The Tax Court recently determined that the fair market value (FMV) of a life insurance policy distributed by a terminated 419 welfare benefit plan is reduced by surrender charges. [Lowe v. C.I.R., T.C. Memo. 2011-106 (2011)].

This ruling further cements the Tax Court’s position on surrender charges that was enunciated in Schwab v. Commissioner [Michael P. Schwab et ux. v. C.I.R., 136 T.C. No. 6 (2011)]. Although the IRS continues to challenge taxpayers who apply surrender charges to reduce or eliminate their tax liability when a policy is distributed to them by a welfare benefit plan, this ruling adds another degree of certainty to the FMV calculation.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of Tax Court rulings in Advisor’s Journal, see Tax Court Revives Partnership Self-Employment Tax Debate (CC 11-56).

Why is this Topic Important to Wealth Managers? This blogiticle discusses how financial statements are used in connection with business insurance planning. The information is presented because valuations become an important factor in a number of situations where wealth managers are working with clients.

First, properly kept financial statement can help ensure easier access to capital as well as give a truer understanding of the business’ financial position. Second, insurance underwriters are concerned with risk exposure. Thus most businesses are required to provide financial information of the company through the financial statements when a substantial amount of insurance is purchased.

In addition, the financial statements are commonly used in the risk management processes. Assets are usually examined to determine what amount of exposure the business may have. Further, outstanding liabilities in connection with cash flow may present operational and risk issues.

But one area where financial statements are really important is: business valuation. Most if not all business valuation is based primarily on financial statement analysis. This process generally begins with an examination of the assets of the business. Further, as was discussed yesterday the amount that a business’ assets exceed its liabilities is called owner’s equity.  During personal planning situations with closely held corporations and other entities, owner’s equity is an important amount, as this is what the owners are entitled to after all liabilities are settled with assets on hand.

Moreover, business valuation is important when drafting buy-sell agreements or purchasing insurance in connection with a buy-sell or otherwise on a key employee, including but not limited to owners of such organizations.  Small businesses are especially sensitive to the exposure of ownership ending up with individuals the surviving owner(s) don’t want to do business with.

Thus, under the traditional buy-sell agreement the owners enter into a binding buy-sell agreement among themselves. They contract to purchase the interest of any other owner who dies; each stockholder agrees and contracts for the sale of his or her interest at death. Alternatively, the agreement may be between the owners and the entity, obligating the business to purchase the shares of a deceased owner and either hold the shares as treasury stock or retire them. Either route that is exercised must nevertheless be based upon some valuation. This is where the financial statements come into use.

In other words, key employee insurance and buy-sell agreements are generally based on some total dollar amount that represents the value of the business. This figure is usually based on some number that is related to the financial statements and accounting of the business. Whether it’s the total assets, a factor of revenue or income, or some other determination, the need for a basic knowledge of financial accounting for small businesses is essential.

What’s more, because a price or method of establishing the sales price is generally set out in the agreement, the accuracy of financial reporting and presentation within the financial statements is critical. Since the amount to be paid for the deceased’s stock is set out in the contract, and since the terms of payment are agreed upon in advance those keeping unsound records and accounts will likely incorrectly value the business which could negatively affect other planning aspects.

For a detailed analysis on business valuation and how it relates to buy sell agreements see Advanced Markets AdvisorFX: Insurance Needs Revealed in Financial Statements.

For sample buy-sell and cross purchase agreements see Advanced Markets AdvisorFX: Sample Close Corporation Buy-Sell Agreements.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

The Tax Court recently calculated the fair market value (“FMV”) of life insurance policies distributed by a terminated 419 welfare benefit plan. The FMV of the policies—which must be included in the taxpayers’ income—was determined by the court based on: (1) surrender charges, (2) conditions imposed on the taxpayers by the insurance company, and (3) “paid-up insurance coverage remaining on the policies as of the date of distribution.”  Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of policy valuation in Advisor’s Journal, see Tax Courts Holds Employee Taxable for Value of Life Insurance Owned by Welfare-Benefit Plan (CC 11-14).

For in-depth analysis of welfare benefits plans, see Advisor’s Main Library: B—Welfare Benefit Funds.

Why is this Topic Important to Wealth Managers? Presents wealth managers with relevant law and analysis related to the HIRE Act and foreign trusts.  Also, discusses important reporting requirements regarding foreign trusts owned by U.S. persons. 

Use of Foreign Trust Property and Deemed Distributions

The new FATCA law expands 26 U.S.C. § 643(i) to provide that any use of trust property by a U.S. grantor or U.S. beneficiary, or any U.S. person related to a U.S. grantor or U.S. beneficiary, is treated as a distribution equal to the fair market value of the use of the property. [1] 

“Thus, the rent free use of real estate, yacht, art work or other personal property (wherever located including the United States) or an interest-free or below-market loan of cash or uncompensated use of marketable securities will trigger a distribution equal to the FMV for the use of such property to the extent of distributable net income”. [2]

However, if the trust is paid the fair market value, within a reasonable period of time, for the use of property or the market rate of interest on a loan by the trust, the new law does not create a deemed distribution. [3]

This provision is effective after March 18, 2010. 

When does a foreign trust have a U.S. beneficiary?

The new also law creates a rebuttable presumption that the trust has a U.S. beneficiary when a U.S. person directly or indirectly transfers property to a foreign trust. [4]

This presumption can be overcome by submitting information (as the Treasury may require) and by demonstrating to the satisfaction of the IRS that (i) under the terms of the trust no part of the income or corpus of the trust may be paid or accumulated during the tax year to or for the benefit of a U.S. person, and (ii) if the trust were terminated during the tax year, no part of the income or corpus could be paid to or for the benefit of a U.S. person. [5]

The presumption becomes effective after March 18, 2010.

Reporting requirement by U.S. owners of foreign trusts.

The new FATCA law also requires U.S. persons, “when treated as an owner of any portion of a foreign trust under the grantor trust rules, to provide information as may be required with respect to the trust, in addition to ensuring that the trust complies with its [traditional] reporting obligations.” [6]

“In other words, if a U.S. person is treated as the owner of a foreign trust under the grantor trust provisions, the U.S. person is responsible for ensuring that the trust files an information return for the year and that the trust provides other information to the IRS as the Treasury may require to each U.S. person who is treated as the owner of any portion of the trust or receives any distribution from the trust.” [7]

The provision is effective for tax years beginning in year 2011.

General reporting rules

If a U.S. person creates or transfers property to a foreign trust, the U.S. person generally must report this event and certain other information by the due date for the U.S. person’s tax return, including extensions, for the tax year in which the creation of the trust or the transfer occurs. [8]

If a U.S. person directly or indirectly receives a distribution from a foreign trust, the U.S. person generally must report the distribution by the due date for the U.S. person’s tax return, including extensions, for the tax year during which the distribution is received. [9]

If a U.S. person is the owner of any portion of a foreign grantor trust at any time during the year, the person is responsible for causing an information return to be filed for the trust, which must, among other things, give the name of a U.S. agent for the trust. [10]

Penalties

The new law increases penalties if the reporting requirements with respect to certain foreign trusts are not met. [11]

“Under the new law, an initial minimum penalty of $10,000 or 35 percent of the gross reportable amount may be imposed for failing to report where the Treasury has insufficient information to determine the gross reportable amount of the property transferred to a foreign trust under [26 U.S.C. § 6048].” [12]

This provision is effective to notices and returns required to be filed after December 31, 2009.

Tomorrow’s blogticle will conclude this week’s discussion of international tax compliance. 

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[1] Section 531. HIRE Act. H.R. 2847. 2010.; See generally, TAXES – The Tax Magazine, FATCA: The Global Financial System Must Now Implement a New U.S. Reporting and Withholding System for Foreign Account Tax Compliance, Which Will Create Significant New Exposures—Managing This Risk (Part III). CCH. Sept. 1, 2010. ; See also Dean Marsan. FATCA: An Analysis.  21 JITAX 24, 63-64. 2010. 

[2] TAXES – The Tax Magazine. FATCA. Sept. 1, 2010.

[3] Id.       

[4] Section 532. H.R. 2847;TAXES – The Tax Magazine. FATCA. Sept. 1, 2010.; 21 JITAX 24, 63-64. 2010. 

[5] Id.

[6] 21 JITAX 24, 63.; See also, Section 534. H.R. 2847.

[7] TAXES – The Tax Magazine. FATCA. Sept. 1, 2010.; See also, Section 534. H.R. 2847.

[8] TAXES – The Tax Magazine. FATCA. Sept. 1, 2010. Citing, 26. U.S.C.§ 6048(a).

[9] Id. Citing, 26. U.S.C.§ 6048(c).

[10] Id. Citing, 26. U.S.C.§ 6048(b).

[11] Section 535. H.R. 2847.

[12] TAXES – The Tax Magazine. FATCA. Sept. 1, 2010.; See generally, Section 535. H.R. 2847.