NewsNotes

Lesli S. Laffie, J.D., LL.M.

Bankruptcy and OICs   Divorce/Estate Planning
Trust Disregarded Entities and Tax Liabilities

Court Decisions

Bankruptcy and OICs

According to a Georgia district court in William K. Holmes, MD GA, 3/16/04, the bankruptcy court acted within its jurisdiction in issuing an order directing the IRS to consider a debtors offer-in-compromise (OIC), notwithstanding its policy against considering OICs from persons involved in pending bankruptcy proceedings.

Facts: William K. Holmes, a debtor, owned approximately 3.2 million shares of WorldCom stock in 2000, which, at one time, had a value of about $200 million. As WorldCom began to show signs of financial difficulty, the debtors stockbroker sold his shares as they decreased in value to meet margin calls.

Although the sale triggered capital gain with accompanying tax liabilities, the debtor did not receive sales proceeds, because they went directly to pay margin debt. On July 1, 2002, the debtor filed a Chapter 11 bankruptcy petition.            

The IRS filed a proof of claim that included a priority claim for $9,372,245 in income tax and interest and a $920,462 general unsecured claim for penalties. The debtor submitted an OIC to the IRS for $621,326, which it rejected; it would not process the offer because it does not consider OICs from persons involved in pending bankruptcy proceedings.

The debtor then filed a motion in bankruptcy court to determine tax liability and to object to the IRSs claim. He sought an order requiring the IRS to consider his OIC, arguing that 11 USC Section 525 prohibits discriminatory treatment, including the denial of consideration of an OIC, against debt-ors involved in bankruptcy.

The bankruptcy court rejected the debtors argument as to 11 USC Section 525, but in line with the reasoning of In re Macher, 303 BR 798 (WD VA 2004), ordered the IRS to process and consider the OIC. It based its ruling on 11 USC Section 105, which provides that a bankruptcy court may issue any order, process, or judgment that is necessary to carry out the provisions of this title. The IRS appealed, arguing that the (1) bankruptcy court lacked subject matter jurisdiction to order the IRS to consider the OIC and (2) order violated the Anti-Injunction Act in 26 USC Section 7421(a).         

Decision: The district court af-firmed the bankruptcy courts order directing the IRS to consider the debtors OIC. The district court agreed with the reasoning of the bankruptcy court, its reliance on Macher and the broad reading afforded to 11 USC Section 105 by other courts. The district court dismissed as misplaced and misleading the IRSs arguments surrounding the possible future effects of the bankruptcy courts decision and the connection with the Anti-Injunction Act.

From the IRS

Divorce/Estate Planning Trust

In Letter Ruling 200413011, the IRS ruled favorably on a trust created to (1) deal with the possibility of divorce under a prenuptial agreement and (2) achieve estate planning goals.

Facts: B, who is married to M, intends to create a trust and transfer his separately owned property to it. He will retain the power to appoint all the trusts income or principal. The power will not apply to property distributed to beneficiaries under other trust provisions and will terminate on the first to occur of (1) Bs death, (2) Ms death, (3) Bs written release of the power or (4) 20 years and two months. The power may not be exercised in favor of B, his creditors, his estate or his estates creditors; thus, it is a special power of appointment.

During Bs life, the trustee is to pay all of the trusts net income, at least annually, to or for Ms benefit. After Bs death, the net income is to be paid, at least quarter-annually, to or for Ms benefit. The trustee is to distribute to or for Ms benefit so much of the principal as the trustee, in its sole discretion, considers necessary or advisable for her health, support, maintenance and education. On Ms written demand, unproductive property is to be made reasonably productive.

Under its terms, the trust will terminate if B and M so agree, and principal will be distributed to her.

B and M also intend to enter into a prenuptial agreement as to the disposition of their property on divorce. They agree that the property transferred to the trust will retain the characterization (as marital or separate property) it had before the transfer. The property transferred to the trust is to be divided on divorce as provided in the agreement. On a divorce, the court having jurisdiction is to determine the portion (if any) of trust property that B is to receive. The agreement is to be null and void on the first to occur of (1) B signing a document nullifying it or (2) 20 years.

Rulings: According to the IRS, Bs transfer of assets to the trust while he retains the power to appoint income and principal will not be a gift under Sec. 2501; under Regs. Sec. 25.2511-2(c), a gift is incomplete if and to the extent that a reserved power allows the donor to name new beneficiaries or to change their interests as between themselves, unless the power is a fiduciary power limited by a fixed or ascertainable standard.

Because the trust provides that if B does not exercise his power, the trustee must pay all the net income to M during her life and may distribute principal to her, a completed gift to M will occur each time she receives a payment of income or principal. These gifts will qualify for the Sec. 2523 unlimited gift tax marital deduction.

Because of Bs power and the provision on divorce, Ms interest is not a qualifying income interest for gift tax marital deduction purposes under Sec. 2523; however, when the power of appointment is terminated and the agreement is nullified, Ms income interest will qualify for Sec. 2523 purposes. Thus, if B makes a valid qualifying terminable interest property (QTIP) election under Sec. 2523(f) at that time, the trust assets will qualify for the gift tax marital deduction and no part of the trust will be includible in his gross estate if M survives him. If the QTIP election is made and M does not dispose of any part of her income interest during her life under Sec. 2519, the trusts assets will be includible in her gross estate under Sec. 2044, whether or not she survives B.

Regulations

Disregarded Entities and Tax Liabilities

The IRS has issued proposed regulations (REG-106681-02) on qualified real estate investment trust (REIT) subsidiaries, qualified subchapter S subsidiaries (QSubs) and single-owner eligible entities disregarded as entities separate from their owners. The regulations would clarify that these disregarded entities are to be treated as separate entities for purposes of any Federal tax liability for which they may be liable.

Background: Under the Code and regulations, three types of entities may be disregarded as separate from their owners: qualified REIT subsidiaries (under Sec. 856(i)(2)), QSubs (under Sec. 1361(b)(3)(B)) and single-owner eligible entities (under Regs. Sec. 301.7701-3(a)). A disregarded entity generally is not liable for the Federal tax liabilities of its owner for tax periods during which it is disregarded. However, a disregarded entity may be liable for Federal taxes for tax periods during which it was not disregarded or because it is the successor or transferee of a taxable entity.

Proposed rules: The proposed regulations would clarify that a disregarded entity liable for Federal taxes will be treated as an entity separate from its owner for purposes of those liabilities. As a result, an assessment could be made against the disregarded entity; its assets could be subject to lien and levy; and it could consent to extend the period of limitations on assessment. Also, a disregarded entity could be entitled to a refund or credit. The regulations would apply after March 31, 2004.