Extreme Makeover: Arts Edition Paducah, Kentucky

A postive story about urban redvelopment sparked by the arts from Sheppard, Mullin, Richter & Hampton LLP recently posted at the National Law Review:

The notion that the arts make our culture “richer” is commonplace in our vernacular, but an undeniable trend has emerged giving an entirely new meaning to the phrase: across the board, the country’s nonprofit arts and culture industry has grown by twenty-four percent over the past five years, generating over $166 billion in economic activity a year. Art can be big business, and not just in cosmopolitan meccas like New York and Los Angeles. Across the United States, small and midsized cities are harnessing their creative energy to jumpstart their local economies, often with striking results. Cities that have taken heed of this trend have been rewarded in multiple ways—from the rehabilitation and development of uninhabitable areas of the city to the welcoming of tourists, businesses, and well-heeled residents to those very areas. One seminal example is New York’s Soho and Tribecca neighborhoods, which now exceed the famed Upper East Side and Central Park West neighborhoods in rental and real estate prices. It is a reversal of the commonly held notion that artists drain resources, rather than attract them. Perhaps no city has been more successful in exploiting the economic potential of the arts than Paducah, Kentucky, a town of 27,000 which got the Extreme Makeover formula just right when it implemented what has come to be known as an Artist Relocation Program.

Ten years ago, artists were lured to the blighted downtown neighborhood of LowerTown by the prospect of free home ownership and creative autonomy in developing their properties. As a result, Paducah today has been transformed into a thriving community of galleries, shops, and cafes. It is just the kind of place that attracts visitors and tourism. Paducah’s tourist revenue has drastically increased from $66 million in 1991 to nearly $287 million in 2009. Since the Artist Relocation Program began, the city has attracted 234 new businesses, created over 1,000 jobs, raised over $52 million from private investors and invested nearly $50 million from public funds. Tom Barnett, Paducah’s former city planning director, boasted that for every dollar the city has put into the program, it has received $14 back—an extremely impressive return on its investment. Paducah has indeed become a national model for how a city can reinvent itself as a cultural destination.

Paducah is hardly different in its skeleton than countless cities across the country. It suffered from both a loss of the economy that had helped it prosper (in this case, a uranium enrichment plant), and perhaps more substantially, from suburban flight. LowerTown, which is the oldest neighborhood in the town, was once a thriving, self-contained neighborhood. But as its older residents passed on, the next generation showed little interest in returning from their larger homes outside town. LowerTown’s homes were gradually chopped up into apartments and largely neglected. It is a story repeated across the country. Now, many of these cities are mimicking the Paducah strategy. Chattanooga, Tenn., Pawtucket, R.I., and Oil City, Pa., provide just three of many examples of smaller cities that are wholeheartedly embracing the idea of an Artist Relocation Program.

When pursuing a rehabilitation process, city governments and planning committees begin by first consulting the current zoning laws and maps. Fortunately for Paducah, LowerTown was already designated as a mixed use zone, thus it did not have to drastically adjust the districts’ zoning laws. Mixed use zones accommodate multiple land uses in one zone, allowing a retail store to sit next to a single-family home or a restaurant to be housed on the first floor of a 100-unit condominium complex. On the other hand, conventional zoning, often referred to as Euclidean zoning, divides a city into specific and separate districts and assigns each district a permitted land use, such as residential, commercial, or industrial. To further complicate matters, Euclidean zoning also utilizes overlay zones to control land use, so for instance, a lot will be designated “commercial” and then in addition, the overlay rules will mandate that each lot be a minimum of 10,000 square feet. Zoning laws were originally written to be “as of right.” This means that by consulting the zoning ordinance governing their land, owners can determine what types of projects they are able to develop, subject only to the city’s verification that the owner’s plan complies with the applicable zoning laws. There has been a distinct trend over time to move towards discretionary zoning, which grants a city the right to review virtually all land use projects within a zone and determine whether the project will be approved, rejected or approved with additional conditions. Developers typically prefer ‘as of right’ zoning over discretionary zoning because discretionary zoning requires a public hearing, which often leads to increased costs and time. While most cities have employed discretionary zoning on mixed use zones, Paducah continued to utilize ‘as of right’ zoning in order to encourage growth and minimize expenditures for new developers.

Specifically tailored zoning ordinances allowed Paducah to effectively control both the aesthetic character of renovation projects and the intent of artists and businesses relocating to the city, in order to ensure the city’s rehabilitation project evolved into the community the city hoped to build. Further, Paducah took advantage of its mixed use zoning to enable artists to use their residences as both a home, studio, and sometimes even a gallery, leading to more affordable property values and rental costs. In addition, mixed use zones naturally lend themselves to more compact, close-knit communities that are organized to make walking and biking easier and more pleasant. This is helpful for an art community because it connects artists with the community while simultaneously providing the public easy access to artists’ works and galleries. It also leads to more “mom and pop” owned cafes and boutiques that serve as social hot spots for the local community.

In addition to offering mixed use real estate, Paducah provided qualifying artists with financial incentives to relocate to the city, as well as affordable properties to purchase in connection with a reimbursement program for artists who choose to restore their newly purchased property. For instance, Paducah offered relocating artists up to $2,500 in moving expenses, properties for $1 with an approved qualifying proposal, a $2,500 reimbursement for architectural and professional improvements and up to $5,000 for rehabilitation costs associated with the new property. In addition, the locally owned Paducah Bank offered artists long-term loans with generously fixed interest rates to finance the purchase and renovation costs of their homes. After approving these legislative measures, Paducah began actively seeking out artists via commercials and advertisements that portrayed Paducah as a quirky southern town which embraced the arts. The Artist Relocation Program and successful PR campaign have incentivized over 75 artists to relocate to LowerTown from across the country, helping to reduce the town’s crime rate and revive Paducah’s economy.

Further, the significant twenty-four percent growth in the country’s nonprofit arts and culture industry can largely be attributed to the substantial amount of event-related spending by arts audiences. Art and cultural events generate economic activity for local businesses, including restaurants, hotels, retail stores and parking garages. Astutely realizing this potential, Paducah organizes large-scale events to entice tourists, such as the annual quilting convention that brings in nearly 40,000 tourists and the LowerTown music festival. During these events, the city’s “no vacancies” signs are lit, restaurants are hopping, and local boutiques are brimming with customers. In addition, Paducah plans local events to encourage residents to socialize and support one another. An example of this is Paducah’s “Live On Broadway” series that occurs every Saturday night in the summer. At these events, the city provides free live music, public art demonstrations, and horse-drawn carriage rides throughout the downtown district. Paducah residents are encouraged to support their community by shopping at local galleries and boutiques that remain open late into the evening exclusively for the event. Thus, Paducah effectively capitalizes on the arts’ economic potential by utilizing both large and small scale events to attract tourists and local residents.

Paducah’s future appears to be in good hands under the guidance of Mayor Bill Paxton, who explains, “As a Paducah native, I have watched the City grow and change. It’s always been known as a hub for river traffic and a regional destination for shopping, entertainment, employment, education, and medical facilities. But with the artist relocation program that revitalized LowerTown, the National Quilt Museum of the United States, and the Paducah School of Art, Paducah has become a nationally known cultural center. The City Commission and I are committed to making Paducah even better. We are working hard to bring new jobs to the area, revitalize more neighborhoods, and make the downtown and riverfront areas a destination for all. Everything we do is to improve the quality of life.”

As far as Extreme Makeovers go, one Paducah resident may have said it best when she stated that her city “makes you feel good to live here.” More importantly, Paducah and this overall national trend demonstrate how the arts can serve as an effective catalyst in reviving a community by paving the way for a richer city, both economically and culturally.

Planning Opportunities Under the New Estate and Gift Tax Law

Recent post summarizing Gift and Estate Tax changes at the National Law Review by Lowndes, Drosdick, Doster, Kantor & Reed, P.A. – read on:

On December 17, 2010 Congress enacted a new tax law which changes the federal gift, estate and generation-skipping transfer (“GST”) taxes currently in effect. However, the new law is only effective for the next two years, through December 31, 2012. The new law reinstates the lifetime exemptions for the estate, GST and gift taxes and increases the amount of the exemptions to $5,000,000 per person with a top tax rate of 35%.

The law provides new opportunities for clients. The increased gift tax exemption allows for clients to make tax-free gifts of their estate which might otherwise be taxable. The new gift tax provisions allow someone who has already made taxable gifts totaling $1,000,000 during his or her life to have an additional $4,000,000 of gift tax exemption available for use during his or her life. This is an immediate planning opportunity for clients who may wish to take advantage of the tax law changes.

The new law may also alter many clients’ estate plans. For example, assume a client’s estate plan is drafted to provide that the estate is to be divided into a family trust and a marital trust with the family trust being funded with the maximum estate tax exemption and the marital trust being funded with the amount, if any, of the estate that exceeds the exemption amount. Thus, under current law, the family trust would be funded with the first $5,000,000 of the estate (or the entire estate depending on the value of the estate) with the possibility that no portion of the estate would pass into the marital trust. Given the increased exemption, this may or may not be what a client would want to happen.

Many clients’ current estate plans include a family trust to ensure the use of the first spouse’s estate tax exemption because the prior law provided if the estate exemption was not used at the first spouse’s death it was lost. The new law provides for “portability” of the estate tax exemption. Thus, a surviving spouse may elect to add the deceased spouse’s unused estate and gift tax exemption to the surviving spouse’s exemption, thereby increasing the surviving spouse’s estate and gift tax exemption for transfers during life or upon death. For instance, if the first spouse dies and only used $2,000,000 of his $5,000,000 estate tax exemption, upon election, the surviving spouse would now be able to shelter $8,000,000 from estate and gift tax (the surviving spouse’s exemption of $5,000,000 plus the deceased spouse’s unused $3,000,000 of exemption).

The new law also applies to the estates of individuals who died in 2010 and who may wish to take advantage of some of the planning opportunities. If a family member passed away in 2010, you may want to discuss what planning opportunities are available related to the estate with your estate attorney.

While the new tax law is a step in the right direction, it only applies through December 31, 2012. Therefore, it is important to confirm your estate planning documents are drafted to address the changing tax law as well as to take advantage of the new opportunities that are currently available and may expire in two years. Even if your estate is below the new exemption amount, it is still important to make sure your estate plan is up to date to ensure your intent is carried out and to maximize all of the options available to you.

Section 409A Again? Employers Need to Re-examine Executive Employment Contracts and Other Agreements Conditioning Severence Payments Upon a Release of Claims

Recently posted at the National Law Review by Nancy C. Brower and David L. Woodard of Poyner Spruill LLP – information for employers about the tax Consequences of employment agreements, retention agreements, severance agreements and change in control agreements:

Agreements that provide for payments upon termination of employment, such as employment agreements, retention agreements, severance agreements and change in control agreements, often condition payment upon the return of an executed release of claims. Since Section 409A allows agreements to provide for a payment window of up to 90 days from separation from service, it was widely believed that an agreement could provide for payments to begin upon the return of a release, provided the release was required to be returned within the 90-day window period and the company determined the time of payment. In Notice 2010-6, the IRS stated that this type of provision is not Section 409A compliant. Fortunately, at the end of last year, the IRS came out with relief that will allow companies to correct this problem without employees incurring Section 409A taxation.

Action Step

Companies should immediately identify all employment agreements, retention agreements, severance agreements and change in control agreements that condition severance payments upon the return of a release. All of these agreements should be reviewed for Section 409A compliance based on the new guidance from the IRS. Companies should not rely on the fact that the agreements were previously reviewed for Section 409A compliance, since the 2010 guidance from the IRS was not anticipated by most practitioners. Companies should pay careful attention to the timing of payments made under impacted agreements during 2011, as payments made after March 31, 2011 must comply with the corrective guidance contained in Notice 2010-80. Further, any impacted agreements that are outstanding or have any payments still due after December 31, 2012, must be amended to correct the agreement provisions in accordance with Notice 2010-80 no later than December 31, 2012.

Congress Finally Resolves Estate Tax Uncertainty: But Only for Two Years!

Very Comprehensively written article by Michael D. Whitty and Igor Potym of Vedder Price P.C. – so much good Year End Tax Information we thought we’d include it here too:

As part of a compromise to extend the income tax rates in effect from 2003 to 2010 (sometimes described as the “Bush tax cuts”) and unemployment benefits, Congress has finally resolved uncertainties in the estate, gift, and generation-skipping transfer (“GST”) taxes. The new law makes the most significant changes to these taxes since 2001, including a generous increase in exemptions and a significant reduction in tax rates for 2011–2012. In order to take advantage of some one-time wealth transfer opportunities, action is required before the end of 2010. For nearly all high-net-worth persons, the next two years will bring extraordinary estate planning opportunities. Unfortunately, and contrary to many media claims, 2011 and 2012 will also bring added complexity and uncertainty. Surprisingly, estate planning for married persons with estates of less than $10,000,000 may actually be more complicated than planning for married persons with larger estates. Accordingly, all estate plans should be reviewed early in 2011 to determine whether the plan will work as intended under the new tax laws. Persons who would like to discuss how the new estate, gift, and GST tax laws affect their specific situations and existing estate plans should call a member of the Estate Planning Group of Vedder Price P.C.

Executive Summary

The following is an executive summary of the most notable effects of the new law; a more detailed discussion of each can be found inside this Bulletin:

Income Tax Rates Continued for 2011–2012. The 2010 income tax rates are continued for two more years, including the preferential 15% tax rate for long-term capital gains and qualified dividends.
Estate Tax Made Optional for 2010. The estate tax, which had been repealed for 2010, was reinstated effective January 1, 2010, but the executor for a person dying in 2010 may elect to opt out of the estate tax and apply carryover basis instead.
Transfer Tax Exemptions Increased, Tax Rate Reduced. The lifetime exemption amount for transfer taxes—the estate tax, gift tax, and GST tax—is set at $5,000,000. These increases are effective in 2010 except for the gift tax exemption, which remains $1,000,000 until 2011. The tax rate on estates, gifts, and generation-skipping transfers above these amounts is 35%.
Generation-Skipping Transfer Tax Rate Is Zero for 2010. For all of 2010 (including the balance of the year), the GST tax rate is zero.
Unused Estate Tax Exemption Transferable to Surviving Spouse. Beginning in 2011, the unused estate and gift tax exemptions of the first spouse to die may be transferred to the surviving spouse for both gift and estate tax purposes.
Bullets Dodged. The new legislation did not include recent proposals to reduce or eliminate the effectiveness of several of the most advantageous estate planning techniques.
Direct Gifts from IRAs to Charities Reinstated for 2010–2011. In 2008–2009, IRA owners over age 70½ could make direct distributions from their IRAs to charities and exclude the amount from income while treating it as part of their required minimum distribution. The new law extends that option through 2011. Because so little time remains in 2010, a special rule permits taxpayers to make such a transfer in January 2011 and treat it as if it had been made on December 31, 2010.

The “Tax Relief, Etc.” Act of 2010

The bill passed by Congress and signed by President Obama on December 17, 2010, H.R. 4853, was titled the “Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010” in its final form. (It had previously carried other names, including the “Middle Class Tax Relief Act of 2010.”) For simplification, this Bulletin will refer to it as the “2010 Tax Act” or “the Act.”

The bill went through many changes in the last month prior to enactment, and includes some unexpected provisions while excluding other provisions that had been expected. As a result, some of our recommendations from prior bulletins have changed. Please contact a member of our Estate Planning Group for confirmation before acting on our prior recommendations.

The benefits of the Act may be temporary, however. All of the tax changes included in the Act will expire on or before January 1, 2013. Without further action by Congress, the estate, gift, and GST tax rates and exemptions applicable on January 1, 2001 will return on January 1, 2013. Additional legislation in late 2012 or early 2013 seems likely, but it is impossible to predict the details of that legislation.

Income Tax Rates Continued for 2011–2012

The Act continues the 2009 income tax rates through 2012, including the preferential 15% tax rate for long-term capital gains and qualified dividends. Apart from other changes discussed later in this Bulletin, these changes include:

Withholding of Social Security tax from wages and self-employment income for 2011 decreased by two percentage points (with the gap made up from general federal revenues)
AMT “relief” for most taxpayers through 2011
Ability to deduct state sales tax as an itemized deduction through 2011
Enhanced business capital investment deductions and research and development credits

Summary of Changes to Transfer Tax Rates and Exemptions

		2009		2010				2011–2012		2013 (if no action)
Tax:		Exemption	Rate	Exemption			Rate	Exemption	Rate	Exemption	Top Rate
Gift		$1,000,000	45%	$1,000,000		35%		$5,000,000	35%	$1,000,000		55%
Estate		$3,500,000	45%	$5,000,000	[1]	35%		$5,000,000	35%	$1,000,000		55%
GST		$3,500,000	45%	$5,000,000		0%		$5,000,000	35%	$1,400,000	[2]	55%
Notes:	[1] Executors for decedents dying in 2010 may opt out of estate tax, into carryover basis.
	[2] The GST exemption shown for 2013 is a projection, as it would be $1,000,000 indexed for inflation.

Estate Tax Made Optional for 2010

Under the 2001 tax act, the estate tax had been gradually eased, and was then repealed for one year only, 2010. The new Act reinstates the estate tax and stepped-up basis (used for measuring capital gains) effective January 1, 2010. This default rule benefits most estates that are too small for estate taxes but benefit from having stepped-up basis automatically apply to all assets. However, the executor of a 2010 estate may elect to opt out of the estate tax and instead apply carryover basis (where the heirs take the decedent’s basis). (See the item below regarding due dates.)

Transfer Tax Exemptions Increased, Tax Rates Reduced

The Act resets the estate tax exemption to $5,000,000 per decedent, effective January 1, 2010 (up from $3,500,000 in 2009). The exemption for the GST tax is also $5,000,000 effective January 1, 2010. The Act also increases the gift tax exemption to $5,000,000 to re-unify it with the estate tax exemption, but that change is delayed until 2011. These exemption amounts are also adjusted for inflation, beginning in 2012. However, all of these exemptions will revert to $1,000,000 in 2013 unless Congress takes additional action. The Act sets a 35% tax rate on estates, gifts, and generation-skipping transfers above the exemption amounts. This compares favorably with the 45% top rate that applied in 2009, and the 55% rate that would have applied in 2011 if Congress had not acted (and will apply in 2013 if Congress fails to take additional action).

The Act also changes how prior taxable gifts are taken into account in gift and estate tax calculations, by applying the tax rates for the year in question rather than the year of the prior gifts. In our October 2010 Bulletin, we described how the transition in the gift tax rates and exemption from 2010 to 2011 would allow some donors who had already used all of their gift tax exemption to make a modest additional tax-free gift of $36,585 in 2011. The Act’s changes in the gift tax rate, exemptions, and calculations of taxes on prior taxable gifts will eliminate that effect for 2011, but will allow much more extensive tax-free gifts.

Due Dates for 2010 Returns, Disclaimers

To prevent unfairness, the Act extends the due date for all estate and GST tax returns affected by the Act until September 17, 2011, nine months after the date of enactment (as that date falls on a Saturday, the effective date will be September 19, 2011). The due date for related tax payments is also extended to the same date. The deadline for qualified disclaimers (an affirmative election to decline a gift or bequest, treated under federal law as if the disclaimant had predeceased the transfer) is also extended to September 17, 2011. However, the due date for 2010 gift tax returns was not extended.

Generation-Skipping Transfer Tax Rate Fixed at Zero for 2010

The Act sets the GST tax rate at zero for all of 2010 (including the balance of the year after enactment). This means that gifts, bequests, trust terminations, and trust distributions to grandchildren made this year will face no GST tax. If the transfer was made to a trust for a grandchild, the GST tax consequences are more tricky. Neither the transfer to the trust nor a future distribution to the grandchild will be subject to GST tax. However, future distributions from the trust to great-grandchildren or younger descendants will be subject to GST tax unless the trust is made exempt by allocation of the transferor’s GST exemption. In addition, a transfer in 2010 to a typical generation-skipping trust that benefits children, grandchildren, and younger descendants will not be exempt from GST tax in the future unless the trust is made exempt by allocation of the transferor’s GST exemption. If you have already made or plan to make gifts to grandchildren in 2010, contact a member of our Estate Planning Group to discuss the effects of the new Act, including reporting requirements and tax elections.

Unused Estate Tax Exemption Transferable to Surviving Spouse

Beginning in 2011, the unused estate tax exemption of the first spouse to die may be transferred to the surviving spouse by an election filed with the first spouse’s estate tax return. This may require the filing of an estate tax return in cases where a return would not otherwise be required. The surviving spouse may use this transferred exemption for lifetime gifts as well as for bequests at death. Only the unused exemption from the last deceased spouse will apply, and the death of a subsequent spouse will reset the identity of the last deceased spouse. However, lifetime gifts could use a predeceased spouse’s exemption before the death of a subsequent spouse changes the amount of exemption available.

For planning purposes, transferability of the unused estate tax exemption of the first spouse does not eliminate the value of so-called credit shelter trusts and QTIP trusts as part of the estate plan. As one example, the new law does not allow the unused GST tax exemption of the first spouse to be transferred to the surviving spouse. The credit shelter trust and QTIP trust are two tools to avoid wasting the first spouse’s GST tax exemption.

Bullets Dodged

The Tax Reform Act of 2010, in its final form, did not include recent legislative proposals (some of which had already passed in the House or Senate, but not both) to reduce or eliminate the effectiveness of several of the most attractive estate planning techniques. The final legislation did not include recent proposed legislation to reduce or eliminate valuation discounts on intra-family transfers of non-operating partnerships and LLCs, to impose a 10-year minimum term on grantor retained annuity trusts (commonly known as GRATs), or to require taxpayers to use a consistent basis for estate and income tax purposes.

Direct Gifts from IRAs to Charities Reinstated for 2010–2011

In 2008–2009, IRA owners over age 70½ could make direct distributions from their IRAs to charities of up to $100,000 per year and exclude the amount from income, while treating it as part of their required minimum distribution. The new law extends that option through 2011. Because so little time remains in 2010, a special rule permits taxpayers to make such a transfer in January 2011 and treat it as if it had been made on December 31, 2010.

Roth Conversions

The new Act did not change the rules regarding Roth IRA conversions, discussed in prior Bulletins. The only thing that expired in 2010 was the election to report the tax over the following two taxable years (2011 and 2012). Conversions in 2011 will still work as in 2010, except that the taxable income has to be recognized entirely in 2011.

The New Law’s Effect on Estate Planning

The fundamental principles and priorities of estate planning will remain the same. However, the effect and relative value of certain specific techniques have changed. Some opportunities have been improved, others have disappeared, and still others remain but have decreased in relative importance.

As noted at the opening of this Bulletin, the new tax laws create extraordinary estate planning opportunities for high-net-worth individuals. Additionally, the new tax laws will impact the basic estate plan of nearly all persons with significant assets. Estate planning for married persons with combined estates of less than $10,000,000 will be particularly complex, given the possibility that the estate, gift, and GST tax exemptions will revert to only $1,000,000 per person in 2013.

Time for Action

A few of the opportunities described in this Bulletin have an absolute expiration date: December 31, 2010. Others may expire as soon as December 31, 2012.

Other Super Year-end Tax and Estate Planning Articles:

FEDERAL TAX NOTICE: Treasury Regulations require us to inform you that any federal tax advice contained herein (including in any attachments and enclosures) is not intended or written to be used, and cannot be used by any person or entity, for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service.

Time to Retire the ESOP from the 401k: Assessing the Liabilities of KSOP Structures in Light of ERISA Fiduciary Duties and Modern Alternatives

The National Law Review would like to congratulate Adam Dominic Kielich of Texas Wesleyan University School of Law as one of our 2010 Fall Student Legal Writing Contest Winners !!!

I. Introduction

401k plans represent the most common employer-sponsored retirement plans for employees of private employers. They have replaced defined benefit pension plans, as well as less flexible vehicles (such as ESOPs) as the primary retirement plan.¹ However; some of these plan models have continued their legacy through 401ks through structures that tie the two together or place one inside the other. A very common and notable example is the Employee Stock Ownership Plan (ESOP). ESOPs are frequently offered by companies as an investment vehicle within 401ks that allow participants to invest in the employer’s stock as an alternative to the standard fund offerings that are pooled investments (e.g. mutual funds or institutional funds). Participants may be unaware that the company stock option in their 401k is a plan within a plan. These combination plans are sometimes referred to as KSOPs.²

Although this investment vehicle seems innocuous, KSOPs generate considerable risk to both participants and sponsors that warrants serious consideration in favor of abandoning the ESOP option. Participants face additional exposure in their retirement savings when they invest in a single company, rather than diversified investment vehicles that spread risk across many underlying investments. They may lack the necessary resources to determine the quality of this investment and invest beyond an appropriate risk level. Moreover, sponsors face substantial financial (and legal) risk by converting their plan participants into stockholders within the strict protections of ERISA.³ The risk is magnified by participant litigation driven by the two market downturns of the last decade. Given the growing risk, sponsors may best find themselves avoiding the risks of KSOPs by adopting a brokerage window feature (sometimes labeled self-directed brokerage accounts) following the decision in Hecker.⁴

II. Overview and History of ESOPs

A. ESOP Overview

ESOPs are employer-sponsored retirement plans that allow the employee to invest in company stock, often unitized, on a tax-deferred basis. They are qualified defined contribution plans under ERISA. As a standalone plan, ESOPs take tax deferred payroll contributions from employees to purchase shares in the ESOP, which in turn owns shares of the employer’s stock. That indirect ownership through the ESOP coverts participants into shareholders, which gives them shareholder rights and creates liabilities to the participants both as shareholders and as participants in an ERISA-protected plan. They may receive dividends, may have the option to reinvest dividends into the plan, and may be able to receive distributions of vested assets in cash or in-kind, dependent upon plan rules.⁵

ESOPs offer employers financial benefits: they create a way to add to employee benefit packages in a manner that is tax-advantaged while providing a vehicle to keep company stock in friendly hands – employees – and away from the hands of parties that may seek to take over the company or influence it through voting. Additionally, ESOPs create a consistent flow of stock periodically drawn out of the market, reducing supply and cushioning prices. Moreover, with those shares in the hands of employees, who tend to support their employer, there are fewer shares likely to vote against the company’s decision-makers or engage in shareholder activism.⁶

B. Brief Relevant History of ESOPs

ESOPs are generally less flexible and less advantageous to employees than 401ks. ESOPs lack loan options, offer a single investment option, typically lack a hardship or in-service distribution scheme and most importantly, lack diversification opportunities. Individual plans may adopt more restrictive rules to maintain funds within the plan as long as possible, as long as it is ERISA-compliant. Perhaps the most important consequence of that lack of diversity is that it necessarily ties retirement savings to the value of the company. If the company becomes insolvent or the share price declines without recovery, employees lose their retirement savings in the plan, and likely at least some of the pension benefits funded by the employer. The uneven distribution of benefits to employees helped pave the way for ERISA in 1974.⁷

C. Current State of Law on ESOPs

1. ESOPs Within 401k Plans

After the ERISA regulatory regime paved the way for 401k plans, employers began folding their ESOPs and other company stock offerings into the 401ks. For decades employers could mandate at least some plan assets had to be held in company stock. When corporate scandals and the dot com bubble burst in 2001, it evaporated significant retirement savings of participants heavily invested in their employer’s stock, often without their choice. Congress responded by including in the Pension Protection Act of 2006 (PPA) by eliminating or severely restricting several permissible plan rules that require 401k assets in any company stock investment within 401k plans.⁸

2. ERISA Litigation of the 2000s

Participants who saw their 401k assets in company stock vehicles disappear with the stock price had difficulty recovering under ERISA until recent litigation changed how ERISA is construed for 401k plans. ERISA was largely written with defined benefit plans in mind. Defined benefit plans hold assets collectively in trust for the entire plan. Participants may have hypothetical individual accounts in some plan models, but they do not have actual individual accounts. ERISA required that suits brought by participants against the plan (or the sponsor, trust, or other agent of the plan) for negligence or malfeasance would represent claims for losses to the plan collectively for all participants, so any monetary damages would be awarded to the plan to benefit the participants collectively, similar to the shareholder derivative suit model. Damages were not paid to participants or used to increase the benefits payable under the plan.

Defined contribution plans with individual participant accounts, such as 401k plans and ESOPs, were grafted onto those rules. Therefore, any suit arising from an issue with the company stock in one of these plans meant participants could not be credited in their individual accounts relative to injuries sustained. It rendered participant suits meaningless in most cases because the likelihood of recovery was suspect at best.⁹

The Supreme Court affirmed this view in 1985 in Russell, and courts have consistently held that individual participants could not individually benefit from participant suits. Participants owning company stock through the plan could take part separately in suits as shareholders against the company, but these are distinguished from suits under ERISA. In 2008, the Supreme Court revisedRussell in LaRue and held that Russell only applied to defined benefit plans. Defined contribution plan participants could now bring claims individually or as a class and receive individual awards as participants. This shift represented new risks to sponsors that immediately arose with the market crash in 2007.¹⁰

III. Risks to Employees

The primary risk to employees is financial; a significant component of employee financial risk is the investment risk. 401k sponsors are required to select investments that are prudent for participant retirement accounts. This is why 401k plans typically include pooled investments; diversified investment options spread risk. ESOPs are accepted investments within 401k plans, although they are not diversified.¹¹ This increases the risk, and profit potential, participants can expose themselves to within their accounts. While added risk can be exponentially profitable to participants when the employer has rising stock prices or a bull market is present, the downside can also be significantly disastrous when the company fails to meet analyst expectations or the bears take over the markets.

Moreover, employees may be more inclined to invest in the employer’s stock than an independent investor would. Employees tend to be bullish about their employer for two reasons.¹² First, employees are inundated with positive comments from management while typically negative information is not disclosed or is given a positive spin. This commentary arises in an area not covered by ERISA, SEC, or FINRA regulations. This commentary is not treated as statements to shareholders; they arise strictly from the employment relationship. This removes much of the accountability and standards that otherwise are related to comments from the company to participants and shareholders. Management can, and should, seek to motivate its employees to perform as well as possible. While the merit of misleading employees about the quality of operations may be debatable, the ability to be positive to such an end is not.

Second, employees tend to believe in the quality of their employer, even if they espouse otherwise. They tend to believe the company is run by experienced professionals who are leading the company to long term success. Going to work each day, seeing the company operating and producing for its customers encourages belief that the company must be doing well. It can even develop into a belief that the employee has the inside edge on knowing how great the company is, although this belief is likely formed with little or no knowledge of the financial health of the company. The product of the internal and external pressures is a strong likelihood employees will invest in an ESOP over other investment options for ephemeral, rather than financial, reasons.¹³

Additionally, participants may have greater exposure to the volatility of company stock over other shareholders due to 401k plan restrictions. While some plans are liberally constructed to give participants more freedom and choice, some plans conversely allow participants few options. This is particularly relevant to the investment activity within participant accounts. Participants may be limited to a certain number of investment transfers per period (e.g. quarterly or annually), may be subject to excessive trade restrictions, or may even find themselves exposed to company stock through repayment of a loan that originated in whole or in part from assets in the ESOP. Additionally, the ESOP may have periodic windows that restrict when purchases or redemptions can occur. While a regular shareholder can trade in and out of a stock in seconds in an after-tax brokerage account, ESOP shareholders may find themselves hung out to dry by either the ESOP or 401k plan rules. These restrictions are not penal; they represent administrative decisions on behalf of the sponsor to avoid the added expense generally associated with more liberal rules.

Although employees take notable risk to their retirement savings portfolio by investing in ESOPs within their 401k plans, it can add up to a tremendous financial risk when viewed in the bigger picture of an employee’s overall financial picture. Employees absorb the biggest source of financial risk by nature of employment through the company because it is the major, if not sole, income stream during an employee’s working years. This risk increases if the employer is also the primary source of retirement assets or provides health insurance. The employee’s present and future financial well being is inherently tied directly to the employer’s financial well being. This risk is compounded if the employee also has stock grants, stock options, or other stock plans that keep assets solely tied to the value of the company stock. If the employee is fortunate enough to have a defined benefit plan (not withstanding PBGC coverage) or retirement health benefits through the company, then that will further tie the long term success of the company to the financial well being of the employee. Adding diversification in the retirement portfolio may be a worthwhile venture when those other factors are considered in a holistic fashion.

IV. Risks to the Sponsor

ERISA litigation is a serious risk and concern to sponsors. Although there is exposure in other areas related to participants as stockholders, ERISA establishes higher standards towards participants than companies otherwise have towards shareholders. Sponsors once were able to protect themselves under ERISA but since LaRue participants have an open door to reach the sponsor to recover losses related to the administration of the plan.¹⁴ ERISA requires sponsors to make available investment options that are prudent for 401k plans. The dormant side of that rule requires sponsors to remove investment options that have fallen below the prudent standard. Company stock is not excluded from this requirement.¹⁵

Any time the market value of the stock declines, the sponsor is at risk for participant losses for failure to remove the ESOP (or other company stock investment option) as an imprudent investment within the plan. Participants are enticed to indemnify losses through the sponsor. Such a suit is unlikely to succeed when the loss is short term and negligible, or the value declined in a market-wide downturn. However, as prior market downturns indicate, investors look to all possible avenues to indemnify their losses by bringing suits against brokers, advisors, fund companies, and issuers of their devalued assets. There is no reason to believe that participants would not be enticed to try this route; LaRuewas born out of the downturn in the early 2000s.¹⁶

The exposure for sponsors runs from additional costs to mount a defense to massive monetary awards to indemnify participants for losses. In cases where participants are unlikely to recover, sponsors still must finance the defense against what often turns into expensive, class action litigation or a long serious of suits. However, there is a serious risk of sponsors having to pay damages, or settle, cases where events have led to a unique loss in share value. Participants have filed suit under the theory that the sponsor failed to remove imprudent investment options in a timely fashion. BP 401k participants filed suit following the gulf oil leak under a similar theory that the sponsor failed to remove the company stock investment option from the plan, knowing that it would have to pay clean up costs and settlements. While it remains to be seen if these participants will be successful, they surely will not the last to try.¹⁷

Sponsors should take a good, long look at the ESOP to determine whether the sponsor receives more reward than risk – particularly future risk – from its inclusion. The risk to a company does not have as severe as the situation BP faced this year. Even bankruptcy or mismanagement that results in serious stock decline can merit suit when the sponsor fails to immediately withdraw the ESOP, since it has prior knowledge of the bankruptcy or mismanagement prior to any public release.

To hedge these risks, sponsors can adopt several options. First, sponsors may limit the percentage of any account that may be held in company stock. This is easily justified as the sponsor taking a position in favor of diversification and responsible execution of fiduciary duties. While this may not completely absolve the sponsor of the duty to remove imprudent investment options, it does act as a limit on liability. Although it does provide some protection against risk, it is an imperfect solution.

Second, ESOP plans can adopt pricing structures to discourage holding large positions of company stock for the purpose of day trading. Some 401k plans allow participants to trade between company stock and cash equivalents without restraint. When the ESOP determines share pricing based on the closing price of the underlying stock, it creates a window where participants can play the company stock very differently than the constraints of most 401k investment options.

It is a very alluring reason to take advantage of the plan structure by taking an oversized position in company stock. Add the possibility to indemnify losses in court and it becomes even more desirable. The process is simple: participants can check the trading price minutes before the market closes. If the stock price is higher than the basis, they sell and net profit. If it is below, they hold the stock and try against each day until the sale is profitable. They will then buy back into the ESOP on a dip and repeat the process. This is distinguishable from the standard diversified fund options in 401k plans, where ignorance of the underlying investments preempts the ability to game closing prices. Funds generally discourage day trading – and may even carry redemption fees to penalize it – and encourage long term investing strategies more consistent with the objective of retirement accounts.

Available solutions are directly tied to the cause of the problem; changing the ESOP pricing scheme can eliminate gaming closing prices. ESOPs can adopt other pricing schemes such as average weighted pricing and next day order fulfillment. Average weighted pricing gives participants the average weighted prices of all transactions in the stock, executed that day, by a given entity. For example, if the ESOP is held with Broker X as the trustee, it may rely upon Broker X to provide the prices and volumes of all of its executed orders that day in the stock, which is used to determine the average weighted price participants will receive that day. Alternately, participants could be required to place orders on one day and have the order fulfilled on the following day’s closing with that day’s closing price. Both of these pricing schemes introduce some mystery into the price that diminishes gaming the closing price. This is also an imperfect solution, even if combined with the first option, because it maintains the risks of the ESOP.

Sponsors may also take advantage of brokerage windows to expand employee investment options, including company stock, without the risks afforded to ESOPs. Brokerage windows create brokerage accounts within 401k plans. The brokerage window is not an investment in itself; it is a shell that allows employees to reach through the window to access other investments. Sponsors found good reason to be suspicious of brokerage windows, seeing it as liability for all the available investments that could be deemed imprudent for retirement accounts. A minute minority of participants saw it as a way to have their cake and eat it too during the last rise and fall of the markets; they could invest more aggressively within their 401ks and then demand sponsors indemnify their losses when the markets gave up years of gains on the basis of sponsor failure to review the available contents of the window under the prudence standard.

However, in Deere the court handed down a critcal decision: sponsors could not be responsible for the choices made by participants within brokerage windows. InDeere, several Deere & Co. (John Deere) employees sued the company for making available investments that were imprudent for 401k accounts that caused substantial losses in the 2007 market downturn. John Deere had not reviewed the thousands of available options under the ERISA prudence standard. Although the plaintiffs’ theory was a compelling interpretation of ERISA duties, the court rejected the theory on two grounds. First, it would be impossible for any sponsor to review every investment available through the window. Second, participants had taken ownership of the responsibility to review their investment decisions by choosing to invest through the window.¹⁸

Following the court’s decision in Deere, brokerage windows gained new life as a means for sponsors to expand investment availability at less risk. Rather than having to review a menu of funds and company stock for prudence under ERISA, sponsors can justifiably limit the fund selection directly offered through the plan and leave the rest of the options to the brokerage window. Importantly, this includes offering company stock in the window. By utilizing the brokerage window, sponsors allow access to the company stock without the liabilities of offering an ESOP through the plan. The sponsor will likely lose out on any benefits received from the ESOP, although for most established employers ESOPs are likely more of a convenience factor and a legacy offering rooted in the history of employer-sponsored plans.

Although Deere foreclosed participant abuse of brokerage windows, this option is not without its own negative aspects. Future litigation may reestablish some liability upon the sponsor for the brokerage link. Sponsors may face alternate liability under ERISA for selecting a brokerage window with excessive commissions or fees, similar to requirements for funds under ERISA.¹⁹ Given the flurry of awareness brought to 401k management fees and revenue sharing agreements between sponsors and fund providers following the market crash in 2007, it is likely that brokerage windows will be the hot ticket for participants in the next market crash. Therefore, sponsors should preemptively guard against future litigation by reviewing available brokerage window options to make sure any fees or commissions are reasonable and the categories of investment options are reasonable (even if specific investments in those categories are not).

Perhaps a lesser concern, sponsors need to consider overall plan operation and any negative impacts that may arise from shifting to a brokerage window-based investment offering. These concerns may be less of a legal risk issue than a risk of participant discontent and dealing with those effects. There are primarily two areas that brokerage windows can create discontent. First, when participants want to move from a fund to the brokerage window, they must wait for the sale to settle from the fund and transfer to the window, which generally makes the money available in the window the day after the fund processes the order. Conversely, selling investments in the window may delay transferring money into plan funds because of settlement periods and the added delay of settlement with the fund once the funds are available to move out of the window. Additionally, the settlement periods within the window may frustrate participants, although the plan has no control over those timeframes. Those natural delays in processing the movement of money may create discontent, especially for those participants trying to invest based upon short term market conditions.

Second, those same processes and delays can negatively affect plan distributions. Many plans offer loans and withdrawal schemes, and while sponsors may have their own reasons for making those options available, participants often use those offerings to finance emergency financial needs. Brokerage windows can complicate and delay releasing money to participants. Settlement periods will create delays; if money has to be transferred out of the window to another investment to make those funds available for a distribution that will add at least one more day before money can be released. If participants find themselves in illiquid investments, the money may not be able to move for a distribution at all. Although these issues may not be of legal significance but they will be significant to the people responsible for absorbing participant complaints and there may be additional expenses created in handling those issues.

An additional concern is that the Department of Labor (DOL) is still fleshing out several requirements surrounding brokerage windows and how they relate to ERISA requirements. For example, the DOL October 2010 modification of 401k disclosure rules affects plans as a whole, but it leaves open several areas of ambiguity around the specific effects on brokerage windows. Sponsors may face continuing financial costs complying and determining how to comply with DOL requirements. Future changes in the regulations may negatively affect plans that rely heavily on brokerage windows to provide access to a greater range of investment options.²⁰

These considerations are not exhaustive to the benefits or risks of either ESOPs or brokerage windows, they merely highlight some of the more salient points as they relate generally to the legal and significant financial benefits and risks to sponsors. There may be additional concerns equally salient to sponsors given their particular situation, such as participant suspicion of the removal of the ESOP or unwillingness at the executive level to retire the ESOP.

V. Conclusion

Although brokerage windows may open the door to some new liabilities, it closes the door to the risks of ESOPs, for both participants and sponsors. Sponsor diligence in administering retirement plans will always be the most successful method of checking liability; however, as discussed ESOPs risk putting sponsors in an unwinnable position. Removing the company stock option may not be the most beneficial option in all cases but it may be time for sponsors to consider retiring the ESOP from the 401k in light of the current regulatory regime. A brokerage window option is well suited to take advantage of participant ownership of the employer’s stock, as well as other investment opportunities, while limiting the risk that normally accompanies that ownership. Ultimately, sponsors must consider what is best for the plan and its participants over both the short term and the long term.

Endnotes.

1. Chris Farrell, The 401(k) Turns Thirty Years Old, Bloomberg Businessweek Special Report, Mar. 15, 2010,http://www.businessweek.com/investor/content/mar2010/pi20100312_874138.htm.

2. National Center for Employee Ownership401(k) Plans as Employee Ownership Vehicles, Alone and in Combination with ESOPs, (no date provided),http://www.nceo.org/main/article.php/id/15/.

3. Id.; 29 U.S.C. § 1104 (2010); the term “sponsor” can be used interchangeably with “employer” for purposes of this discussion, however there are some situations where the employer is not the sponsor, such as union plans, or the employer is not the sole sponsor in the case of multi-employer plans. This discussion relates to KSOPs where the sponsor is the employer. Different rules and different liability may apply to other plan structures.

4. Hecker v. Deere & Co., 556 F.3d 575, 590 (7^th Cir. 2009), cert. denied, 130 S. Ct. 1141 (2010).

5. Todd S. Snyder, Employee Stock Ownership Plans (ESOPs): Legislative History, Congressional Research Service, May 20, 2003.

6. William N. Pugh et al. The Effect of ESOP Adoptions on Corporate Performance: Are There Really Performance Changes?, 21Managerial & Decision Econ., 167, 167-180 (2000).

7. Supra note 5.

8. Pension Protection Act of 2006 § 901, 29 U.S.C. 401 (2010).

9. LaRue v. DeWitt, Boberg & Assocs., Inc., 552 U.S. 248, 254-55 (2008).

10. Id. at 255-56.

11. Shlomo Benartzi et al., The Law and Economic of Company Stock in 401(k) Plans, 50 J.L. & Econ. 45, 45-79 (2007).

12. Id.

13. Id.

14. LaRue, 552 U.S. at 254-55.

15. § 1104.

16. LaRue, 552 U.S. at 250-51.

17. E.g., In Re: BP P.L.C. Securities Litigation, MDL No. 2185, 2010 WL 3238321 (J.P.M.L. Aug. 10, 2010).

18. Hecker, 556 F.3dat 590.

19. §1104.

20. 29 C.F.R. § 2550 (2010).

Time Is Running Out for One-Time Estate Planning Opportunities: Gift Tax Rates Will Increase in 2011, Bonus Gift Tax Exemption Available for Some Gifts Made in 2010-11 and Opportunity for Gifts or Trust Distributions to Grandchildren

Very comprehensive post recently received at the National Law Review from Michael D. Whitty of Vedder Price P.C. on year end estate and tax planning issues:

As the end of the year approaches, it appears increasingly unlikely that Congress will pass legislation on gift and estate taxes before 2011. Many one-time opportunities for gifting and tax planning will expire at the end of 2010.

Executive Summary:

Gift Tax Will Increase in 2011. For 2010 only, the tax rate on gifts that exceed the $13,000 gift tax annual exclusion and the $1 million lifetime gift tax exemption is only 35%, compared to a 45% rate in 2009 and rates of up to 55% in 2011 and beyond. Persons who are otherwise facing substantial estate taxes should consider making gifts this year to take advantage of the 35% rate.
Bonus Gift Tax Exemption Available for Some Gifts Made in 2010–2011. Due to quirks in the way the $1 million lifetime gift tax exemption is determined, some donors may not have a full $1 million exemption this year, but if they use the full exemption by the end of 2010, they can obtain a bonus exemption in 2011.
Opportunity for Gifts or Trust Distributions to Grandchildren. Some gifts or trust distributions to grandchildren (or similar younger-generation beneficiaries) can be made in 2010 without any generation-skipping transfer tax (GST tax). Such gifts and distributions must be carefully structured to avoid GST tax in the future, however
Low Interest Rates May Not Last Much Longer. Interest rates have remained low this year, but they will eventually increase. This year could be the best opportunity for the foreseeable future to use a leveraged techniquesuch as a grantor retained annuity trust (GRAT), an installment sale to a grantor trust, an intra-family loan (including refinancing an existing family loan), or a charitable lead annuity trust.
Converting to Roth IRA with Charitable Deduction to Offset the Tax. Conversion of a regular IRA to a Roth IRA in 2010 may provide substantial benefits for certain individuals, in particular those with sufficient liquid assets outside of the IRA to pay the tax. The tax burden can be further reduced, or offset entirely, with substantial charitable gifts made this year. The temporary sunset (for 2010 only) of the phase-out of itemized deductions (including charitable deductions) for high-income earners will allow those taxpayers to obtain a greater after-tax benefit from their 2010 charitable deductions.

Gift Tax Rates Will Increase in 2011

Due to political considerations, the 2001 estate tax act eliminated the estate tax for only one year—2010. The gift tax was retained, even for 2010, primarily to avoid the loss of income tax revenue. For 2010 only, the tax rate on gifts that exceed the $13,000 gift tax annual exclusion and the $1 million lifetime gift tax exemption isonly 35%. This is a substantial discount from the 45% rate for 2009 and rates of up to 55% that will apply after 2010.

Persons facing substantial estate taxes who can afford to transfer assets and pay gift taxes now should give serious consideration to making gifts this year. Gifts in 2010 should substantially reduce the total tax cost of transferring wealth to descendants and other beneficiaries as a result of four factors:

the lower gift tax rate for 2010;
the shift of future income and appreciation out of the taxable estate;
the potential for valuation discounts that often apply to gifts but not bequests of the same property; and
the potential to reduce the taxable estate by the amount of gift taxes paid if the donor survives the gift by three years.

This is illustrated by the three examples in the table on the following page, each involving a donor who has previously used his or her available gift tax annual exclusions and $1 million lifetime gift tax exemption. The donor owns $10 million of other assets in addition to a controlling interest in a company, which would be included in the donor’s estate without valuation discounts (Example 1). Examples 2 and 3 assume a gift of the interest in the company structured in a way that achieves valuation discounts for lack of marketability and lack of control.

It appears increasingly likely that Congress will not act in 2010 to retroactively impose a higher gift tax rate on gifts made previously in 2010. However, to avoid that risk entirely, a gift could be set up in advance of the year-end and then executed in late December 2010 after the possibility of a retroactive rate increase disappears. Other, more complicated alternatives can be structured to allow final decisions to be postponed into 2011.

Large gifts require some planning and implementation, especially if special entities are to be created and appraisals obtained to determine valuation discounts. Consequently, it is important for donors interested in taking advantage of this opportunity to contact their advisors as soon as possible so that there is sufficient time to plan and implement the transfers. Donors who wait until December may not have enough time to implement full and optimal strategies.

Gift Tax Exemption Available for Some Gifts Made in 2010–2011

The common understanding that there is a $1 million lifetime exemption from gift taxes in 2010 and 2011 is not exactly correct. There are some modest but real variations in the way the gift tax exemption is determined in those years. As a result, donors who used $500,000 or more of their exemption before 2010 do not have a full $1 million lifetime gift tax exemption in 2010. However, those who use their full amount by the end of 2010 can obtain a small amount (up to $36,585) of bonus exemption in 2011.

For example, a donor who has made $1,000,000 of taxable gifts before 2010 will have no additional lifetime gift tax exemption in 2010, but will have another $36,585 of exemption in 2011. On the other hand, a donor who had made $600,000 of taxable gifts before 2010 will have only an additional $394,386 (not $400,000) of lifetime gift tax exemption remaining in 2010, but if he or she makes a taxable gift of at least $394,286 in 2010, that taxpayer would have an additional $41,742 of exemption available in 2011. In each case, careful calculations must be made to determine a donor’s remaining gift tax exemption for 2010 and the amount of taxable gifts that should be made in 2010 to obtain the maximum possible additional exemption in 2011.

Table: Illustration of Benefits of Taxable Gifts in 2010
Description	Example 1: Bequest in 2015	Example 2: Gift in 2011	Example 3: Gift in 2010
Value of property in 2010, before transfer (transfer = by bequest or gift, as indicated)	$10,000,000	$10,000,000	$10,000,000
Period of appreciation before transfer	5 years	1 year	0 years
Appreciation before transfer, at 5% per year	$2,762,816	$500,000	(None)
Value at time of transfer	$12,762,816	$10,500,000	$10,000,000
*Valuation discounts (33%)**	$0	($3,465,000)	($3,300,000)
Value subject to transfer	$12,762,816	$7,035,000	$6,700,000
Transfer tax type	Estate	Gift	Gift
Marginal transfer tax rate	55%	55%	35%
Transfer taxes (estate or gift; federal and state combined)	$7,052,689	$3,699,250	$2,345,000
Value of other estate in 2015**	$10,000,000	$6,300,750	$7,655,000
Estate taxes on other estate	$5,671,059	$3,682,200	$4,478,000
Net to beneficiaries ***	$7,276,251	$8,919,300	$10,832,000
Cost of postponement compared to 2010 gift	($3,555,749)	($1,912,700)	(None)
Effective tax rate ****	63.62%	45.28%	38.65%
* Valuation adjustments for factors such as lack of marketability and minority interest are commonly in this range, but sometimes higher or lower. A qualified appraisal should be arranged as part of the planning on the transaction. This table’s Example 1 assumes that the interest is retained until death in a manner that does not qualify for valuation discounts.
** Value of other estate = $10 million less gift taxes paid (Examples 2 and 3), plus value of other estate in 2015, less estate taxes on other estate
*** Net to beneficiaries = pre-discount 2010 value less transfer (estate or gift) tax, plus value of other estate in 2015, less estate taxes on other estate
** Effective tax rate = tax ÷ (tax + net to beneficiaries) Opportunity for Gifts or Trust Distributions to Grandchildren In years before and after 2010, gifts or trust distributions to grandchildren (or similar younger-generation beneficiaries) were subject to a generation-skipping transfer tax in addition to any gift tax that might be due. The GST tax is a flat tax at the top estate tax rate, and only applies after a lifetime exemption is fully used. Because the GST tax is suspended for 2010, gifts or trust distributions this yearcan avoid that additional tax. Such gifts and distributions must be carefully structured to avoid future GST tax, however. Transfers to trusts or trust equivalents (including UTMA accounts) for the benefit of a grandchild will still be subject to GST tax when later distributed to the grandchild. A direct transfer to a grandchild (including, we believe, a guardianship estate for a minor grandchild) will avoid the tax, both now and later. Persons planning gifts or bequests to grandchildren should consider whether a gift this year might be more advantageous. Trustees expecting future distributions to grandchildren of the trust’s donor should consider whether accelerating the distribution into 2010 would provide more of a tax advantage. In both cases, an attorney can help analyze whether and to what extent taking action this year would help. Low Interest Rates May Not Last Much Longer Interest rates remained low this year, but they will eventually increase. We may never see a better opportunity to use leveraged techniques such as GRATs, installment sales to grantor trusts, intra-family loans (including refinancing existing family loans) and charitable lead annuity trusts. A weighted average of Treasury rates is used to calculate the rates used in these wealth transfer techniques. Once those rates increase, techniques that perform best with low interest rates will lose some of their advantage. This would affect some of the most attractive wealth transfer techniques, all of which are described in prior newsletters: GRAT: a gift of future appreciation while retaining the present value of the transferred property Charitable lead annuity trust (CLAT): a gift of future appreciation while transferring the present value of the transferred property to charities of the donor’s choice Installment sale to grantor trust: a sale of appreciating property without immediate income tax consequences, with low interest rates and principal repayment in the future Intra-family loan (including refinancing of a prior loan): giving family members the benefit of lower interest rates than those available from commercial lenders Because these leveraged techniques will be far more powerful while interest rates remain low, now is the time to put these techniques to work for you.** Converting to Roth IRA with Charitable Deduction to Offset the Tax Starting with 2010, the income ceiling for conversions of regular IRAs to Roth IRAs was eliminated. Conversion of a regular IRA to a Roth IRA in 2010 or 2011 can provide a substantial benefit for certain individuals, in particular those with sufficient liquid assets outside of the IRA to pay the tax. Conversions in 2010 are generally more favorable than those postponed to 2011, both for a lower tax rate (under current law) and for the option to spread the additional taxable income over two years (2011 and 2012). The tax burden of a Roth IRA conversion can be further reduced, or offset entirely, with substantial charitable gifts made this year. Donors who have substantial charitable plans but do not wish to donate large amounts to independent charities in the current year could make substantial charitable gifts this year to a private foundation or donor-advised fund, from which those funds could be donated in turn to other charities over many years. Private foundations and, to a lesser extent, donor-advised funds take some time to set up in time for gifts to be completed by year-end. If this opportunity is of interest, donors should contact their advisors as soon as possible. From 1990 through 2009, and again after 2010, high-income taxpayers (with $166,800 or more of adjusted gross income in 2009) lost up to the lesser of 3% of their AGI or 80% of their itemized deductions (including charitable deductions). The temporary sunset (for 2010 only) of this reduction of itemized deductions will allow those high-income taxpayers to obtain a greater after-tax benefit from their 2010 charitable deductions. To Reduce Tax Uncertainty, Plan Now, Execute in December Some tax legislation in the 2010 post-election “lame duck” session cannot be ruled out, and the chances for tax legislation in early 2011 are even greater. Unfortunately, the opportunities described in this Bulletin will generally have to be implemented by the end of 2010 to take full advantage of them. Fortunately, the types of tax legislation that would most likely be passed in early 2011 will not remove the advantages of transactions completed in 2010. Time for Action Many of the opportunities described in this Bulletin have an absolute expiration date: December 31, 2010. Others may not be available much longer than that in this volatile economic and legislative environment. Your advisors to identify the opportunities that are most relevant in your situation and implement them while the opportunities remain available. FEDERAL TAX NOTICE: Treasury Regulations require us to inform you that any federal tax advice contained herein (including in any attachments and enclosures) is not intended or written to be used, and cannot be used by any person or entity, for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service.

Renewable Energy Financial Incentives: Interested Parties Scramble for More Time

The National Law Review’s featured guest bloggers this week are from Pepper Hamilton LLP. Jane C. Luxton provides a ‘heads up’ on important deadline which is quickly approaching. Read on:

When Congress passed the American Recovery and Reinvestment Act – familiarly known as the “stimulus bill” or “ARRA” – in 2009, it specified that funding would expire on September 30, 2011. Any project not “shovel ready” by that date is out of luck, and application deadlines for available money fall due even earlier. Renewable energy funding under ARRA comes principally under Department of Energy loan guarantee programs and Treasury Department grants in lieu of existing tax credits.

Originally, DOE established a cutoff date of August 30, 2010, for part 1 applications for the multi-billion dollar loan guarantee fund for commercial-scale renewable energy projects added under ARRA as Section 1705 of the Energy Policy Act of 2005. Giving away all that money turned out to be harder than expected, however, and under pressure from critics, DOE recently extended its deadlines, but not by much. It is possible further extensions will occur, but for now applications for renewable energy generation projects must be filed by October 5, and for proposals based on manufacture of renewable energy components, by November 30. Further, DOE recently clarified that only large projects will qualify for manufacturing grants: those totaling $75 million or more. Details are available at http://www1.eere.energy.gov/financing/.

Meanwhile, interested parties have secured bipartisan congressional support to extend the Treasury Department program that allows taxpayers to obtain cash grants in lieu of renewable energy tax credits, authorized under Section 1603 of ARRA. Whether this support is sufficient to win passage in the waning pre-election days of a turbulent Congress is an open question. Developers, investors, and other interested parties should monitor these developments closely.

While time may be growing short for the ARRA programs, other sources of federal and state incentive money remain available and continue to play a key role in promoting renewable energy deals.

About the Author:

Ms. Luxton is a partner in the Environmental Practice Group of Pepper Hamilton LLP, resident in the Washington office. She is chair of the firm’s Sustainability, CleanTech and Climate Change Team. Ms. Luxton has practiced for more than 20 years in the field of environmental law, and she is actively involved in climate change and renewable energy matters. 202-220-1437 / www.pepperlaw.com

Navigating the Internal Revenue Service’s Industry Issue Focus Program: Ten Guidelines for Taxpayers

This week’s National Law Review featured blogger is Matthew D. Lerner of Steptoe & Johnson LLP providing some very detailed tips on what to expect and how to handle an IRS audit if your business is the subject of the Industry Issue Focus Program:

Background

In March 2007, the Large and Mid-Size Business Division (“LMSB”) of the Internal Revenue Service (“IRS”) implemented new procedures for the “Industry Issue Focus Program” (the “Program”). LMSB has since begun reorganizing into the Large Business and International Division (“LB&I”), and the IRS now also refers to the Industry Issue Focus Program as “Issue Tiering,” but the principles underlying the Program remain the same. The Issue Tiering approach is a very significant change in the IRS’s approach to recurring issues and can present unique audit challenges, particularly for taxpayers who are unfamiliar with the Program’s procedures. Nonetheless, it also presents opportunities for taxpayers that use the information available under the Program to position themselves better for audit.

The Program is the latest effort to consolidate the IRS approach to certain common issues presented by multiple taxpayers. Such issues are now considered with an unprecedented level of coordination across taxpayers and industries. Taxpayers and their advisors have frequently expressed the concern that the Program causes inflexibility and results in an inappropriate one-size-fits-all approach to issues that fails to consider distinguishing facts. It removes discretion from the line agents who work with individual taxpayers as well. The IRS has stated its goals for the Program are: (i) consistency in resolution across industry lines; (ii) improved currency; (iii) increased coverage of non-compliant taxpayers by maximizing limited resources; and (iv) greater oversight on and accountability for important issues. As recently as June of this year, LMSB area counsel Nancy Vozar Knapp attempted to reassure taxpayers by stating that the Program was under review and will “evolve with the times.”[1]

This article explains some basic facts about the Program and offers a list of guidelines for taxpayers facing audit issues that have been designated for participation in the Program. Understanding the rationales and goals of the Program and how the Program actually works is key to handling a case involving an issue that has been designated as a “tiered issue.” Although the Program presents challenges, its procedures also provide opportunities to understand the IRS’s approach to an issue in advance in order to develop your strategy and defense.

The basic concept of the Program is that the IRS identifies compliance issues and then prioritizes those issues based on their prevalence and level of compliance risk. This prioritization is implemented by designating issues using a series of “tiers.” Issues that have been so designated are generally referred to as “tiered issues.”

Tier I issues are identified by the IRS as issues of high strategic importance that have a significant impact on one or more industries. There are two categories of issues within Tier I: (i) compliance issues and (ii) shelter issues. According to the IRS, Tier I identification does not necessarily mean a transaction or issue is “bad,” but rather indicates that the transaction or issue presents considerations that are of high importance. Unfortunately, anecdotal evidence suggests that agents in the field do associate a negative, “shelter-like” connotation with any Tier I issue. Tier II issues are identified by the IRS as issues where there is potentially high non-compliance and/or a significant compliance risk. Tier III issues are generally industry-related and designated because of their prevalence, not necessarily because of their importance or risk level.

Issues are classified by the Industry Directors. Potential Tier I or Tier II issues are presented to a group called the Compliance Strategy Council for approval. If approved, an issue is assigned to the primary affected industry executive or another issue executive to develop a compliance strategy. Once an issue has been fully developed and a resolution strategy prepared, it will move from “active” status in its tier to a “monitoring” status in the same tier. The IRS does not typically “demote” issues from higher-priority to lower-priority tiers. According to the IRS, an issue is considered eligible for “monitoring” status when the Issue Management Team (“IMT”) responsible for the issue has: (i) identified the universe of returns that are likely to contain the issue; (ii) provided the necessary direction to the Field; (iii) issued appropriate procedural guidance and legal position; (iv) developed a resolution strategy; and (v) determined that there is no need to continue the heightened level of oversight.

If you have an issue that is designated as a tiered issue, that issue will likely be more difficult to resolve, given the IRS’s coordinated approach. You will face a very strong, pre-conceived notion on the part of the IRS as to how the issue should come out. However, following a few guidelines can give you the best chance to use the Program to your advantage and achieve the best possible resolution under the circumstances.

Guidelines for Handling a Tiered Issue Under the Program

1. Be Proactive Before and During Your Audit.

You need to know whether you may have a tiered issue before your audit. Accordingly, it is important to research the different issues that have been designated as tiered issues and have a general understanding of the types of issues the IRS considers for the Program.

For most tiered issues, the IRS has published guidelines, which include an analysis of the issue and the pertinent facts, directions to agents on how to develop the issue, and Model Information Document Requests (“IDRs”). If an issue has been designated, you must use this guidance to your advantage. These published materials tell you what the IRS will ask to see and what facts it views as problematic. Try to structure your transactions not to share those difficult facts. Be sure you develop and maintain the specific types of information that you know the agent will demand. Where the materials describe the scope of the issue, use that information to position your transaction outside of the definition or to make sure your transaction is as strongly defensible as possible.

You also need to understand the facts in IRS guidance and work proactively to distinguish your facts from those described in the guidance even before the inevitable audit commences and as you present those facts to the examination agent. Being prepared to address the issues that you know will be raised will put you in the best position possible. Recognize that your response to IDRs may be critical in defining the direction the examiners take. Proceed cautiously during the initial stages of an audit and be careful not to let an agent mistakenly label an issue or transaction as tiered because it has some similarity to a tiered issue.

2. Develop a Good Relationship with the Agent.

An agent’s general impressions of a taxpayer may influence his or her interpretation of transactions. This is purely common sense. Where you develop a relationship of mutual respect and work to keep the audit current, the agent will more readily accept your representations and consider your arguments. If the agent perceives you as unduly hostile or obstructionist, he will be more skeptical of your representations and less receptive to your arguments.

As it relates to tiered issues, if you take steps to cooperate with the agent by providing information as requested and generally make efforts to keep the audit moving, the agent may be more willing to consider your arguments that a transaction falls outside of the tiered issues, or at least go to bat for you in presenting his or her report to the IRS issue specialist or issue owner executive. The tone the agent takes may have a significant impact on the issue specialist or issue owner’s involvement with the issue. Do not wait until the last second to provide information or to establish a working relationship with the agent—establish a good relationship from the beginning so you can work to “manage” the examination as much as possible. The agent is the gatekeeper, and it is better he trusts you. Understand that a good relationship will not cause an agent not to do his job, but it can help your arguments against an issue’s being a tiered issue gain a foothold.

3. Distinguish Your Facts.

One of the most critical tasks in handling a tiered issue is to distinguish your facts from those described in negative IRS guidance and from those of other taxpayers. You should take steps to be prepared early in your audit to present your specific facts to the examining agent and highlight the differences. Sometimes this may be difficult if the guidance is vague and the facts described are generic. However, the more specific facts that you can develop with respect to your own case, the better chance you will have to identify distinctions and convince the IRS your case is different. Doing so is the best opportunity to avoid having your transaction mistakenly labeled as a tiered issue. Once that label is assigned, it will be much more difficult to resolve the issue on audit.

4. Don’t Rely Too Heavily on Arguing the Law With the Examining Agent.

There is a tendency among practitioners to believe that they can fashion a compelling legal argument that will change the IRS’s mind. However, the IRS has very bright, capable tax specialists who analyze these issues extensively, and believe they have fully considered all sides, so the chances of getting them to change their view of the law are remote. The IRS legal position on an issue that has been designated as a tiered issue is developed with consideration by multiple parties. Any one person responsible for handling your issue will not have authority to reverse or modify that position himself or herself. In almost all cases, the examining agent will understand that the Service’s issue experts have fully vetted the law, and will take a very pro-IRS view of the law. Thus, neither agents nor the IMTs will be particularly receptive to your view of legal arguments that others at the IRS have considered as a group. Unless you have an argument that you feel confident that the IRS has never considered, you are better off focusing on ways to distinguish your facts.

5. Understand How the IRS Approaches Your Issue.

As noted above, if you have an issue that has been designated, read the guidance published by the IRS on that issue. IRS guidance may include directives, settlement guidelines, audit guidelines, notices, rulings, coordinated issue papers, regulations, and other published materials. This not only helps you in planning and implementing transactions, but also aids during the audit. Compare your facts to those described in the guidance and answer the following questions: Do your facts appear to be better or worse than the facts in the guidance? How has the IRS approached this issue in this past? What is the IRS record on this issue with respect to other taxpayers? The answers to these questions will influence your strategy in pursuing a resolution to the issue.

6. Understand the IRS’s General Litigation Strategy on Tiered Issues.

Anecdotal evidence has generally led practitioners to believe that the IRS’s strategy with respect to tiered issues is to identify the cases with the worst facts for the taxpayer and get those cases into court. The IRS is therefore likely to try to delay or settle cases with better facts early on in an issue’s development so it can develop law favorable to the IRS by trying cases with facts unfavorable to the taxpayer. Understanding this dynamic, you should work to position your case as a case that the IRS does not want to try in court and would rather settle. Pushing your case forward quickly when it is strong may force the IRS’s hand, so that your case does not become the test case for an issue. If your case has good facts, allowing it to languish is a mistake. That means that you need to double your efforts to stick to deadlines and provide quick responses to all reasonable IDRs on all issues under examination so as not to provide the tools of delay. It may even mean not agreeing to statute extensions that will keep your case from court. In the most extreme cases, you may have to pay the tax, and file a refund claim, to move your case more quickly if being the test case for an issue is your chosen route.

7. Consider How Your Case Fits in With the IRS General Litigation Strategy.

You should learn as much as you can about the cases on the IRS docket with respect to your issue. Is the IRS litigating these cases? What are the facts in these cases? What are the strengths and weaknesses of the cases that are further along in the IRS administrative process or in the courts than yours? Identifying the range of cases that exist and where your case falls in the spectrum between the most-IRS favorable and the most-taxpayer favorable cases can help you select the best strategy. Do not fall into the common trap of convincing yourself your case is the best, without developing more information.

8. Coordinate With Other Taxpayers With Similar Issues.

If possible, make an effort to identify other taxpayers with similar issues and learn their facts. Learn how the IRS is approaching your issue with other taxpayers. You may be able to exchange information with other taxpayers and work collectively to accelerate the strongest taxpayer’s case and delay the weaker ones. If the issue is new and the IRS is still formulating its approach, getting cases with favorable facts to the forefront may influence the pattern IDRs issued by the IRS, alter the IRS’s legal position, and present the IRS with reasons to give examining agents more flexibility to settle cases.

For example, if you believe that you have a strong case and your issue has not been tested in the courts, put pressure on the audit team to move quickly to make your case one of the first. As noted above, if you can convince the IRS that you have strong facts, there is a good chance the IRS will not want your case to be the test case and therefore will be more willing to engage in meaningful settlement discussions.

9. Consider Elevating the Case.

If you are having difficulty resolving your case administratively, consider elevating the case within the IRS to get a new, more senior person involved. The IRS has said that its goal is to resolve cases at the lowest possible level. Thus, a lower level person at the IRS may be reluctant to seek guidance from more senior personnel unless you push for that. Under the normal IRS Rules of Engagement, the seniority progresses as follows: (i) Team manager; (ii) Territory manager; and (iii) Director of Field Operations. The Director of Field Operations has a direct line of communication with the “issue owner executive” responsible for the IRS’s coordinated approach to the issue. The issue owner executive is usually not involved in specific cases, but at least one IRS official has said informally that a taxpayer may want to contact the issue owner executive if he/she has tried to elevate the case under normal channels without success. Sometimes, only a high level official will have the authority or experience necessary to make the decision that a set of facts that looks like a tiered issue is not one.

10. Understand Settlement Procedures.

There are special procedures that apply to the settlement of tiered issues. Make sure that you understand these procedures before you start negotiations towards a resolution. The exam team must present any proposed settlements of tiered, listed issues (i.e., Tier I shelter issues) to the Technical Advisor, Issue Specialist, and/or Counsel before going forward with any resolution other than full concession by the taxpayer unless there are settlement guidelines. Otherwise, whether the proposed settlement of a tiered, non-listed issue needs to be presented to the Issue Management Team may depend on the following circumstances: (i) issue “maturity” (i.e., how well-developed the IRS position is, whether other cases have been settled, etc.); (ii) whether Counsel has provided published guidance; (iii) whether the issue has been designated for litigation; and (iv) whether the issue is being considered for litigation in a different case.

Note that the settlement of other, non-tiered issues you may have during your audit may also be more difficult when you also have a tiered issue. The presence of the tiered issue may cause your examining agent or appeals officer to view such issue as already decided in favor of the IRS. Thus, you as the taxpayer may lose the opportunity to trade a concession on that issue for the IRS’s concession on another issue. While no one likes to think of an audit as a “horse trading” exercise, as a practical matter an audit is a series of negotiations that involves “gives” and “takes” by both taxpayers and the IRS.

Note that the special Fast Track settlement procedures may be available to resolve tiered issues. Under Fast Track, the parties agree to seek a resolution within 120 days. This accelerated time frame may conserve taxpayer resources and allow a case to be resolved before other unfavorable cases either cause the IRS to impose inflexible settlement guidelines or result in unfavorable court decisions. Moreover, it may also help convince the IRS team that you do not have a tiered issue if a more independent third party thinks the distinctions you are making are legitimate.

The taxpayer, exam team, IMT coordinator, and Fast Track coordinator all must agree to use Fast Track. It is better to get support from the exam team first because the exam team manager can contact the other constituencies and be helpful in obtaining the necessary approvals. If Fast Track appears to be an attractive option, be prepared to address the views and concerns of all constituencies. For example, IRS Appeals may look for settlements that can be used in other cases. Remember that Fast Track is a mediation process, so the taxpayer should be prepared to compromise. Do not use Fast Track and expect to receive a full, or near-full concession from the IRS parties involved.

Conclusion

The Industry Issue Focus Program presents unique challenges because the IRS may be more inflexible as a result of the coordinated approach to issues established through the Program. However, taxpayers that are proactive and aware of these challenges can still achieve favorable resolutions.

[1] LMSB Tiered Issues Program Under Review, IRS Official Says, Simon Brown, Tax Notes Today, 2010 TNT 108-9, June 7, 2010.

About the Author:

Matthew D. Lerner is a partner in the Washington-based law firm of Steptoe & Johnson LLP, where he is a member of the Litigation and Business Solutions Departments. He represents both corporations and high net worth individuals involved in tax controversies, from pre-audit advice about transaction documentation, file organization and privilege protection, to representation during IRS audits and appeals, through litigation in the Federal Courts. His experience is broad and includes cases involving repair and rehabilitation expenses, asset classification for depreciation purposes, losses from trading in securities and derivatives, corporate restructuring, domestic production activities, international intercorporate transactions, foreign tax credits, tax accounting method questions, and valuation issues. Matt also advises clients facing legal and public relations crises, coordinating responses to congressional inquiries, criminal investigations, civil litigation, public relations scrutiny, and agency review.

Matt received his J.D. from Harvard Law School, magna cum laude, and was editor of Harvard Law Review. He received his A.B. from Amherst College, Phi Beta Kappa. 202-429-8024 / www.Steptoe.com

Protecting Tax Documents after United States v. Deloitte

This week’s National Law Review featured blogger is Matthew D. Lerner of Steptoe & Johnson LLP who provides some great tips on how to manage tax documents to best prepare for legal action.

A recent appeals court decision provides the latest development in the ongoing battle between taxpayers and the IRS regarding the disclosure of tax workpapers. It also provides hope that work product protections may still be available for litigation analyses that a company’s attest auditors review in preparing financial statements.[i] Typically, taxpayers claim that certain workpapers are protected by the work product doctrine because they contain analysis of potential tax issues raised by transactions in anticipation of future litigation with the IRS over those issues. The IRS asserts that these workpapers are used to prepare financial statements and should not be subject to protection either because they are not prepared in anticipation of litigation or because they are disclosed to third party auditors, thus waiving any protection.

On June 29, 2010, the D.C. Circuit became the latest court to address this controversy in a matter that involved documents prepared by, or in the possession of, the accounting firm Deloitte LLP (then known as Deloitte & Touche LLP) (“Deloitte”). In this case, the United States sought to compel Deloitte to produce two categories of documents related to a civil tax refund case brought by partnerships formed by subsidiaries of the Dow Chemical Company (“Dow”) (the partnerships are referred to as the Chemtech partnerships or “Chemtech”). The first category included three documents Deloitte withheld on the basis of privileges asserted by Dow, including (i) a June 2005 tax opinion related to Chemtech; (ii) a September 1998 legal and tax analysis provided to Deloitte by an in-house attorney at Dow; and (iii) a July 1993 internal Deloitte memorandum recording thoughts and impressions of Dow’s attorneys concerning tax issues related to Chemtech. The second category of documents included all responsive documents maintained at Deloitte’s affiliate in Zurich, Switzerland ( “Deloitte Switzerland”).

At the trial court level, the District Court for the District of Columbia held that the three documents in the first category were protected from disclosure by the work product doctrine because they were prepared in anticipation of future litigation over the tax treatment of Chemtech.[2] The court held that the protection was not waived by disclosure to Deloitte because Deloitte, as Dow’s independent auditor, was not a potential adversary, and no evidence suggested that it was unreasonable for Dow to expect Deloitte to maintain confidentiality.

The trial court also denied the motion to compel with respect to the second category of documents. The court held that Deloitte did not have sufficient control over the documents maintained at Deloitte Switzerland to enable their production. The court stated that the government failed to establish that Deloitte had the “legal right, authority or ability to obtain documents upon demand” from Deloitte Switzerland. The court determined, “Close cooperation on a specific project does not per se, establish an ability, let alone a legal right or authority, on [Deloitte’s] part to acquire documents maintained solely by a legally distinct entity.”

The United States appealed the District Court’s decision with respect to the three documents in the first category withheld by Deloitte: (i) the June 2005 tax opinion related to Chemtech; (ii) the September 1998 legal and tax analysis provided by an in-house attorney at Dow; and (iii) the July 1993 internal Deloitte memorandum recording thoughts and impressions of Dow’s attorneys concerning tax issues related to Chemtech.[3]

The government argued that the 1993 internal Deloitte memorandum was not work product because (i) it was prepared by Deloitte, not Dow or Dow’s counsel; and (ii) it was generated as part of the audit process, not in anticipation of litigation. The D.C. Circuit rejected the government’s categorical arguments with respect to the first document prepared by Deloitte. The court stated that Deloitte’s preparation of the document does not exclude the possibility that it contains Dow’s work product. The court also stated that a document can contain protected work product material even though it serves multiple purposes, so long as the protected material was prepared because of the prospect of litigation. However, the court determined that the District Court did not have a sufficient evidentiary foundation for its holding that the Deloitte memorandum was purely work product. The court therefore remanded so that the District Court could conduct an in camera review of the document and determine whether it was entirely work product, or whether a partial or redacted version of the document could be disclosed.

The government also argued that the other two documents were not protected from disclosure because Dow waived work product protection by disclosing the documents to Deloitte. The D.C. Circuit rejected this argument and concluded that (i) Deloitte was not a potential adversary with respect to the litigation that the documents address and (ii) Deloitte was not a conduit to potential adversaries because Dow had a reasonable expectation of privacy as a result of Deloitte’s obligation to refrain from disclosing confidential information.

The Appeals court decision makes clear that some documents that become part of the tax audit workpapers do retain work product protection, even if disclosed to financial auditors to assist in the preparation of financial statements. However, it is also evident from this decision that such work product claims will likely continue to be challenged by the IRS and heavily scrutinized by the courts. Accordingly, it is imperative that taxpayers take as many precautions as possible to preserve work product protection, as well as attorney-client privilege, with respect to sensitive analysis contained in tax workpapers.

Taxpayers must understand that proving work product generally involves common sense. One trying to prove that a document was prepared in anticipation of litigation should ask herself what steps would indicate to a court that litigation truly was expected and this document was prepared for that purpose. What follows is a series of suggestions to help preserve such protection to the extent possible.

1. Get Counsel Involved.

To preserve privilege, be certain to include counsel meaningfully in communications regarding legal issues, and document counsel’s substantive role in these communications. While an attorney’s involvement is not legally required to make something work product in most jurisdictions, as an evidentiary matter, it helps to establish an anticipation of litigation and indicates that an issue is being treated as more than just an item for audit. Coordinate with the company’s General Counsel with respect to sensitive tax documents to avoid waiver of work product with respect to those documents through disclosure in other litigation. At the same time, be careful to avoid asserting inappropriate claims of protection on documents. An inappropriate claim of privilege risks waiver of privilege with respect to documents that otherwise would be privileged with respect to the same issue. Inappropriate privilege claims can also damage your credibility and result in higher tensions and increased controversy over what should be “routine” privilege claims.

2. Formalize a Tax Litigation Group.

Creating a formal tax litigation group within the company can help to identify tax controversy matters more clearly and separate issues that are anticipated to result in litigation. Such a group should advise the company on the conduct of tax controversies and litigation. In this primary role, the group should give advice to the company regarding whether and how to proceed in litigation, whether to settle, and what settlement terms to propose or accept. Secondarily, the company may use the group’s hazards-of-litigation advice in establishing financial statement tax reserves.

It is preferable that the group’s leader be an attorney responsible for managing tax litigation and have at least a dotted line reporting relationship to the law department (to enjoy a presumption that the attorney-client privilege applies as well). The group should exclude the persons whose responsibilities are solely the preparation of financial statements.

This does not require hiring new personnel or re-assigning people to a new tax controversy position. The group may be composed of people with other job responsibilities. It is really a “part-time” committee of people with related roles. The key is that decisions about which matters litigation may be expected for come in the setting of this separate group’s meetings or consideration, that the group members separately perform this function, and that they document their conclusions and clearly identify issues for which more than a mere audit is expected. In the group’s analyses, it must be careful not to suggest that the company believes its position is wrong and that is why litigation is expected. Document only that the IRS, given its policies and positions, is expected to challenge the company on the issue and the company intends to fight.[4]

3. Control Who Creates Documents.

If the company has a tax litigation group, sensitive analysis of tax issues should be confined to documents created at the direction of, and under the control and supervision of, the group’s leader. If not, they should be prepared by someone with a key role and responsibilities regarding tax controversy decisions. Such documents should indicate that they are prepared by attorneys or tax practitioners and that they are prepared at the request of the group leader for litigation purposes. Take care not to attach these labels to other documents or that label will cease to have meaning and potentially be used to argue that a waiver of privilege or work product protection has occurred with respect to other documents. Do not combine these work product analyses with non-work product discussions.

4. Create Only Defined Types of Documents.

Categorizing your documents and establishing guidelines for what types of analysis should be included in each category can help confine sensitive legal analysis to litigation-oriented documents that are most entitled to privilege and work product protection. When creating documents, separate legal analysis from non-privileged information, including: (i) business advice; (ii) tax reserve numbers and calculations; and (iii) other advice not intended to remain confidential. Create specific documents for disclosure outside the group that are limited to only hazards-of-litigation percentages and only aggregate reserve information.[5]

5. Control How Documents Are Labeled

Documents should be labeled, as appropriate, to state that they contain confidential legal advice, subject to privilege and protected by the work product doctrine. While not legally required, attaching a work product label to a document intended as such provides evidence of the company’s intent with respect to that document. Likewise, be careful not to label business advice, tax return advice, or other advice not intended to be confidential, as privileged or protected. If one overuses labels, the labels lose credibility even when properly attached, and may be ignored by a court in its analysis. At the same time, also take care not to label documents containing legal analysis and advice as documents that relate to tax reserve analysis or tax contingency analysis.

6. Control Access to Documents Inside the Company

The wider the distribution of a document, the more likely it is that a court will find there has been a waiver with respect to attorney-client privilege or work product protection. Because one of the indicia of privilege or work product is the care with which a document is handled, common sense dictates that a court will look askance at claims for protection of documents that were made widely available within the company to people whose jobs did not require their access to those materials. Accordingly, only disclose legal documents with respect to an issue to other employees/officers on a need-to-know basis. Also, to the extent possible, try to avoid “broadcast” emails and limit email “chains” related to documents. Each e-mail and response to an e-mail generates a copy of the document and increases the risk of waiver. When storing documents, separate and clearly mark legal documents. This not only protects against waiver, but can demonstrate intent to keep the information confidential. Keep in mind that no protections attach to business advice documents, so store business documents in a separate location from the legal documents.

7. Enact and Follow Policies to Identify Anticipated Litigation

It is critical to prove that litigation was anticipated with respect to an issue in order to establish work product protection for documents that contain analysis of that issue. General litigation policies can be used effectively as “designation” tools to identify issues for which litigation is anticipated clearly. For example, make use of document hold requests to communicate that litigation is anticipated. Consider formal guidelines that certain counsel must be involved in issues expected to result in litigation, and then include such counsel only when litigation is expected. When enacting such general policies, be cognizant of the fact that the presence of a general policy and the absence of its application in a specific case can create a negative inference. Thus, if a company has a general policy that documents related to issues for which litigation is anticipated are made subject to a litigation hold, then the absence of a litigation hold with respect to documents related to another issue may be used to demonstrate that litigation was not anticipated with respect to that issue.[6] As a result, the tax department must apply a litigation hold to those documents relating to any issue for which the company is claiming to anticipate litigation Likewise, if company policy dictates that the General Counsel must approve litigation-related decisions (e.g. budget, choice of counsel), be sure those policies are followed for potential tax litigation.

8. Work With Your Auditors and Other Third Parties to Protect Work Product

Interactions with auditors and other third parties create significant risks that material that would otherwise be subject to privilege or work product protection will lose that protection as a result of waiver. Accordingly, take steps to work with your auditors and other third parties to develop a good relationship and preserve protection where possible.

For example, many times accountants are hired not as auditors but to provide specific support in connection with a tax issue. In those instances, enter into written agreements through counsel with third-party consultants to whom you wish to disclose privileged information (e.g., so-called Kovel arrangements), so that their work is performed under the direction and control of counsel. Such a step makes the assertion of attorney-client privilege possible for communications with the consultant, and provides strong evidence of the anticipation of litigation. Be aware of the potential limitations of the accountant-client privilege, particularly when considering whether to disclose sensitive documents in the context of the preparation of an opinion letter. Request that your attest auditors’ engagement letter include a specific confirmation that those accountants must and will maintain confidentiality of your documents to the fullest extent allowed by law. It may also be helpful to have the engagement letter acknowledge that the relationship between company and auditor is non-adversarial and the two expect to work together cooperatively. Where possible, have auditors review key documents but not take copies. While that has no direct, legal effect on whether a protection is actually waived, it can bolster a claim that you took all possible steps to avoid wider dissemination by keeping control of the actual document, which is a key element of proving work product protection should apply. Ask that your auditors specifically note when a conclusion in their workpapers was derived from documents prepared by the company as litigation analyses. Finally, do not prepare separate documents directly for the auditors that discuss litigation analysis. While a decision regarding work product should be based on the purpose for which the underlying analysis was prepared, not the specific documents, the recent decisions suggest that it is easier to preserve work product protection when the document itself was prepared for the purpose of litigation.

9. Negotiate Disclosures with the IRS

After taking some or all of the above steps above to preserve protection of documents, take steps to prevent inadvertent disclosure to the IRS of protected documents. Require approval of the group’s leader before documents are disclosed to the Service or establish some other formal screening process to prevent disclosures that could result in a waiver of privilege. When withholding documents subject to protection, prepare a detailed privilege log, stating the specific grounds that support the claim for privilege and protection of each document withheld.

It is inevitable that there will be disagreements about the scope of protection afforded specific documents. Try to manage the disclosure process to minimize the scope and intensity of these disagreements. Be candid with the IRS about your concerns, try to get overbroad demands for protected materials scaled back, work quickly to provide responsive, non-protected materials, and be reasonable about the scope of your privilege claims. Doing this can help establish a cooperative relationship with the IRS and focus the controversy, if any, on the most protected documents. Likewise, consider disclosing the least confidential documents to the Service. For example, disclose to the Service those documents that contain no legal analysis or advice. Where there is protected material the IRS really wants that the company is willing to disclose, attempt to negotiate a written agreement that the disclosure of that document will not waive privilege or work product protection more broadly. If, after all this, controversy about a protection still arises, the fact of your cooperation and efforts to comply as much as possible may influence either the IRS’s decision to seek the documents through judicial proceedings, or the judge’s view of the matter. Force the IRS to determine whether it wishes to press the issue against a taxpayer that has cooperated, but that has taken careful steps to create and maintain confidential documents.

The confines of the work product doctrine in the tax context are still being defined. These suggested steps will help you best position your company to obtain the maximum protection. As you consider the creation of materials, ask yourself “does this step help show that we really did anticipate litigation and that this document was created for that purpose.” That is what a court may be called on to determine, and you want the record to demonstrate that the answer is yes.

[1] This is important because the review of such documents by third party auditors waives attorney-client privilege, the other common protection for sensitive materials.

[2] United States v. Deloitte, Case No. 08-411 (D. D.C. June 8, 2009).

[3] United States v. Deloitte, No. 09-5171, (D.C. Cir. June 29, 2010)

[4] Although not free from doubt, it is generally believed that the expectation of having an issue be unagreed and go to IRS Appeals is sufficient to show “an expectation of litigation.”

[5] Understand that there is a tension between protecting the attorney-client privilege and the work product protection. Providing your accountant with a privileged document prepared in anticipation of litigation may result in a broad attorney-client privilege waiver, but it is more likely the document will be viewed as work product than a document drafted especially for the auditor. Given the broad scope of auditors’ need for information and the fact that the document prepared for an auditor likely reveals privileged communications anyway and thus waives attorney-client privilege, many companies are placing more of their eggs in the work product basket.

[6] A litigation hold consists of formal notification of the likelihood of litigation to personnel whose files may contain relevant information, and the implementation of document preservation steps to make certain those materials are not discarded.

About the Author:

Matt received his J.D. from Harvard Law School, magna cum laude, and was editor of Harvard Law Review. He received his A.B. from Amherst College, Phi Beta Kappa. 202-429-8024 / www.Steptoe.com

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Executive Summary

The “Tax Relief, Etc.” Act of 2010

Income Tax Rates Continued for 2011–2012

Summary of Changes to Transfer Tax Rates and Exemptions

Estate Tax Made Optional for 2010

Transfer Tax Exemptions Increased, Tax Rates Reduced

Due Dates for 2010 Returns, Disclaimers

Generation-Skipping Transfer Tax Rate Fixed at Zero for 2010

Unused Estate Tax Exemption Transferable to Surviving Spouse

Bullets Dodged

Direct Gifts from IRAs to Charities Reinstated for 2010–2011

Roth Conversions

The New Law’s Effect on Estate Planning

Time for Action

Other Super Year-end Tax and Estate Planning Articles:

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I. Introduction

II. Overview and History of ESOPs

A. ESOP Overview

B. Brief Relevant History of ESOPs

C. Current State of Law on ESOPs

1. ESOPs Within 401k Plans

2. ERISA Litigation of the 2000s

III. Risks to Employees

IV. Risks to the Sponsor

V. Conclusion

Endnotes.

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Executive Summary:

Gift Tax Rates Will Increase in 2011

Gift Tax Exemption Available for Some Gifts Made in 2010–2011

Table: Illustration of Benefits of Taxable Gifts in 2010

Opportunity for Gifts or Trust Distributions to Grandchildren

Low Interest Rates May Not Last Much Longer

Converting to Roth IRA with Charitable Deduction to Offset the Tax

To Reduce Tax Uncertainty, Plan Now, Execute in December

Time for Action

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Guidelines for Handling a Tiered Issue Under the Program

Conclusion

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1. Get Counsel Involved.

2. Formalize a Tax Litigation Group.

3. Control Who Creates Documents.

4. Create Only Defined Types of Documents.

5. Control How Documents Are Labeled

6. Control Access to Documents Inside the Company

7. Enact and Follow Policies to Identify Anticipated Litigation

8. Work With Your Auditors and Other Third Parties to Protect Work Product

9. Negotiate Disclosures with the IRS

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