The most recent revision of the S.C. Department of Revenue’s Form SC2848, Power of Attorney and Declaration of Representative, contains a significant change that will affect communications between the Department and a taxpayer’s representative. Some practitioners may not have detected this change upon first glance, and, as such, may want to take a closer look.
Previously, Form SC2848 (Rev. 11/15/07) provided that all notices and other written communications will be automatically sent to the first representative listed. If an individual did not want any notices or communications sent to his or her representative, he or she could elect to “opt out” by checking the corresponding box. This is similar to the Internal Revenue Service’s Form 2848, Power of Attorney and Declaration of Representative, which allows a taxpayer or practitioner to “opt out” of receiving notices and communications from the Service.
In stark contrast, Form SC2848 (Rev. 1/9/09) now requires an individual to “opt in” if he or she wants notices or communications sent to his or her representative. The ramifications of not checking the box can be disastrous at worst and can result in delays in communications at best. Most clients assume you are getting the same correspondence as they are; after all, they are paying you to represent them before the Department.So don’t get left in the dark. Make sure you check the box and alert your clients that they need to let you know when they receive correspondence from the Department.
After a divorce, individuals sometimes forget to change the designated beneficiary of such nonprobate assets including life insurance, IRAs and 401(k) accounts. It is incumbent for a divorcee to update his or her estate plan. A client advised to “update his estate plan” may execute a new Last Will and Testament and powers of attorney but not think about updating payable on death designations. If an individual does not update his Last Will, S.C. Code Ann. §62-2-507 revokes the portion of the Will that would leave any property to the ex-spouse and any provision in the Will which names the ex-spouse as executor. I am not aware of any statute that would revoke an ex-spouse’s right to serve as an attorney-in-fact under a power of attorney. Some states have statutes that revoke beneficiary designations for nonprobate assets. See, for example, Wash. Rev. Code § 11.07.010(2)(a). I am not aware of any South Carolina statute that would revoke an ex-spouse’s designation as a beneficiary of a nonprobate asset.
The following line of cases deals with the effect a divorce has on nonprobate transfers and hinges primarily on the waiver language used in the separation agreement:
A recently decided case deals with qualified retirement plans governed by ERISA. Regardless of what a separation agreement provides, an ERISA plan will be governed by the “plan document rule.” Kennedy v. Plan Administrator for DuPont Savings and Investment Plan, 129 S.Ct. 865, 172 L.Ed.2d 662 (Jan. 26, 2009).
The U.S. Supreme Court said that a plan administrator need look no further than the terms of the plan document. Assume you have a separation agreement in which one party specifically waives his/her rights to the other party’s 401(k) account. Since the 401(k) plan documents will probably provide that the only way to change a designated beneficiary is by delivering a completed form to the plan administrator, the separation agreement will not terminate the designation of the former spouse as the beneficiary of the 401(k) account. The plan administrator will pay the account to the former spouse upon the death of the participant. The participant’s heirs or successors may have a claim against the former spouse, but they will have no claim against the administrator of the 401(k) plan.
The new Health Care and Education Reconciliation Act of 2010 passed this year may have some very unhealthy consequences for unwitting small businesses and individual taxpayers in the form of strict liability tax penalties. With close to 150 million federal income tax filers in the country, taxpayers are given no comfort in the revelation that Congress enacted yet another strict liability penalty for transactions that lack “Economic Substance.” The weight of the Economic Substance penalty is sure to be borne by small businesses and individuals, not the large corporations that can afford the costs of engaging in controversy with the IRS.
With the enactment of the strict liability penalty, the IRS apparently seems unable to learn from its past mistakes. Section 6707A was enacted to impose strict liability for the failure to disclose and report tax shelters to the IRS. Although the penalties reaching $300,000 per year were intended for large corporations, Section 6707A victimized many small businesses for attempting to do good deeds such as establishing employee benefit plans. Laura Saunders, Small-Business Owners Fret Over Large IRS Fines, The Wall Street Journal, September 19, 2009 at B1.
As word spread of the damage being caused to small businesses by Section 6707A’s strict liability, senators and congressmen from around the country pleaded with the IRS to cease its imposition. What resulted was a moratorium on the collection of the penalty until Congress created a solution. Letter from Max Baucus, Chairman, Senate Committee on Finance, Charles Grassley, Ranking Member, Senate Committee on Finance, John Lewis, Chairman, House Committee on Ways & Means, and Charles W. Boustany Jr., Ranking Member, House Committee on Ways & Means, to Douglas H. Shulman, Commissioner, Internal Revenue Service (June 12, 2009) (available at the U.S. Senate Committee on Finance website). Even the National Taxpayer Advocate Nina Olson accused the fine of being unconstitutional in her yearly report. Taxpayer Advocate Service, 2008 Annual Report to Congress, vol. 1, p. 421. Congress has not fixed 6707A’s unintended damages but, nonetheless, the IRS marches forward with strict liability penalties for transactions that it unilaterally deems to lack economic substance.
By way of reference, a strict liability penalty is one for which there exists no reasonable cause defense under Section 6664. Even if the taxpayer had a reasonable basis for the position by relying on a tax professional in good faith and discloses the transaction to the IRS, the penalty still applies. See 26 U.S.C. §6707A(a); Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (to codify “economic substance” at 26 U.S.C. §7701(o)(1)). Thus, the only defense is to convince the IRS that the transaction in fact has economic substance. Good luck.
In theory, the IRS’s stated policy is against strict liability. Policy Statement 20-1 provides that the “Service will demonstrate the fairness of the tax system to all taxpayers by … providing every taxpayer against whom the Service proposes to assess penalties with a reasonable opportunity to provide evidence that the penalty should not apply; giving full and fair consideration to evidence in favor of not imposing the penalty, even after the Service’s initial consideration supports imposition of a penalty; and determining penalties when a full and fair consideration of the facts and the law support doing so.” Perhaps Congress should reexamine the IRS stated policies when deciding whether to enact strict liability penalties that strip the taxpayer’s right to full and fair consideration. In addition, the penalties are not insignificant.
The Economic Substance penalty is 20 percent of the taxpayer’s understatement if the transaction is disclosed and 40 percent if the transaction is not disclosed under Section 6662. In addition, the Section 6662A penalty is also stacked on top of it, which is another 20 percent. Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (to be codified at 26 U.S.C. §6662(b)(6)).
If a potential 60 percent penalty is not daunting enough, the economic substance doctrine is one of the most fluid and facts-and-circumstances based “test” in the Code and is a judicially created vehicle whose standard varies from circuit to circuit. In general, the Economic Substance Doctrine stands for the idea that anticipated tax benefits from a transaction may be denied, even if the transaction completely complies with the technical aspects of the Internal Revenue Code, if the transaction otherwise does not result in a meaningful change to the taxpayer’s economic position other than a reduction in federal income tax. See Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89 (4th Cir. 1985); see also ACM P’ship v. Comm’r, 157 F.3d 231 (3d. Cir. 1998). The codification does not provide further clarity.
Section §7701(o) states that “[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.” The only defined term relating to Section 7701(o) is “economic substance doctrine,” which is defined as the “common law doctrine [under which certain tax treatment may be disallowed if the transaction does not have economic substance].” Simply adopting a common law doctrine that varies from circuit to circuit implants ambiguity in the statute.
Congress also failed to define terms such as “transaction to which the economic substance doctrine is relevant”; “changes”; “meaningful way”; “taxpayer’s economic position”; and “substantial purpose.” The codification provides no further assistance in determining any red flags that may trigger a transaction’s disallowance. In fact, Congress seems to have codified the judicial doctrine and inserted some new, undefined terminology that will keep the litigation lively.
The issue with the application of the Economic Substance doctrine is that it is usually applied to transactions that occurred many years ago, and then the IRS makes a decision to aggressively attack the transaction. One such transaction of late would be stock loan transactions consisting of non-recourse loans individuals and businesses took on a stock portfolio. Many taxpayers’ advisors agreed with the loan treatment under the Internal Revenue Code. Even though law existed to support the loan treatment and the taxpayer did actually transfer stock to the lending entity, the courts agreed with the IRS that the transactions lacked economic substance. Nagy v. United States, Slip Copy, 2009 WL 5194996 (Dec. 22, 2009). These taxpayers would be subject to a 60 percent penalty because the loan proceeds would not have been disclosed on the return, and the return preparer may be subject to preparer penalties.
In the future, what could keep the IRS from taking the position that the discounts related to the transfer of Family Limited Partnership interests funded with stock, bonds and other liquid assets lack economic substance? I am sure that every tax practitioner could think of a client who engaged in a transaction in the past that may lack economic substance.
By codifying this ambiguous, strict liability economic substance penalty, Congress is undoubtedly placing an insurmountable burden on small businesses and individuals. The IRS will not consider any documentation, CPA’s advice, tax opinions or other facts and circumstances that could support a reasonable cause defense before imposing this penalty. There is no defense to this penalty on the administrative level unless you can convince the IRS that the transaction does have economic substance. Should the IRS remain unconvinced, the only option left is to litigate the economic substance issue, which is a fact intensive and expensive process, especially when facing the litigation resources of the United States. Jasper L. Cummings, Jr., Making Litigation Complex, Tax Notes, June 28, 2010.Congress seems intent on implementing harsher and harsher penalties to raise revenue at the expense of small businesses and individual taxpayers.
In 2001, Congress enacted legislation that provided for a one-year, temporary repeal of the federal estate and generation-skipping transfer (GST) taxes. That year is 2010. Ever since 2001, most practitioners have expected Congress to either make the repeal permanent or provide that the tax would continue through and after 2010 with exemption amounts and rates similar to those applicable in 2009. Instead, the one-year repeal is in effect now, and the rates and exemptions are set to return to the same levels that existed in 2001 when the legislation was originally enacted.
While there are many implications of the one-year repeal from a tax planning perspective, the state law interpretive and dispositive implications of the one-year repeal are beginning to manifest themselves as well. A recent article in the South Carolina Lawyer provides an excellent summary of these issues. Boyle, Medlin and Zaritsky, Construing Wills and Trusts During the Estate Tax Hiatus in 2010, South Carolina Lawyer (September 2010).
In general, the problem arises in wills and trusts that contain formulas using federal estate and GST tax definitions and terms. For persons dying in 2010 these terms have no meaning, and a mechanical application of the formulas can produce results that are nonsensical and, especially in the case of wills and trusts drafted prior to the 2001 legislation, almost certainly not what the decedent intended.
For example, many tax formula wills require that the decedent’s estate be divided with the surviving spouse, or a marital trust, to receive an amount of assets equal to the “maximum marital deduction” allowable to the estate, less the maximum amount of assets that can pass free of estate tax other than by way of the marital deduction. The balance of the estate then goes to a family or credit shelter trust (of which the surviving spouse may or may not be a beneficiary). In 2010, the term “maximum marital deduction” has no meaning, and the amount of assets that can pass free of tax other than by the marital deduction is all of the estate assets. Therefore, such wills could be interpreted as requiring that all estate assets pass to the credit shelter trust and none to the surviving spouse.
In contrast, other tax formula wills divide the estate by devising an amount equal to the then applicable “unified credit” exemption amount to the credit shelter trust and the balance to the surviving spouse. Here, because “unified credit” has no meaning in 2010, the surviving spouse is arguably entitled to all of the estate assets.
In fact, there are many different ways that tax formula divisions have been expressed in estate planning documents. Some documents use a fractional division of the estate as opposed to a pecuniary division. Many documents use the GST exemption amount as a benchmark for division. In general though, as long as there was an estate and GST tax in effect at the time of the decedent’s death, the results under all of the formulas were the basically the same, and the mechanics of making the division was driven by more subtle concerns (such as post-death appreciation or depreciation in asset values). However, in the absence of an estate and GST tax, the specific language used to make the division of the estate ends up controlling the ultimate disposition of the estate assets. And, as in the case of the examples above, it is almost always an “all or nothing” proposition, with the surviving spouse either inheriting all of the estate or none of the estate.
Neither result is likely what the decedent intended. Moreover, it is very unlikely that the decedent even contemplated the effect that a one-year repeal of the estate and GST taxes would have on the estate. Therefore, trying to glean the decedent’s intent from the will or trust document is arguably a fruitless exercise.
Earlier this year, the S.C. General Assembly considered enacting legislation that would have deemed 2009 estate and GST tax law to apply for purposes of interpreting the dispositive provisions of wills and trusts containing tax formulas if the decedent died in 2010 and if the will or trust document did not otherwise address a no-tax situation. However, a number of practitioners objected to the proposed legislation. They pointed out that fiduciaries and beneficiaries might want to argue that all of the decedent’s assets should be distributed to either the marital share or the bypass trust, depending on the circumstances. In large estates, the one-year repeal could be viewed by a surviving spouse (and family members) as an opportunity to pass significantly more than $3,500,000 (the 2009 exemption amount) in assets to the next generation without having to pay estate taxes in future years at potentially higher rates and with a smaller exemption. Since the decedent adopted a will or trust that sought to minimize federal estate and GST taxes, the estate fiduciaries could certainly make a reasonable argument that a disposition of the estate that minimizes these taxes would have been the decedent’s intention if he had ever contemplated the current tax situation.
Therefore, rather than impose a presumption that the decedent would have wanted 2009’s tax laws to apply, the legislature enacted, and the governor signed, Act 251, R 314, S 1348 (effective June 11, 2010). The new Act will be codified as Section 62-2-612, see Boyle, Medlin and Zaritsky at 39, and reads as follows:
The statute makes it clear that fiduciaries and even affected beneficiaries can bring an action to have the decedent’s intent determined. What is still not absolutely clear under existing law is whether wills and trusts containing tax formulas in 2010 will be considered ambiguous so as to permit the admission of extrinsic evidence to aid in their interpretation. If not, then the fiduciaries might not be able to even make their argument. A court could find that under normal common law rules of construction a clear result can be reached from the four corners of the document itself. However, the fact that the legislature added the above statute to the Probate Code does at least suggest that it believes such documents are ambiguous, perhaps even per se.
As emphasized in the Boyle, Medlin and Zaritsky article, families should strongly consider using a family settlement agreement under S.C. Code Section 62-3-912 to resolve disputes and address ambiguities in situations involving tax formula wills and trusts in 2010. While such agreements do not have to be accepted by the courts, they often are, and in theory they should represent the best possible balance of competing intra-family interests.
The 31st Annual Conference of the National Association of State Bar Tax Sections (NASBTS) will be held October 29-30, 2010 at the law offices of Holme Roberts & Owen, LLP, 560 Mission St., 25th Floor in San Francisco, CA.
Registration for the conference is $395, which includes a continental breakfast, coffee breaks and luncheon. To register and for additional information, please click links below or contact Jerry Geis at (651) 808-6409 or firstname.lastname@example.org.
A block of rooms has been reserved at the San Francisco Marriott Marquis, 55 Fourth St. Please make your reservations by October 8 in order to receive the discounted rate of $219 per night (single/double). Taxes, resort fees and incidental charges are additional. Please contact the hotel directly by calling (800) 228-9290 or visit http://www.marriott.com/hotels/travel/sfodt-san-francisco-marriott-marquis/
2011 S.C. Bar Convention
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