whether to make annual gifts of family limited partnerships, the partnership agreement should be read carefully so as to ensure that it contains language that will ensure such gifts will be treated as present interests and eligible for the annual exclusion. 

California Entrepreneur Fills Out Form Himself-- Loses $18.5 Million Charitable Deduction

In what can be considered one of the harshest Tax Court cases of the year, the Tax Court denied a gigantic charitable deduction because admittedly "confusing" IRS forms were not filled out properly.

A prominent Sacramento real estate broker, certified real estate appraiser, and entrepreneur, donated six properties worth at least $18.5 million to a charitable remainder trust in 2003 and 2004, but failed to read and ultimately follow the instructions to Form 8283 (Noncash Charitable Contributions).  Although the Tax Court acknowledged that "the property was quite likely more valuable than the [broker] reported on [his] tax returns," the Tax Court denied the claimed charitable deduction for failure to comply with the substantiation requirements.  Ouch. Mohamed v. Commissioner, T.C. Memo. 2012-152 (May 29, 2012):

We recognize that this result is harsh—a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions—all reported on forms that even to the Court's eyes seemed likely to mislead someone who didn't read the instructions. But the problems of misvalued property are so great that Congress was quite specific about what the charitably inclined have to do to defend their deductions, and we cannot in a single sympathetic case undermine those rules.

The lesson here is that any time a person seeks a charitable deduction for real estate, a competent adviser should actually prepare the Form 8283 and ensure that any attached appraisal meets IRS requirements. 

(See more from Tax Prof)

Formula Value Gifts--How to Make a Gift That is Essentially Audit Proof

"I hereby make a gift of a portion of my LLC interests worth $X to my son, BUT, if the IRS audits me and says that this gift is worth much more than $X, than I really gave much less of my LLC interests so that this gift will not incur gift tax."

While the above headline and gifting statement is an oversimplification, a recent Tax Court case, Wandry v. Commissioner, has opened up a realm of possibilities for those interested in making gifts of business interests to their children.  Normally, a person can make a tax free gift of $13,000 annually (for 2012) to as many recipients as they wish.  Thus, a business owner could give away large portions of his business piece-by-piece ($13,000 each year) without suffering any adverse gift tax consequences.  However, the hardest thing to determine when dealing with family businesses is how much of that ownership interest actually equals the tax free gift amount of $13,000.  While appraisals are normally acquired, the IRS can always challenge the appraised value and argue that the gifts of interests you made were really worth much more than $13,000, leaving you with a potential gift tax liability.

The Wandry case is promising because the Tax Court allowed the use of a formula value clause in a gift agreement which means that if there were ever an audit and the appraised value of the business were increased, then the percentage of ownership interests deemed gifted would be changed to ensure no gift tax would be incurred.  In short, while the IRS could audit you and challenge the value of the gift, there would be no incentive to do so as if the value increased, there would still be no increase in gifts.  Understandably, the IRS has challenged formula value clauses on public policy grounds as it creates a situation where taxpayers can make aggressive low-ball valuations without any fear of audit consequences if those valuations are disregarded.

Prior to Wandry, the best advice was for a family to designate a charity to receive any excess value after audit adjustments--no extra tax would be due but the family would lose some control.  Wandry really opens up possibilities for strategic giving, particularly for those families using FLPs or FLLCs to make gifts to their children.

Employee Could Not Deduct Forgiven Interest on Employer's Loan

In a recent Tax Court case a taxpayer employee was denied interest deductions on a loan from his employer after the employer forgave the loan.

The taxpayer was recruited as a stock broker and as part of his compensation, the employer lent him $500,000, upfront, which was to be paid back by the taxpayer (including interest) at the end of each year over five years.  However, the note provided that the employer could forgive that year's installment payment if the taxpayer continued working for the employer.  (This arrangement is fairly common and allows the employer to give an employee a large signing bonus, while spreading tax payments over several years). 

The taxpayer worked for all five years and so all principal and accrued interest was forgiven and such forgiven amounts were properly included in the employee's income.

However, the taxpayer argued that he should be allowed to deduct the forgiven interest from income because under Section 108(e)(2),  the payment of such interest would have been otherwise deductible under Section 212 as being incurred for the production of income (namely, his work as a stock broker). 

Unfortunately for the taxpayer, the Tax Court held that he did not produce enough evidence to show that he used the $500,000 loan proceeds to buy stock or securities, but simply produced a list of transactions he had entered into.  As such, there was no ability to trace the use of the loan proceeds to those financial transactions. 

It is imperative that anytime an employer and an employee enter into a loan arrangement that both parties keep accurate records and seek advice from competent tax advisers to ensure that the loan is structured properly. 

(Brooks v. Commisioner, T.C. Memo. 2012-25)