As more citizens express their frustration with taxes and crime and hear the “siren song” of foreign lands and the supposed low cost of living offered, tax practitioners should advise clients of the existence of the “exit tax” and its ramifications, even if they are just contemplating expatriation.
I.R.C. § 877(a)(2)(A)(B)(C). (Defining “covered expatriate” as an individual who has an average annual net income tax greater than $124,000, a net worth of $2,000,000 or more, or have failed to certify compliance of meeting requirements of the title.) This mark to market tax provision of the HEART Act has been codified as Internal Revenue Section 877A.
The “exit tax” was not an overnight phenomenon. Its passage in 2008 was preceded by sections in three distinct acts targeting expatriates, the first having been enacted in the Foreign Investors Act of 1966 (FITA), which subjected expatriates to U.S. income tax on income associated with a U.S. source, including an income derived from an U.S. trade or business, for a period of 10 years after termination of citizenship. Foreign Investors Act of 1966 (FITA), 89 Pub. L.No. 809. (Expatriation provisions of FITA were codified as I.R.C. § 877 on November 13, 1966.) However, the expatriation provision applied only to those individuals terminating citizenship for the principal purpose of tax avoidance. (I.R.C. Section 877(a) under FITA stated: “for one of its principal purposes, the avoidance of taxes.”)
Perhaps due to the subjectivity of the term “purpose,” coupled with the fact that U.S. source income could be converted easily to non-U.S. source income, the FITA provision was not aggressively enforced. Scant attention was given to those citizens expatriating. However, Congress and the public received a wake-up call in 1994 with a media blitz describing the good life of those expatriating, particularly the very wealthy. As a consequence of the publicity, FITA was superseded by a provision in HIPAA. In the 1996 HIPAA legislation, the category of expatriates was expanded to include U.S. resident aliens, who previously had been free to terminate their U.S. residency and return to their country of origin without tax consequences. Simply stated, unless “excepted,” a resident alien, if having held status as a green card holder or “long term resident alien” for eight of the 15 years before departure, became subject to the “alternative method” of taxation of expatriates created by FITA. The HIPAA provision also partially curtailed the benefits of bilateral tax treaties, which previously allowed expatriates to escape double taxation.
The next revision of the “expatriation tax” came with The Jobs Act of 2004. The provision within the Act closed many loopholes and tightened up reporting requirements for expatriates, and thus the “alternative tax,” “shadowing” the expatriate for a 10-year period after expatriation. This revision remained intact as the deterrent to expatriation and tax avoidance until the swift and quiet passage in May 2008 of Article III, Revision of Tax Rules on Expatriation, contained within the HEART Act. Examination of discussion of the Act, prior to passage, reveals that the only discussion of the revision of expatriation taxation contained in the bill was in the Senate Chamber, by Senator Baucus, who stated that:
Another offset in the bill is a provision that makes certain that individuals who relinquish their American citizenship or long-term residency pay their fair share of Federal taxes. This provision ensures that these folks pay the same tax for appreciation of assets, such as stocks or bonds, as they would pay if they sold them as U.S. citizens or residents. (154 CONG. REC. H4187)
In order to understand the challenges posed by the “Exit Tax” as a consequence of its inclusion in the HEART Act, those most affected—tax practitioners, expatriating citizens and long-term residents leaving the country—need to examine its substance and interpretation.
The HEART Act, Section 301: Substance and Interpretation
I. Who is subject to the rules?
2. What exactly is the “exit tax,” and how is it determined?
The “exit tax” or the “mark to market tax” is a unique tax by the fact that it taxes unrealized gains. It affects both expatriating U.S. citizens and green card holders returning home. Although controversy swells around the “exit tax,” the tax practitioner should have a basic understanding of its provisions and whom it affects.
Three Key Things I Learned When I Helped a Disabled Friend with Health Care Choices
Recently, a friend qualified at the age of 41 for Social Security Disability. The decision came roughly 2.5 years after the date of disability, so she immediately received 24 months of Social Security benefits. For Medicare purposes, after a person receives 24 months of Social Security benefits, she is eligible for Medicare. At the time of her disability determination, she was carried as a spouse on a group health insurance plan (what we’ll call the “Group Plan”). She asked if I could help with determining which health insurance option to use.
Unprepared for a difficult task
Not knowing about this problem, I first thought the thing to do would be to refer her to an expert. I work with many financial planners, so I asked a few of them for advice. Examples of two of the answers I received from my request were “I wish I knew more, but can’t help” and “I had to read up on that for the exam and it was the worst few hours of my life.” The folks who sell health insurance were more helpful, but the problem is they don’t always have good understanding of all the Medicare issues. The governmental employees assigned to assist the public with Medicare questions can’t help with the private insurance questions. My experience in seeking help reminded me of how my mother, an elementary school teacher, had mastered the preparation of the family’s tax return: call the Winston-Salem, Greensboro and Charlotte office of the IRS with any questions and take the best answer. For reasons I’ll explain later, this is not the way to make the Medicare decision. Next, I tried to find some articles or courses online, and again, no luck.
Last, I decided no easy help was forthcoming, so I’d have to do it the old-fashioned way and “read the instructions.” It was game on.
Medicare vs. Group Plans and how to compare
Enrollment in Medicare
Part A - Hospitalization
The Group Plan document in this case didn’t cover what happens when someone is covered by both the Group Plan and Medicare. However, 42 U.S.C. §1395y(b) addresses this by providing that if an employer has fewer than 100 employees in the case of a disabled person under age 65 or fewer than 20 employees in the case of a person age 65 or older, Medicare pays first and the Group Plan pays only what is covered under its plan and what Medicare doesn’t pay. See also Medicare and You 2010 73.
Part B - Doctors and Other Medical Services
The general rule is that if you don’t sign up for Medicare Part B when you are eligible, there is a penalty. The penalty is 10% higher premiums for every year you were eligible and didn’t pay into some system of Medicare or private insurance. The penalty applies unless you sign up during a Special Enrollment Period. At age 65, there is a six-month window to sign up when the right to buy is guaranteed. If you are under 65 and have group coverage, your Special Enrollment Period is generally any time you have group coverage and for eight months after termination of plan coverage. Medicare and You 2010 has more details on this Special Enrollment Period beginning at page 22. The Special Enrollment Period under Part B is also critically important for Medicare supplemental insurance, also known as “Medigap” insurance. If you are 65 or older, after you sign up for Part B, you have a six-month Medigap open enrollment which gives you a guaranteed right to buy Medigap insurance. This right for the disabled varies by states which retain the right to regulate the private insurers selling Medigap insurance. For example, North Carolina gives the disabled enrolling in Part B a Special Enrollment Period to purchase Medigap insurance. However, South Carolina does not offer such a right. Instead, South Caroina has created the South Carolina Health Insurance Pool to provide Medigap insurance to the disabled. The significance of this Medigap issue will be discussed below.
In the case of the disabled, the issue isn’t one of enrolling within the Special Enrollment Period, but of opting out in time. At the time a disabled person receives her 25th month of disability benefits, she is automatically enrolled in Part B, but can cancel it by following the directions on the enrollment notification card. If she cancels in time, she will receive a refund of any premiums deducted from the disability payments. See Medicare and You 2010 21. Once enrolled in Part B, the premium for Part B for both the retired and the disabled will be deducted from retirement or disability payments. Note that some Group Plans may require people eligible for Part B to apply for and receive Part B. This is a requirement of CHAMPVA, the health insurance option for military families.
Medicare Part B requires enrollees to also pay an annual deductible. In 2010, this amount was $155. Enrollees pay this at the beginning of the year before coverage for expenses begins. Once the deductible is paid, enrollees pay a share of the cost of services that Medicare covers. This is usually about 20% of the total bill. Services covered under Part B include approved medical services from any doctor who accepts Medicare patients; diagnostic tests done outside hospitals and nursing facilities; certain number of preventative services and screening such as flu shots and mammograms; some medical equipment; some outpatient hospital treatment received in an emergency room; inpatient prescription drugs given in a hospital or doctor's office usually by injection (such as chemotherapy drugs for cancer); some coverage for therapies; outpatient mental health care; and approved home health services. See Medicare and You 2010 26.
Part D - Prescription Drugs
“Part D was the result of a bitter political battle in Congress between lawmakers with opposing philosophies. One group (mainly Democrats) wanted prescription drug coverage to be run by the federal government as a simple add-on to Medicare, for which beneficiaries would pay an extra premium and uniform co-pays for each prescription – a proposal that would have cost billions of dollars more than Congress was willing to allow. Another group (mainly Republicans) argued that a drug benefit offered by competing private insurance plans would hold down costs and give beneficiaries more choice. A third group wanted a benefit that would give drug coverage only to low-income people. And a fourth group didn’t want a drug benefit at all, arguing that it would add an expensive new entitlement to Medicare that the country couldn’t afford.”
So with this background, I guess it makes sense that we have a confusing system of private insurance companies competing to provide drug coverage to Medicare enrollees.
Generally, you can join, switch or drop a Medicare Prescription Drug Plan at these times: 1) when you are first eligible for Medicare and the seven-month period beginning three months before the month you turn age 65 and ending three months after the month you turn 65; 2) if you are under age 65 but get Medicare due to a disability, you can join any time during the period starting three months before your 25th month of disability benefits and ending three months after your 25th month; 3) you may also change plans annually between November 15 and December 31 of each year for the succeeding calendar year. If you are eligible for Medicare due to a disability, you will also have another chance to join beginning three months before the month you turn age 65 and ending three months after the month you turn age 65. See Medicare and You 2010 63.
If you do not decide to join a Medicare Prescription Drug Plan when you are first eligible, then you will pay a late enrollment penalty in the form of higher premiums if you join later. The higher premiums are based on the national base beneficiary premium for Prescription Drug Plans and the penalty is equal to 1% of this monthly amount for each month you do not enroll in a Medicare Prescription Drug plan. For 2010, the penalty amount was $.32 per month for every month you are late, which is added to all subsequent Prescription Drug Plan premiums. See Medicare and You 2010 67 & 122. The penalty does not apply if you are eligible for a Prescription Drug Plan but choose to keep other health insurance like employer coverage that covers your drugs as long as your other insurance is “creditable” prescription drug coverage. “Creditable” drug coverage is drug coverage that is actuarially expected to pay, on average, at least as much as Medicare's standard prescription drug coverage. See Medicare and You 2010 116. Each year your other drug plan should tell you if your drug coverage is creditable coverage.
Before choosing to enroll in a Medicare Prescription Drug Plan, there are a few other peculiar things about Medicare Part D to understand. While most people generally like prescription drugs, I think 42 U.S.C. §1395w-102 of Medicare Part D may be one of the most unpopular laws dealing with prescription drugs ever written. First, it is the section that created the “doughnut hole,” and second, Congress, which has its own drug plan, chose to exclude from the definition of a required covered Medicare prescription drug in 42 U.S.C. §1395w-102(e)(2)(A) any drug for sexual dysfunction. In other words, Medicare enrollees may have to pay full cost for their Viagra®. Somehow, I doubt Congress made the same sacrifice.
But even more important than the covered drugs for the sexually dysfunctional in Congress is the doughnut hole. The doughnut hole is the perfect example of healthcare design by committee. The doughnut hole was created in its statutory definition of “basic prescription drug coverage” found at 42 U.S.C. §1395w-102(b). This section sets forth the minimum requirements for Medicare Prescription Drug Plans to be sold by private insurance companies. Since this is the minimum required, as far as I can tell, all Prescription Drug Plans sold in South Carolina have the doughnut hole, and no insurance companies try to compete by extending coverage through the doughnut hole. A good resource for comparing plans is through Medicare.gov’s prescription drug plan finder, which can use your zip code to bring up Prescription Drug Plans available to you. The doughnut hole refers to the fact that Medicare Prescription Drug Plans have a big hole in their coverage. For example, in 2010, people paid four different out-of-pocket costs for the same drug because of four different stages of coverage under their Medicare Prescription Drug Plan. In stage 1, the insured pays the first $310 of annual drug costs as a deductible. In stage 2, the insured pays a co-payment for each drug once the deductible is met, and the Prescription Drug Plan pays the remaining drug costs until what both the insurance company and the insured have paid plus the deductible reaches $2,830. The co-payments are based on each company’s drug formulary and pricing tiers for the drugs. Once the total drug costs exceed $2,830, the insured is in the doughnut hole or coverage gap of the Prescription Drug Plan. The insured is then responsible for all drug costs until the maximum insured out-of-pocket amount of $4,550 is reached. Once the insured pays the maximum out-of-pocket cost for drugs, the catastrophic coverage applies and the insured pays only a small co-payment for any drugs covered under the plan. See Medicare and You 2010 66. The recently enacted Health Care and Education Reconciliation Act of 2010 has made substantial changes to the doughnut hole and over the next 10 years will eliminate approximately 75% of the current gap in coverage.
Understanding a plan’s covered drugs is also important. 42 U.S.C. §1395w-104(b)(3)(B) dictates the statutory requirements for Prescription Drug Plans in creating their drug formularies. It requires the insurance companies to have committees of internal and external experts review the formularies to make sure the formularies meet certain medical requirements and also requires the formularies to include drugs within each therapeutic category and class of covered Part D drugs, although not necessarily all drugs within such categories and classes. As you will see in the comparison of the options, these Part D drug formularies tend to be more limited than the Group Plan counterparts.
These policies help pay the health care costs original Medicare doesn't cover. See Centers for Medicare and Medicaid Services, 2010 Choosing a Medigap Policy: A Guide to Health Insurance for People with Medicare 9. The plans are standardized by the federal government and labeled Plan A-N, but after May 31, 2010, plans E, H, I and J will no longer be sold. Those in the eliminated plans are grandfathered, but as my knowledgeable insurance friend pointed out, with no new healthy people enrolling in those plans, the premiums will likely increase as the pool ages. See 2010 Choosing a Medigap Policy 12. For example, a Plan C Medigap policy will cover the $1,100 per illness Medicare Part A deductible for a hospital stay as well as the insured hospital costs of $275 per day for days 61 through 90 and the $575 per day for 60 lifetime reserve days and the 20% co-insurance payments for Medicare Part B services as well as the $155 annual deductible in 2010. It also covers emergency health care costs incurred in foreign travel. Plan F covers these same costs but also covers the non-assigned costs. Non-assigned costs are the costs doctors charge that are allowed but not covered by Medicare Part B. Doctors can agree to accept only the Medicare-approved amounts for a service, and this is known as “assignment.” Alternatively, they may accept the Medicare-approved amount and bill a patient an additional amount as long as this additional amount does not exceed 15% of the Medicare approved amount. Plan F covers 100% of these additional charges. See 2010 Choosing a Medigap Policy13.
For retirees, the best time to buy a Medigap policy is during the Open Enrollment Period. The Open Enrollment Period lasts for six months and begins on the first day of the month in which someone is both 65 or older and enrolled in Medicare Part B. See 2010 Choosing a Medigap Policy 16. In the case of the disabled, the federal statutes leave the question of open enrollment to the states. South Carolina has not opted to impose a mandatory open enrollment for the disabled to purchase Medigap insurance. Instead, the S.C. General Assembly created the South Carolina Health Insurance Pool (SCHIP) in 1989. The SCHIP is a pool made up of insurance companies offering coverage in South Carolina. Its purpose is to make health insurance coverage available to residents of South Carolina who are either unable to obtain health insurance because of a medical condition or whose premium for health coverage exceeds 150% of the pool rate. It is currently administered by Blue Cross Blue Shield of South Carolina. S.C. Code Ann. §38-74-20 provides the governing board of SCHIP with broad powers, including the power to establish procedures for the collection of assessments from all members to provide for claims incurred or estimated to be incurred under the plan and for administrative expenses incurred or estimated to be incurred during the period for which the assessment is made. S.C. Code Ann. §38-74-30(A)(3) provides that South Carolina residents who are covered under Medicare Parts A and B for reasons other than age (the disabled) are eligible for insurance through SCHIP once they show they were turned down or priced out of the private marketplace. S.C. Code Ann. §38-74-60(B) goes on to require SCHIP to offer Medigap Plan A and C policies to the disabled. SCHIP, Outline of Medicare Supplement Coverage (10/2009) outlines the benefits of the different Medicare Plans A and C and quotes the monthly premiums of $787.57 and $1,001.27 respectively. One thing not mentioned in this Outline of Coverage is that S.C. Code Ann. §38-74-30(E)(5) makes anyone who has received $1 million in benefits from SCHIP ineligible for additional coverage. In the case of a disabled person under the age of 45, a lifetime of serious hospital stays could push that limit and is something to consider.There are also currently two companies selling Medigap plans to the disabled in South Carolina, but there is no right to purchase these plans, and the companies are free to exclude people based on histories and other factors.
Medicare Advantage Plans
When I am faced with tasks like determining the cost of an insurance plan, I find it helpful to flowchart how the costs are determined. My Medicare and Group Plan flowcharts follow. Before this exercise, I thought of health insurance as anything but simple, but it actually is simple compared to Medicare. There's only one insurance policy to worry about, there are deductibles for services and a maximum OOP costs for the co-insurance once the deductible is met, there are regular copayments for the drugs and doctors, and practically all the drugs my friend's doctors prescribe are covered. The summary below shows our best estimate at the annual OOP cost for my friend. The premiums under the Group Plan come to $6,611 per year, we used prior year’s actual copayments for estimating the drug and doctor visits which added another $5,100 to the OOP cost, and finally figured that in most years between hospital stays and durable medical equipment, we would meet the $4,500 maximum OOP cost. This brought the total OOP cost of the Group Plan to $16,211 per year.
In determining the health care OOP costs under the Medicare option, I chose to look at what could be the only two options in our case. Since there is no guaranteed right for the disabled to buy Medigap insurance in South Carolina, I chose to compare the Group Plan option with the policies available to the disabled under SCHIP. As you can see, only the basic premiums for Medicare Part B are included. Not included are possible premium increases for the couple’s income. Next, my friend would have to purchase drug coverage, and I went with the plan recommended by my knowledgeable insurance friend. The premiums for it are $49.10 per month.
To understand the next line, you need to understand what everyone refers to as the “doughnut hole” discussed above in the explanation of Part D. In our case, Walgreens was able to run a report showing what each Prescription Drug Plan covered of the drugs my friend had purchased from Walgreens. Not a single Prescription Drug Plan offered in her area covered all the drugs she had purchased, so she would likely have no coverage for some drugs she needed in any plan she chose. In stark contrast to the Medicare Prescription Drug Plans, the Group Plan formulary starts out by saying it covers most medications approved by the United States Food & Drug Administration (FDA). When I discovered this difference and knowing that Congress had decided to exclude drugs for sexual dysfunction from a required benefit, I just had to satisfy my curiosity again. After a less-than-exhaustive search, I couldn’t find a single Medicare Prescription Drug Plan that covers Viagra or Cialis, two widely-advertised drugs. The Group Plan covered Viagra, Cialis, Lavitra, a couple of alternatives I’d never heard of, and I’m sure would cover any generic versions of these drugs.
For analysis purposes, we just assumed my friend would hit the maximum under the doughnut hole and that we would be able to choose a plan that at least covered the expensive drugs.
As you can see, the cost of the Group Plan was the clear favorite. In addition, there were some other factors in favor of the Group Plan. First, state law allows the SCHIP to change rates, so the high SCHIP premiums could go higher with no competition in for this market. Second, I’m not sure how difficult the grievance process is with Medicare, but having gone through the disability determination process, we weren’t ready to find out. The Group Plan is not a self-funded plan, so it is not subject to ERISA, so in addition to state law consumer protections, a local jury trial is available to resolve conflicts. Third, the drug coverage under the Prescription Drug Plan is not as broad as the Group Plan, so there was a chance that an expensive drug might not be covered and could quickly increase the cost of the Medicare options. Fourth, in addition to the $1 million cap on lifetime benefits, the Medigap policies limit the hospitalization to 365 lifetime days. At age 41 with a chronic illness, my friend could use these days up during her lifetime and then have no coverage for hospital stays. Last, once a plan is chosen, she generally would have no guaranteed right to change Medigap plans unless the plan terminated due to bankruptcy or insolvency of the insurance company. S.C. Code of Regulations §69-46-12(A).
So, we decided that as long as my friend is covered under the Group Plan, we can opt not to apply for Part B and will not be penalized in acquiring Part B, Prescription Drug Plans (the Group Plan meets the definition of creditable coverage), or Medigap policies if we later apply for Medicare Part B while she is covered by the Group Plan or the eight-month post-employment period.
I believe there will be a lot of changes in health care in the coming years, and the place to be is on the sideline with as many options as possible available.
Anyone on Medicare needs to continuously monitor their plans
The problem in my family is that my 70+ year-old mother, who lives in a town with fewer than six stop lights, needs written directions to find her way home when she has to use an alternate entrance to her subdivision. As far as technology goes, she can’t operate her cell phone. There’s simply no way she can monitor her Medicare benefits, and the how of having someone else do it for her would require another article.
Ever since Commissioner v. Procter was decided by the Fourth Circuit Court of Appeals in 1944, gifts defined by formula have consistently and successfully been challenged by the IRS as being in violation of public policy. 142 F.2d 824 (4th Cir. 1944). However, in a recent case, the Tax Court has ruled in favor of a taxpayer who made a gift by formula.
While there are several different manners by which to structure a formula gift, the goal is to transfer as much property as possible without paying any transfer tax, even if the value of the gift is adjusted on audit. Section 2501(a)(1) of the Internal Revenue Code imposes a tax on the transfer of property by gift by any individual during each calendar year. The person making the gift (donor), and not the gift recipient (donee), is liable for paying the tax. IRC §2502(c). Each donor can give up to $13,000 each to an unlimited number of donees each year. IRC §2503(b). In addition to the $13,000 gifts, each donor can make up to $1 million in gifts before incurring any gift tax liability. IRC §2505.
Some formula gifts have tried to “take back” the amount of the gift that would be subject to gift tax, while others have attempted to shift that excess portion of the gift to a charity, or other third party, instead. In Procter, the taxpayer attempted to avoid gift tax by including the following clause in his trust:
This transfer attempted to “un-gift” the amount that would cause the taxpayer to pay gift tax—any part of the gift that would be taxable would revert to the donor. The Fourth Circuit held that this violated public policy because it discouraged the collection of tax, and caused the court to decide a moot case in what would essentially be a declaratory judgment. Thus, the taxpayer, Frederic Procter, was liable for tax on his gift whether it legally reverted back to him or not.
However, in Estate of Petter v. Commissioner, which was decided by the Tax Court in December of 2009, a taxpayer’s formula gift was challenged based on the public policy argument articulated in Procter. T.C. Memo. 2009-280 (Dec. 7, 2009). In Petter, the taxpayer made gifts of LLC units to trusts for the benefit of each of her two children, such that the appraised value of the gifted units were approximately equal to her remaining unified credit against gift tax. She also gave membership units in the LLC to two different charities. Subsequent to the gifts, she sold the remainder of her membership units to the trusts.
All of the gifts and sales to the trusts were by formulas which provided if the IRS adjusted the values of the gifts or the units sold to the trusts, any membership units subject to gift tax would be transferred to the charities. The gift document provided that “if the value of the Units [the trust] initially receives is finally determined for federal gift tax purposes to exceed [$453,910], Trustee will, on behalf of the Trust and as a condition of the gift to it, transfer the excess Units to [the charity] as soon as practicable.” Id. at 2206-2207. The taxpayer gave each of the trusts membership units in the LLC that were appraised for approximately $453,000. On audit, the IRS adjusted the gifts and concluded that the fair market value of each gift of membership units to each trust was approximately $672,000 ($219,000 more than the reported value). Also, the fair market value of the units sold to each trust was increased by almost $2 million. According to the sale and gift documents, this adjustment resulted in a shift of over $4.3 million worth of membership units to the charities.
Based on Procter and other decisions, the IRS argued that the formula clauses should not be honored for federal gift tax purposes. See Knight v. Commissioner, 115 T.C. 506 (2000); Rev. Rul. 86-41, 1986-1 C.B. 300. Despite any ruling on the tax consequences of the matter, the units were effectively transferred to the charities when the values were finally determined for federal gift tax purposes. Dishonoring the formula would only disallow a charitable deduction for the amounts transferred to the charities and result in over $4.3 million in taxable gifts for which Anne would have a tax liability.
The taxpayer argued that the formula gifts did not violate any public policy and that the formula clauses should be permissible to define what is being giving away. The taxpayer’s reasoning was that Congress allows formula clauses and defined value transfers in many situations, and thus there cannot be a public policy against formula provisions. Rev. Proc. 64-19 (sanctioning the use of formula clauses in marital deduction bequests); Treas. Reg. § 1.664-2(a)(1)(iii) (“The stated dollar amount [of a payment to the recipient of a charitable remainder annuity trust] may be expressed as a fraction or a percentage of the initial net fair market value of the property irrevocably passing in trust as finally determined for Federal tax purposes”); Treas. Reg. § 26.2632-1(d)(1) (permitting formula allocations for GST exemption); Treas. Reg. § 25.2518-3(d), Example (20) (allowing a fractional disclaimer); Treas. Reg. § 25.2702-3(b)(1)(ii)(B) (allowing a fractional formula for determining (The definition of qualified annuity interests says that the “fixed amount” to be given to the beneficiary can include “a fixed fraction or percentage of the initial fair market value of the property transferred to the trust, as finally determined for federal tax purposes.”).
The Tax Court agreed with the Taxpayer. In reaching its decision, the Tax Court examined Procter, along with several other cases that followed its reasoning. The Tax Court, relying on its recent decision in Estate of Christiansen v. Commissioner, found that the transfers in Petter, while having similarities to the transfer in Procter, did not violate public policy. 130 T.C. 1 (2008), aff’d 586F.3d 1061 (8th Cir. 2009). In Christiansen, the taxpayer structured a formula disclaimer of her inheritance to keep part of the inheritance and allow the rest to pass to charity. See disclaimer rules at IRC § 2518. The Tax Court found that there is a distinction “between a donor who gives away a fixed set of rights with uncertain value--that's Christiansen--and a donor who tries to take property back--that's Procter.” T.C. Memo. 2009-280 at 2034 (“A shorthand for this distinction is that savings clauses are void, but formula clauses are fine.”). In Petter the Tax Court ruled that the gifts to the trusts were gifts of a fixed set of rights with an uncertain value rather than “take back” or “ungift” formulas. The court held that the “transfers, when evaluated at the time [the taxpayer] made them, amounted to gifts of an aggregate and set number of units, to be divided at a later date based on appraised values. The formulas used to effect these transfers were not void as contrary to public policy, as there was no ‘severe and immediate’ frustration of public policy as a result, and indeed no overarching public policy against these types of arrangements in the first place.”Id. at 2037.
While the Tax Court approved formula gifts in Petter and formula disclaimers in Christiansen, both of these cases involve formulas by which the excess gifts have gone to charity. In deciding both of these cases, the Tax Court has stated that there is a strong public policy in favor of giving to charity and that public policy argument may have had great weight in reaching the decisions. It is not clear how the court would hold if the formula provided that the excess portion of the gift would be transferred to another deductible donee, like the donor’s spouse. Because the donor’s spouse could simply give the property back to the donor, this type of transfer could likely face greater scrutiny, and the public policy in favor of giving to charity would not be present. While Procter long has been an impediment to formula gifts, it seems as if Petter has opened a small door. If structured and drafted correctly, especially when the excess gifts benefit a charity, formula transfers can be an effective gifting method.
Timing and character of income are powerful decision drivers in the tax world, and perhaps nowhere is this better illustrated than in the context of restricted stock, Section 83 and the election thereunder. Section 83 governs the tax treatment of transfers of property in connection with the performance of services. As a starting point, Section 83 tells us that a service provider (employee) will recognize gross income equal to the amount that the fair market value of the property transferred exceeds the amount, if any, paid for the property. The timing of the income inclusion is delayed until the property is transferable or no longer subject to a substantial risk of forfeiture. The income is compensation income and therefore ordinary in character. From this default, Section 83(b) gives the employee the ability to make an election to accelerate the ordinary income event to the time of grant, as opposed to waiting until the property vests, that is to say, waiting until the property is transferable or no longer subject to a substantial risk of forfeiture. Although the income inclusion is accelerated under the election, any future appreciation in the restricted property, usually stock, will be taxed at traditionally favorable capital gains rates.
The decision to make (or not to make) the election under Section 83 affects both employers and the employed. The basic economic drivers for the employer are derived from the corresponding deduction for compensation expense that is generated when the employee includes an amount in income. Although the timing of the deduction in this case is often in the hands of the employee, some employers mandate that the employee make, or not make as the case may be, the election. Employers that expect dramatic growth in stock values would generally be well advised to require (at the employee’s expense) that the employee not make the election. This is true because the employer derives more benefit from a large deduction several years out than from a small deduction now. In essence, the time value of money associated with a small deduction taken at grant will not outweigh the advantages of a large future deduction taken when the stock vests. As would be expected then, in the instance where modest stock growth is forecast, the present value of the deduction is generally more valuable to the employer than the future deduction.
For the employee, the inherent advantage of making the election under Section 83(b) is that appreciation of the stock will be taxed as capital gain and not ordinary income on subsequent disposition. It is the current spread in these tax rates that flies in the face of deferral. Also beneficial to the employee is that the election accelerates the capital gain holding period to the date of the grant, rather than the vesting date, ensuring that the capital gain will be further preferenced as long-term capital gain. However, depending on what the employee paid for the stock at grant, depreciation in the stock occurring between the date of grant and the vesting date could result in the inclusion of a larger amount in ordinary income than would have been realized in the absence of the election.
Given: Ordinary Income Tax Rate–35%
In the base case above, it appears that making the election results in a greater net cash position for the employee (evidenced by the fact she is $14,560 richer). This example, however, is misleading. Forgiving the assumption that the employee has the ability to pay the tax (and ignoring whether or not the employer may provide a cash bonus to pay the tax), the example does not account for the fact that the $35,000 used to pay the tax could have been put more productive use, perhaps by purchasing more shares of the employer. As is illustrated by the second example below, the employee under that circumstance is better off, from a net cash standpoint, not making the election (evidenced by the fact the she is $7,098 richer):
Section 83 is but one example of how the Internal Revenue Code drives decisions made by taxpayers, and the example above is but one reminder of the many possible scenarios that taxpayers must contemplate when trying to drive those decisions where they want to go.
10th Annual NC/SC Tax Section Workshop
Al Todd Estate Planning Workshop
Hotel reservations may be made by calling the Kiawah Island Golf Resort Reservations Department at 800-654-2924. Be sure to reference the S.C. Bar Estate Planning Workshop when calling (booking code #7217). A one-bedroom East Beach Villa (where program will take place) is $265/night, and a one-bedroom West Beach Villa is $235/night. Reservations must be made by June 7, 2011 to ensure the reduced rate.
The speaker will be Howard M. Zaritsky, attorney and nationally-recognized expert on estate, gift and generation-skipping transfer taxes, fiduciary income taxes, estate planning and estate administration. Lunch on Friday will be included with your seminar registration.
Terms beginning July 1, 2011
The Section Council would like to improve the content of Section newsletter. Should you have any suggestions and/or submissions, please forward to Tara Smith at firstname.lastname@example.org.
For additional information on the Tax Law Section, click here.