Why is This Topic Important to Wealth Managers? This blogticle discusses one area that is well known to many wealth managers. However, this reexamination of a topic is designed to provide a refresher to wealth managers. Here we discuss the three year bring-back rule.

With certain exceptions, there is a general rule with respect to estates which requires that any property transferred by gift within three years prior to the transferor’s death has to be included in the gross estate of the deceased transferor, at its date-of-death value (even though the transferor may have had no ownership interest or retained rights of any kind when she died). [1] This rule is sometimes referred to as the “three year rule” or the “bring-back rule”.

The 3-year “bring-back” rule is applicable with respect to dispositions of retained interests in property which otherwise would have been includable in the gross estate.[2] All of these sections involve transfers of property as to which the transferor retained some form of continuing interest or right, which, if still retained when the transferor dies, is deemed sufficient to require the inclusion of the property in the gross estate of the transferor:

• §2036 -  Transfers with certain life interests retained
• §2037 -  Transfers with a reversionary interest retained
• §2038 -  Transfers with a right retained to alter, amend or revoke the transferee’s beneficial interest
• §2042 -  Transfers of life insurance policies with an incident of ownership retained

Under I.R.C §2035, if an insured individual transfers an insurance policy to a trust or another individual, even though the insured may no longer retain any incidents of ownership, if he dies within the 3-year period following the transfer, the entire policy proceeds will be includable in the insured’s gross estate, effectively defeating the major objective of the having the death benefits payable outside the estate.

For the most part, this problem can be eliminated by establishing a trust with a new policy (i.e., never owned by the insured). This, of course, may not be a viable alternative when an existing policy is involved. While consideration might be given to cancellation of an existing policy and replacement with a new one, such a course of action should be based more upon the non-tax aspects of a policy change (e.g., premium costs, contractual terms, quality of carrier, etc.) than purely the tax risk of §2035, the 3-year bring back rule.

In situations where a decision is made to establish an irrevocable life insurance trust with a policy to be newly issued, the §2035 problem (the 3-year rule) can usually be avoided by simply having the policy applied for by, and initially issued to, the trust as owner. If this is properly accomplished, the insurance proceeds will not be includable in the insured’s gross estate even if he should have the misfortune of living less than three years thereafter.

The critical factor in assuring the inapplicability of I.R.C. §2035 (the 3-year rule) is that the grantor/insured not have possessed at any time anything that might be deemed an incident of ownership with respect to the policy.

Generally it is the IRS’ position that reapplication by third party owner after decedent initially applied for the insurance within three years of death does not present a three year rule problem. Central to the position is the notion that an application for insurance (as long as money is not submitted with the application) is only an offer to contract. There being no contract between the parties, decedent never held any incidents of ownership.[3]

Tomorrow’s blogticle will continue to discuss issues surrounding wealth management.

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

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[1] I.R.C. §2035.

[2] For example, under I.R.C. §§ 2036, 2037, 2038, or 2042.

[3] See Technical Advice Memorandum (TAM) 9323002.

Why is this Topic Important to Wealth Managers? This blogticle presents an overview of the credit shelter trust. Given the $5 million estate and gift tax exemption, along with the portability of the spousal credit, and wealth managers and clients alike are asking how this will affect estate plans. We thus review the credit shelter trust so as to provide information for decision making regarding client estate plans given the new estate and gift tax legislation.

The unlimited marital deduction is “superficially” attractive. The wealthier spouse doesn’t have to worry about estate tax erosion of assets transferred to a surviving, less wealthy spouse. But what about the second death? The unified credit and portability may be sufficient in some cases to shelter the estate, but not always. Therefore, some affluent families benefit from the split-estate (A-B Trust) concept in marital deduction planning. The benefits arising from the use of such instrument are nevertheless being questioned by wealth mangers given the new estate and gift tax exemption amounts.

While the marital deduction provides a tremendous tax benefit at the first death, it largely postpones the estate tax on the qualified property until the second spouse dies. Since most clients are anxious to conserve as much of the estate as possible for succeeding generations, proper estate planning considers the effects of the combined estate tax on both spouses’ estates and takes steps to keep death taxes at a minimum in the survivor’s estate as well as at the first death.

For many years the testamentary credit shelter trust has been a standard element in estate planning for married persons. These trusts, created upon death and funded to the extent of the decedent’s applicable exemption amount, still represent a vast potential market for the sale of life insurance. Life insurance on the life of the surviving spouse can be a highly suitable asset for credit shelter trusts. This discussion focuses on the advantages of life insurance as an asset of a credit shelter trust notwithstanding the increased gift and estate tax exemption amount and spousal portability.

Significant advantages can be achieved by widows and widowers and their heirs who are beneficiaries of credit shelter trusts (established upon the deaths of their respective spouses), through the purchase by the credit shelter trust of insurance on the life of the surviving spouse.

One of the appealing aspects of investing credit shelter trust assets in life insurance is that when the trust is ultimately distributed to children (or other heirs) after the death of the surviving spouse, the property will have achieved, in effect, two successive step-ups in basis subsequent to the death of the first spouse.

In summary, it works as follows: Consider a spouse with appreciated assets who dies. The appreciated assets are transferred by the decedent’s will to a credit shelter trust, taking a stepped-up basis equal to the market value at which they were included in the gross estate. Assume that before the assets appreciate further in value some portion is sold by the trustee at no taxable gain. The proceeds of the sale are used to purchase an insurance policy on the life of the surviving spouse. When the surviving spouse dies, the death benefit will be received by the trust income tax free under I.R.C. §101. Thus, in effect, the property that was received by the trust with a stepped up basis upon the death of the first spouse will have grown to an amount equal to the insurance death benefit by the time the second spouse dies. This second increase in value (occurring between the death of the first spouse and the death of the second spouse) is not subject to income tax, because of Code §101, and thus, there has effectively been a second step-up in basis for the increased asset amount eventually received by the couple’s heirs.

Next week’s blogticles will present discussion related to estate planning generally.

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

Why is this Topic Important to Wealth Managers? This blogticle provides discussion and analysis on listed property generally and cell phones specifically. The new law provides for relaxed standards for the deduction requirements of cell phones used in a trade or business. Thus wealth managers who maintain their own trade or business will benefit from the information regarding the tax treatment of this technology equipment.

Property, including cellular telephones and similar telecommunications equipment (hereinafter collectively ‘‘cell phones’’), used in carrying on a trade or business is subject to the general rules for deducting ordinary and necessary expenses under IRC Section 162. Under these rules, a taxpayer may properly claim depreciation deductions under the applicable cost recovery rules for only the portion of the cost of the property that is attributable to use in a trade or business. Similarly, the business portion of monthly telecommunication service is generally deductible, subject to capitalization rules, as an ordinary and necessary expense of carrying on a trade or business.

In the case of certain listed property, special rules apply. Listed property generally is defined as (1) any passenger automobile; (2) any other property used as a means of transportation; (3) any property of a type generally used for purposes of entertainment, recreation, or amusement; (4) any computer or peripheral equipment; (5) any other property of a type specified in Treasury regulations; [1] and (6) formally any cellular telephone (or other similar telecommunications equipment).[2]

For listed property, no deduction is allowed unless the taxpayer adequately substantiates the expense and business usage of the property.[3] A taxpayer must substantiate the elements of each expenditure or use of listed property, including (1) the amount (e.g., cost) of each separate expenditure and the amount of business or investment use, based on the appropriate measure (e.g., mileage for automobiles), and the total use of the property for the taxable period, (2) the date of the expenditure or use, and (3) the business purposes for the expenditure or use.[4] The level of substantiation for business or investment use of listed property varies depending on the facts and circumstances. In general, the substantiation must contain sufficient information as to each element of every business or investment use.[5]

With respect to the business use of listed property made available by an employer for use by an employee, the employer must substantiate that all or a portion of the use of the listed property is by employees in the employer’s trade or business.[6] If any employee used the listed property for personal use, the employer must substantiate that it included an appropriate amount in the employee’s income.[7] An employer generally may rely on adequate records maintained and retained by the employee or on the employee’s own statement if it is corroborated by other sufficient evidence, unless the employer knows or has reason to know that the statement, records, or other evidence are not accurate.[8]

Section 2043 of the Small Business Jobs Act of 2010 [9] removes cell phones from the definition of listed property. Thus, under the provision, the heightened substantiation requirements and special depreciation rules that apply to listed property no longer apply to cell phones.

The provision generally does not affect the Treasury’s authority to determine the appropriate characterization of cell phones as a working condition fringe benefit under IRC Section 132(d) or that the personal use of such devices that are provided primarily for business purposes may constitute a de minimis fringe benefit, the value of which is so small as to make accounting for it administratively impracticable, under IRC Section 132(e).

Tomorrow’s blogticle will continue our series on tax law changes related to wealth managers in 2011.

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

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[1] IRC Sec. 280F(d)(4)(A).

[2] Cellular telephones (or other similar telecommunications equipment) were added as listed property as in section 7643 of the Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101–239 and subsequently removed by section 2043 of the Small Business Jobs Act of 2010, Public Law 111–240.

[3] IRC Sec. 274(d)(4).

[4] Temp. Treas. Reg. sec. 1.274–5T(b)(6).

[5] Temp. Treas. Reg. sec. 1.274–5T(c)(2)(ii)(C).

[6] Temp. Treas. Reg. sec. 1.274–5T(e)(2)(i)(A).

[7] Temp. Treas. Reg. sec. 1.274–5T(e)(2)(i)(A).

[8] Temp. Treas. Reg. sec. 1.274–5T(e)(2)(ii).

[9] Public Law 111–240.

Why is this Topic Important to Wealth Managers? This topic presents discussion on the child and dependent care credit. For those wealth managers who participate fully in clients planning decisions, it is helpful to understand the implication of tax credits generally. This particular blogticle explores one such credit, the child and dependent care credit.

In addition this blogticle presents an excerpted preview of new, updated material from Advanced Markets which will be available soon (see www.advisorfx.com). Over the coming 9 months, the entire AUS service is being revised and will be rolling out monthly. The updating will include many new areas and a sharper focus with practical explanations and client presentation aides for current areas. We look forward to helping you secure your next sale.

A credit is available for certain child and dependent care expenses incurred by a taxpayer as a result of employment.[1] Eligible taxpayers are allowed a credit of up to 35% of certain expenses incurred for the care of a “qualifying individual.” [2] However, the credit is subject to several restrictions.

First, the 35% is reduced (but not below 20%) by one percentage point for each $2,000 (or fraction thereof) by which the taxpayer’s adjusted gross income for the taxable year exceeds $15,000.[3] The effect of this reduction is that for taxpayers with adjusted gross income of more than $43,000 the applicable percentage is 20%.

A second restriction further reduces the credit by limiting the amount of expenses eligible for the credit to $3,000 for one qualifying individual or $6,000 for two or more qualifying individuals.[4]

A “qualifying individual” is defined as: (1) a child under age 13 for whom the taxpayer is entitled to take a dependency exemption, (2) a physically or mentally incapacitated dependent, or (3) a physically or mentally incapacitated spouse.[5]

Expenses for household and dependent care services are “employment related” if they are incurred to enable the taxpayer to be gainfully employed.[6] “Gainful employment” includes periods in which the taxpayer is employed full-time, part-time, or in active search of gainful employment.[7]

Expenses for services outside the taxpayer’s household qualify only if they are in respect to a child under age 13 or a qualifying individual who regularly spends at least eight hours each day in the taxpayer’s household.[8] However, no amount of any expenses for overnight camp will be considered “employment-related.” [9]

Payments for child or dependent care to a close relative qualify for the credit so long as: (1) neither the taxpayer nor his spouse is entitled to claim the relative as a dependent; and (2) the relative is not a child of the taxpayer who is younger than age 19 at the close of the taxable year. Taxpayers must provide the name, address and taxpayer identification number of the child care provider in order to claim the credit.[10]

The full material presented under this section will be available soon. Check back with Advanced Markets for more information. Tomorrow’s blogticle will continue to discuss important planning aspects of 2011.

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

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[1] IRC Sec. 21(a)(1).

[2] IRC Sec. 21(a)(2).

[3] IRC Sec. 21(a)(2).

[4] IRC Sec. 21(c).

[5] IRC Sec. 21(b)(1).

[6] IRC Section 21(b)(2).

[7] Treas. Reg. §1.21-1(c)(1).

[8] Treas. Reg. §1.21-1(e)(1).

[9] Treas. Reg. §1.21-1(d)(6).

[10] IRC Sec. 21(e)(9).

Now more than ever, clients and potential clients are concerned about how they’re going to continue to enjoy the lifestyle they’ve grown accustomed to pre-retirement.  Most clients are still looking for the same basic retirement advice from their advisors—advice on how to define and meet their retirement goals.

Following the recent financial crisis, your affluent clients are more likely to gravitate to conservative investment strategies that will preserve their hard-earned principle.  But many of them are not clear on the risks of that strategy—they aren’t aware of the opportunities they’re missing.

You can help them reach the retirement they want and find the level of risk appropriate to their long-term goals.  Here’s a breakdown of their values and priorities and how you can appeal to them.  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 high net worth investors in Advisor’s Journal, see High Net Worth Clients: How to Find Them, How to Service Them (CC 10-07).

For in-depth analysis of investment planning for affluent clients, see Advisor’s Main Library: Investment Planning.

Why is this Topic Important to Wealth Managers? Discusses the taxation of gambling transactions.  Provides wealth managers with an overview of a commonly discussed tax area.

How does the average gambler determine wagering gains and losses for tax purposes?

Mrs. X is a casual gambler.   She uses the cash receipts and disbursements method of accounting and files her returns on a calendar year basis.  Mrs. X’s gaming practice is to commit only $100 to slot machine play on any visit to a casino.  She wagers until she loses the original $100 committed to gambling or until she stops gambling and “cashes out.”

Upon cashing out, there are three possibilities, that she have $100 (the basis of her wagers), less than $100 (a wagering loss), or more than $100 (a wagering gain).   She went to a casino to play the slot machines on ten separate occasions throughout the year.  On each visit to the casino, she exchanged $100 of cash for $100 in slot machine tokens and used the tokens to gamble.  On five occasions, the she lost her entire $100 in tokens before terminating play.  On the other five occasions, the she redeemed her remaining tokens for the following amounts of cash:  $20, $70, $150, $200 and $300.

Under the Internal Revenue Code, gross income means all income from whatever source derived, which has been determined to include wagering gains. [1]

The Code further allows a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. [2] In the case of losses from wagering transactions, losses are allowed only to the extent of gains from such transactions. [3]

In ordinary practice, a wagering “gain” means the amount won in excess of the amount bet (basis). [4] That is, the wagering gain is the total winnings less the amount of the wager.  The term wagering “loss” means the amount of the wager (basis) lost.

Generally, gamblers may not carry over excess wagering losses to offset wagering gains in another taxable year or offset non-wagering income. [5] Nor may casual gamblers net their gains and losses from play throughout the year and report only the net amount for the year. [6]

It is accepted that fluctuating wins and losses left in play are not accessions to wealth until the taxpayer redeems her tokens and can definitively calculate the amount above or below basis (the wager) realized. [7]

Under the facts presented above, Mrs. X purchased and subsequently lost $100 worth of tokens on five separate occasions.  As a result, the taxpayer sustained $500 of wagering losses.  She also sustained losses on two other occasions, when she redeemed tokens in an amount less than the $100 (basis) of tokens originally purchased.

Therefore, on the day the taxpayer redeemed $20 worth of tokens, the taxpayer incurred an $80 wagering loss.  On the day the taxpayer redeemed $70 worth of tokens, the taxpayer incurred a $30 wagering loss.  On three occasions, the taxpayer redeemed tokens in an amount greater than the $100 of tokens originally purchased.  The amount redeemed less the $100 basis of the wager constitutes a wagering gain. [8] On the day the taxpayer redeemed $150 worth of tokens, the taxpayer had a $50 wagering gain.  On the day the taxpayer redeemed $200 worth of tokens, the taxpayer had a $100 wagering gain.  And on the day the taxpayer redeemed $300 worth of tokens, the taxpayer had a $200 wagering gain.

For the year, the taxpayer had total wagering gains of $350 ($50 + $100 + $200) and total wagering losses of $610, ($500 from losing the entire basis of $100 on five occasions + $80 and $30 from two other occasions).  Mrs. X’s wagering losses exceeded her wagering gains for the taxable year by $260 ($610 – $350).  She must report the $350 of wagering gains as gross income under IRC § 61. However, under IRC §165(d), she may deduct only $350 of the $610 wagering losses.  In this case, the taxpayer may deduct only $350 of her $610 of wagering losses as an itemized deduction.   Generally, a casual gambler who takes the standard deduction rather than electing to itemize may not deduct any wagering losses. [9]

Tomorrow’s blogticle will discuss relevant topics to wealth managers in 2011.

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

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[1] IRC Section 61; Rev. Rul. 54-339; Umstead v. Commissioner, T.C. Memo. 1982-573, 44 TCM 1294, 1295 (1982).

[2] IRC Section 165(a).

[3] IRC Section 165(d); Treasury Regulations Section 1.165-10.

[4] See Rev. Rul. 83-103.

[5] Skeeles v.  United States, 118 Ct. Cl. 362 (1951), cert. denied, 341 U.S. 948 (1951).

[6] See United States v. Scholl, 166 F.3d 964 (9thCir. 1999).

[7] See Commissioner v. Glenshaw Glass  Co., 348 U.S. 426 (1955).

[8] See Rev. Rul. 83-130.

[9] See Rev. Rul. 54-339.

Why is this Topic Important to Wealth Managers? Discusses retirement plan investments with regards to client retirement planning.  Provides types of investments retirement plans can and cannot make.

What types of investments can a retirement plan make?

Although there is no list of approved investments for retirement plans, there are special rules contained in the Employee Retirement Income Security Act of 1974 (ERISA) that apply to retirement plan investments.

In general, a plan sponsor or plan administrator of a qualified plan who acts in a fiduciary capacity is required, in investing plan assets, to exercise the judgment that a prudent investor would use in investing for his or her own retirement.[1]

In addition, certain rules apply to specific plan types.  For example, there are different limits on the amount of employer stock and employer real property that a qualified plan can hold, depending on whether the plan is a defined benefit plan, a 401(k) plan, or another kind of qualified plan. [2]

Nevertheless, certain plans, such as 401(k) plans, that permit participant-directed investment can avoid some fiduciary responsibilities if participants are offered at least three diversified options for investment, each with different risk/return factors. [3]

As many wealth managers already know, however, individual retirement accounts are not permitted to invest in life insurance. [4]

Moreover, under the Code, both participant-directed accounts and IRAs cannot invest in collectibles, such as art, antiques, gems, coins, or alcoholic beverages, and they can invest in certain precious metals only if they meet specific requirements. [5]

Are there other transactions that are prohibited?

A prohibited transaction is a transaction between a plan and a disqualified person.  Prohibited transactions generally include the following transactions:

• a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
• any act of a fiduciary by which plan income or assets are used for his or her own interest;
• the receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets;
• the sale, exchange, or lease of property between a plan and a disqualified person;
• lending money or extending credit between a plan and a disqualified person; and
• furnishing goods, services, or facilities between a plan and a disqualified person.

How do prohibited transactions affect IRAs?

A prohibited transaction with respect to an IRA occurs if the owner or beneficiary of the IRA engages in any of the transactions prohibited transactions described above.  In the case of an individual retirement account the Code provides that the account is no longer an individual retirement account, and it is treated as if the assets were distributed on the first day of the taxable year in which the prohibited transaction occurred.[6] Of course, this may trigger an early withdrawal penalty.

Tomorrow’s blogticle discusses additional changes wealth managers can expect in 2011.

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

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[1] ERISA § 404.

[2] ERISA § 407.

[3] See generally, Labor Reg. §2550.404c-1.

[4] IRC §408(a)(3).

[5] IRC §408(m).

[6] IRC §408(e)(2).

Why is this Topic Important to Wealth Managers? Presents discussion on the effect of the Obama Tax Cuts on the Estate Planning industry in general.  Also presents analysis regarding the estate tax burden on taxpayers.

The quintessential planning tool that many wealth managers relied on could easily become a thing of the past.  In other words, the Obama Tax cuts are creating concern for some wealth managers who sold life insurance to cover the tax of an estate at the death of the decedent. Sections 301-304 of the new law reinstated the estate tax, but nevertheless, created large exclusions, essentially removing the need for many to cover the estate tax burden with the purchase of life insurance.

Specifically, the applicable estate tax exclusion amount is $5 million under the law (and is indexed for inflation) for decedents dying in calendar years starting in 2011. Married individuals’ will see a total exclusion of $10 million.  Furthermore, the new law reinstates the maximum estate tax rate of 35 percent.

The high exclusion limit is creating concern among the life insurance industry in particular.  Many wealth managers are aware of the benefit of purchasing life insurance to cover the estate tax burden that a high-net worth individual may face.  Nonetheless, creative wealth managers are finding other ways to sell life insurance and other insurance products, such as annuities, in this changing estate tax climate.

“I’ve turned a lot of my attention to business succession planning”, states Martin Levine, a wealth manager representing high net worth individuals on Long Island, New York.  “Not many clients are going to have an estate over $10 million” says Levine.  Mr. Levine’s contention is not far off; estimates show that in 2009, under the $3.5 million exemption level, only 34,000 estate tax returns were filed.  Moreover, 43 percent of all estates, reported deductions for marital bequests.  Another, 19 percent of estates claimed a charitable bequest deduction.

This means that after the deduction for marriage exclusions, including any charitable bequest deductions, less than half of all estates that filed an estate tax return actually owed any estate tax.  The number of estates that will be subject to pay an estate tax will likely decrease on a going forward basis, because of the large increase of the exemption amount to unprecedented levels.

The estate tax obligation of all estates, in 2009 was approximately $21 billion.  The total Federal receipts in 2009 were $2.213 Trillion.  Therefore, the estate tax represented approximately 0.99% of all Federal revenues.

Just 10 years prior (2000) 108,322 estates filed a return, where 52,000 were taxable estates for a total of around $24.5 billion which represented approximately 1.2% percent of Federal receipts.

Tomorrow’s blog will continue to discuss pertinent provisions of the new Tax Cuts and how they relate to wealth managers.

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

Why is this Topic Important to Wealth Managers? Provides insight into the world of facts and circumstances in light of the economic substance doctrine.  Gives wealth mangers another view of the newly codified doctrine.

This blogticle is written to expound upon the recent AdvisorFX Journal article on economic substance written earlier this month.  AdvisorFX: The Economic Substance Doctrine Can Unwind Even the Best Laid Plans ) (CC 10-74).  Although its material is not required prerequisite knowledge to understand this presentation, wealth managers may find additional information presented therein to be useful.  This blog also sets-out to make a minor correction to the FX article, discussed below.

Many wealth managers are now aware of the codification of the Economic Substance Doctrine in Internal Revenue Code § 7710 (o).  This change was made as part of the Health Care and Education Affordability Reconciliation Act of 2010.

It states that taxpayers, when subject to the application of the economic substance in general, must show that, the transaction changes the taxpayers “economic position” in a meaningful way not including any tax benefits, and the taxpayer has a” substantial purpose” for entering the transaction not including any tax considerations.

The “economic substance doctrine” is a common law doctrine now codified, under which tax benefits with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. [1]

The basis for the recent codification is based on the case law which “requires that the intended transactions have economic substance separate and distinct from economic benefit achieved solely by tax reduction.” [2] “The doctrine of economic substance becomes applicable…where a taxpayer seeks to claim tax benefits, unintended by Congress, by means of transactions that serve no economic purpose other than tax savings.” [3]

The determination of “whether a particular transaction meets the requirements for specific treatment under any of these provisions is a question of facts and circumstances.” [4] Therefore, wealth managers find it even more difficult to establish general rules regarding certain transactions as each case is unique and should be evaluated separately.  Furthermore, this means that two similar transactions under different fact patterns can yield entirely two different results.  Moreover, just because, “the fact that a transaction meets the requirements for specific treatment under any provision of the Code is not determinative of whether a transaction or series of transactions of which it is a part has economic substance.” [5]

This means in essence, the “Commissioner can apply to disallow a transaction” even if the formal characterization claimed by the taxpayer “technically satisfies the statutory conditions” by refusing to ”recognize tax benefits achieved by the form because the transaction lacks economic substance.” [6]

Our recent Advisor FX article (AdvisorFX: The Economic Substance Doctrine Can Unwind Even the Best Laid Plans ) (CC 10-74) mentioned in part, “The new law imposes a strict-liability 40 percent penalty on tax underpayments resulting from transactions that fail the economic substance doctrine.”  However, this author would like to note that, the 20% penalty ordinarily applied to “substantial understatements” is also applied to a “transaction lacking economic substance (within the meaning of section 7701(o)).” [7]

Only when, “any portion of an underpayment which is attributable to one or more nondisclosed noneconomic substance transactions,” will the penalty increase to “40 percent” from “20 percent”. [8] Nondisclosed noneconomic substance transaction means “any portion of a transaction” which is found to fail within the economic substance doctrine, and “relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return.” [9] Therefore, if relevant facts affecting the tax treatment of the transaction are adequately disclosed, then the smaller penalty should apply to the tax underpayment.

Next week’s blogs will revert back to the life insurance arena as we discuss products in detail.

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

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[1] 26 U.S.C. § 7710 (o)(5)(A).

[2] Joint Committee on Taxation.  “Health Care and Education Reconciliation Act of 2010- Technical Explanation of the Revenue Provisions of the Reconciliaton act Of 2010,as Amended, in Combination with the Patient Protection and Affordable Care Act”.  E. Codification of Economic Substance Doctrine and Imposition of Penalties. JCX- 18-10 NO 7, 2010 WL 1047322 (I.R.S.).

[3] Joint Committee on Taxation. Citing, ACM Partnership v. Commissioner, 73 T.C.M. at 2215.

[4] Joint Committee on Taxation.

[5] Id.

[6] Jeff Rector.  A review of the Economic Substance Doctrine”.  10 Stan. J.L. Bus. & Fin. 173, 174 (.2004)

[7] 26 U.S.C. § 6662 (b)(6).

[8] 26 U.S.C. § 6622 (i)(1). [italics added].

[9] 26 U.S.C. § 6622 (i)(2).

Why is this Topic Important to Wealth Managers? Many wealth managers are probably aware that when a client receives income, there is generally a tax effect which has implications on the determination of the income tax liability.  This blogticle presents situations that may or may not trigger specific tax consequences related to common transactions.

As a starting point, The Internal Revenue Code states that gross income, the top line calculation used in determining taxable income, includes income from whatever source derived unless otherwise excluded by law.  [1] One such exclusion occurs when death benefits are received by a beneficiary of a life insurance contract. [2]

To show the extent of the taxing power to include all income except excluded income, the Supreme Court examined a situation where taxpayers received money as settlement in punitive damages arising from anti-trust and fraud litigation.  The Court, in Commissioner v. Glenshaw Glass Co., adopted a broad definition of income as “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” [3] The Supreme Court’s ruling overturned both the District Court and Appeals Court decisions; it was therefore held the taxpayer’s receipt of money from settlement of a lawsuit was an increase in the taxpayer’s wealth, and furthermore, since not excluded under any section of the code, was consequently includable as gross income. [4]

However, where income is not “realized”, the taxpayer does not incur a tax liability.  In Eisner v. Macomber the taxpayer, a shareholder of a corporation, received additional shares representing undistributed earnings. [5] The Supreme Court “determined that a shareholder’s receipt of a stock distribution was not income to the shareholder and, therefore, Congress’s attempt to tax the stock dividend was not authorized by the Sixteenth Amendment.” [6]

The Court in Eisner also illustrated the now well known “fundamental relation of ‘capital’ to ‘income’ ”, as “the former being likened to the tree or the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from springs, the latter as the outlet stream, to be measured by its flow during a period of time.” [7]

In another respect, when property or services are received by a taxpayer, a realization of income has occurred.  It is a long recognized principal that “if services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income.” [8]

Barter transactions are afforded the general tax treatment as if the bartered property, goods, or services were sold, and the property, goods, or services received was purchased with the funds obtained from the that “sale.”  [9] Taxpayers are required to file Form 1099-B for barter transactions.

However, there are instances where even though the taxpayer may not receive anything today,    he has a right to receive something today, and is therefore taxed on it today.  This is the doctrine of constructive receipt.  “Income although not actually reduced to a taxpayer’s possession is constructively received by him” when he can draw upon it, or is otherwise made available to him. [10]

An example of constructive receipt occurs when interest from a savings account is taxed because the right to withdrawal interest from a savings account is present, and therefore the taxpayer has realized the income. [11] Another example is when a corporation “advises its employees that they will be receiving cash Christmas bonuses on December 20.”  One of the employees requests that “the payroll department not issue his bonus check until January 2.”   Since the employee “had an unrestricted right to receive the money on December 20, he is considered to have constructive receipt of the income as of that date.”

This last example as well of the contents of this article are discussed more thoroughly in

Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit. 09-36. (09/01/2009).  Please access AdvisorFX for the above article, or for more information on a free trial membership.

Tomorrow’s blogticle will discuss the similar but slightly different tax theory of economic benefit.

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

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[1] 26 U.S.C. § 61(a); 26 U.S.C. § 63.

[2] 26 U.S.C. § 101.

[3] Commissioner of Internal Revenue v. Glenshaw Glass Co. 348 U.S. 426, 431. 1955.

[4] Glenshaw Glass Co. 348 U.S. at 432-433. Citing, Helvering v. Midland Mutual Life Ins. Co., 300 U.S. 216.

[5] Eisner v. Macomber. 252 U.S. 189, 201. 1920.

[6] Nathel v. C.I.R. 615 F.3d 83, 88. 2010.

[7] Eisner. 252 U.S. at 206.

[8] Rev. Rul. 79-24, 1979-1 CB 60. Citing 26 C.F.R. § 1.61-2(d)(1)

[9] U.S. v. General Shoe Corp. 282 F.2d 9, 12.  1960.  (Taxpayer realized exactly the same gain by transferring real estate as it would have had it sold the real estate for the fair market or appraised value and paid funds to a third party).

[10] 26 C.F.R. §1.451-2(a).

[11] 26 C.F.R. §1.451-2(a)(1).