Category: Tax

Attention Tenants! Grow-NJ Tax Credits Without Prevailing Wage

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A little known regulation makes a big difference for tenants taking less than 55% of a leased facility. Namely, these tenants may be eligible to receive millions of dollars of monetizable corporate income tax credits under New Jersey’s Grow-NJ Program, without having to comply with that program’s prevailing wage mandate. For many, especially suburban tenants, that equates to a great deal of free money.

Grow-NJ is economic incentive program born out of the New Jersey Economic Opportunity Act of 2013 (L. 2013, c. 161) (“EOA”) and administered by the New Jersey Economic Development Agency (“NJEDA”). The goal of the program is to encourage businesses to either stay in or relocate to New Jersey. The program does this by offering tax credits for each job created or retained that range from $500 to $5000 per job, depending on the scope, location, and industry of the project.

However, the EOA specifies that each Grow-NJ recipient must agree to pay the “prevailing wage” to its contractors. The “prevailing wage” is that wage and fringe benefit rate based on collective bargaining agreements established for a particular craft or trade in the locality where the project is taking place. In New Jersey, prevailing wage rates vary by county and statewide and by the type of work performed.

Paying the “prevailing wage” can increase the cost of tenant work by 20% to 30% over non-prevailing wage. Though less of a concern in urban areas where tenants are likely to use union workers, in suburban areas, paying the “prevailing wage” may add substantial costs to the project. Depending on size of the award, this added cost may negate the value of the tenant’s Grow-NJ tax credits.

However, the NJEDA’s regulations provide an important exception to Grow-NJ’s prevailing wage requirements. Under the N.J.A.C. 19:30-4.2, the prevailing wage need not be paid on any project where:

(1) It is performed on a facility owned by a landlord of the entity receiving the assistance;

(2) The landlord is a party to the construction contract; and

(3) Less than 55 percent of the facility is leased by the entity at the time of the contract and under any agreement to subsequently lease the facility.

Because of this regulation, tenants taking less than 55% of a leased facility may be able to benefit from Grow-NJ’s tax credits, without paying “prevailing wage” for their fit-out.

Article By:

Michael A. Bruno
Steven P. Gouin
Of:
Giordano, Halleran & Ciesla, P.C.

IRS Introduces New Form 1023-EZ to Streamline Applications for 501(c)(3) Tax-Exempt Status

Drinker Biddle Law Firm

On July 1, 2014, the Internal Revenue Service (IRS) launched a new Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, that is intended to enable small charities to more easily apply for recognition of tax-exempt status under Internal Revenue Code Section 501(c)(3). The IRS has described the new form as a “common sense approach” to easing the filing burdens for small organizations and to shorten the time delays associated with IRS processing. Although not expressly stated, the new form is undoubtedly part of the IRS’s current effort to alleviate the huge backlog of pending applications awaiting IRS review.

What’s the general idea behind the new form?

The concept associated with the Form 1023-EZ is that the existing 26-page Form 1023 is simply unnecessary in the case of most small organizations. As designed, the new form becomes effectively a “registration” for exemption, rather than a comprehensive description of an organization’s activities, operations, governance, finances, etc. The IRS has clarified that the new forms will not undergo substantive review by IRS personnel. Rather, the IRS will defer that review until a later date when organizations are up and running; at that point, the IRS will evaluate whether organizations are functioning as described in their original filings.

When the new form was announced in draft form earlier this year, many industry experts voiced concern about foregoing the important educational and compliance opportunities associated with completing the full Form 1023 in its standard form. Others expressed doubt as to whether the IRS would be able to effectively and consistently perform the type of follow-up reviews asserted as the means for ensuring compliance with exemption standards. Nonetheless, the IRS has forged ahead, presumably under pressure to address its internal processing challenges and perhaps to present some much-needed “taxpayer-friendly” news from the Exempt Organizations Division.

Concurrent with issuing the new form, the IRS released Revenue Procedure 2014-40, which sets forth the procedures for using the new form and IRS’s processing of the same.

Who is eligible to use the new form?

The Revenue Procedure describes the scope of organizations that are eligible to use the form, consisting generally of organizations whose annual gross receipts have not exceeded $50,000 during any of the past three years and whose projected gross receipts for the current year and next two years are below that threshold. In addition, eligible organizations may not have total assets exceeding $250,000. Notably, when the draft Form 1023-EZ was initially announced earlier this year, the thresholds were appreciably higher – annual gross receipts of $200,000 or less and assets of $500,000 or less. In setting the final eligibility requirements, the IRS reduced those thresholds, presumably in response to exempt community (and possibly state charity official) voices expressing concern about this new approach being poorly suited to ferreting out actual or intended noncompliance, as discussed above.

The Revenue Procedure goes on to list other criteria that render an applicant ineligible to use the new form, including foreign organizations, successors to for-profit entities, churches, schools, colleges, universities, hospitals, supporting organizations described in IRC Section 509(a)(3), HMOs, ACOs, and entities maintaining donor-advised funds.

Notwithstanding the foregoing restrictions, the IRS has estimated that as many as 70 percent of organizations applying for 501(c)(3) status will be eligible to use the new form.

What does the new form look like?

Anyone who has tackled the process of preparing a Form 1023 in the past will recall the burden associated with wading through the standard 26-page application, which by necessity has traditionally covered a vast range of organizations (by size, scope and character) falling under the umbrella of 501(c)(3) status. By comparison, the new Form 1023-EZ is only three pages long and calls for:

  • Identifying information;
  • Form of entity under applicable state law, including check-box attestations regarding inclusion of appropriate language in pertinent organizational documents;
  • General information regarding the organization’s activities, using NTEE classification codes, check-box attestations regarding compliance with basic exemption requirements, and yes-or-no answers to high-level questions presumably aimed at fleshing out potentially at-risk conduct;
  • A check-box approach for attesting to public charity status; and
  • A check-box approach for organizations seeking reinstatement after losing their exemption due to failure to file annual information returns for three consecutive years.

A copy of the new form is available here. The accompanying instructions can be found here.

How is the new Form 1023-EZ to be filed?

Form 1023-EZ must be filed electronically, using the www.pay.gov website. A $400 user fee applies. Once filed, the IRS process will consist of determining whether an application is complete, meaning that the applicant has provided a response to each line item in the form. If a form is incomplete, the IRS may request additional information accordingly. Once complete, the IRS will accept the form for processing.

What if we have a pending Form 1023 already in the queue at the IRS?

If an organization has already submitted Form 1023 to the IRS, it may nevertheless submit Form 1023-EZ if its Form 1023 has not yet been assigned for review. In that case, the IRS will treat the Form 1023 as withdrawn and will instead process the organization’s Form 1023-EZ.

Corey Kestenberg contributed to this article.

Article By:

Linda S. Moroney
T.J. Sullivan
Taylor A. Romigh
Of:
Drinker Biddle & Reath LLP

Bank Regulators Require Changes to Tax Allocation Agreements

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Acting in response to divergent results in recent court decisions, the Federal bankregulatory agencies have adopted an Addendum to their longstanding rules regardingincome tax allocation agreements between insured depository institutions (“IDI”) and their parent holding companies.[i] The Addendum requires holding companies and their IDI subsidiaries to review their existing income tax allocation agreements and to add a specified provision. The review and modifications must be effected as soon as reasonably possible, which the regulators expect to be prior to October 31, 2014.

Background

Most banks and thrift institutions holding deposits insured by the Federal Deposit Insurance Corporation (“FDIC”) are subsidiaries in a holding company structure. The Federal and State income tax returns of these IDI, as members of a consolidated group, are usually filed by the holding company parent. Refunds and other tax benefits of the consolidated group attributable to the IDI subsidiaries received by a parent holding company must be allocated to the IDI subsidiaries.

Since 1998, the Board of Governors of the Federal Reserve System (“Board”), the Office of the Comptroller of the Currency, and the FDIC (collectively, the “Agencies”) have applied uniform rules regarding such allocations. They are set forth in their Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure (the “Policy”).[ii]

The Policy generally mandates that inter-corporate settlements between an IDI and its parent holding company be conducted in a manner that is no less favorable to the IDI than if it were a separate taxpayer. It also establishes a supervisory expectation that a comprehensive written tax allocation agreement will be entered into between a parent holding company and its IDI subsidiaries.

Among other things, the Policy specifies that a parent holding company that receives a tax refund from a taxing authority holds such funds as agent for the members of the consolidated group. It also requires that neither the tax allocation agreement nor the corporate policies of the parent holding company should purport to characterize refunds attributable to an IDI subsidiary received from a taxing authority as being property of the parent.

Addendum to the Policy

In several holding company bankruptcies since 2008, the FDIC has been unsuccessful in recovering for IDI subsidiaries tax refunds received and held by the parent holding company. In those cases, the courts have interpreted the applicable tax allocation agreement as creating a debtor-creditor relationship between the parent holding company and its IDI subsidiaries. Those courts have reached that result notwithstanding the Policy and its mandate that a parent holding company act as an agent for its IDI subsidiaries.[iii]Although other decisions have interpreted tax allocation agreements consistently with the Policy, the Agencies determined to modify the Policy and require additional action by holding companies and IDI with a view to avoiding such situations in future.

Under the Addendum to the Policy, each tax allocation agreement must be reviewed and revised to ensure that it explicitly acknowledges an agency relationship between the holding company and its subsidiary IDI with respect to tax refunds and does not contain any other language to suggest a contrary intent. A sample paragraph which the Agencies regard as sufficient is included in the Addendum.

The Addendum to the Policy also makes clear that tax allocation agreements are subject to the requirements of Sections 23A and 23B of the Federal Reserve Act. Among other things, this means that the parent holding company must promptly transmit tax refunds received from a taxing authority to its subsidiary IDI. An agreement that permits a parent holding company to hold and not promptly transmit tax refunds owed to an IDI may be regarded by the Agencies as inconsistent with Section 23B, and may subject the holding company and IDI to supervisory action. Similarly, an agreement that fails to clearly establish the agency relationship between the parent holding company and its IDI subsidiaries may be treated as subject to the loan collateralization and other requirements of Section 23A.

Conclusion

The Addendum the Agencies have made to the Policy does not represent a change in supervisory approach to these issues. It is a clarification in light of adverse bankruptcy experience and constitutes a reaffirmation of the Policy. Parent holding companies and IDI subsidiaries should arrange for a review of their existing tax allocation agreements and the inclusion in those agreements of the provision specified in the Addendum to the Policy. Action is required as soon as reasonably possible, but in any event before October 31, 2014.

Article By:

John K. Lawrence
Of:
Dickinson Wright PLLC

[i] Board Press Release (June 13, 2014). The Addendum will be published in the Federal Register.

[ii] 63 Fed. Reg. 64757 (Nov. 23, 1998).

[iii] See, e.g., FDIC v. Siegel (In re IndyMac Bancorp, Inc.), 2014 WL 1568759 (9th Cir., 2014).

© Copyright 2014 Dickinson Wright PLLC

Retroactive Tax Planning Re: U.S. Shareholders of Foreign Corporations

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Converting Subpart F Income into Qualified Dividends

U.S. shareholders of foreign corporations are generally not subject to tax on the earnings of such corporations until the earnings are repatriated to the shareholders in the form of a dividend.  Moreover, when a foreign corporation is resident in a jurisdiction with which the United States has a comprehensive income tax treaty, the dividends distributed to its individual U.S. shareholders are eligible for reduced qualified dividend tax rates (currently taxed at a maximum federal income tax rate of 20 percent).

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Where a foreign corporation is classified as a “controlled foreign corporation” (“CFC”) for an uninterrupted period of 30 days or more during any taxable year, however, its U.S. shareholders must include in income their pro rata share of the Subpart F income of the CFC for that taxable year, whether or not such earnings are distributed.  A CFC is a foreign corporation, more than 50 percent of which is owned (by vote or value), directly or indirectly, by “U.S. shareholders.”  A U.S. shareholder, for the purpose of the CFC rules, is a U.S. person who owns, directly, indirectly or constructively, at least ten percent of the combined voting power with respect to the foreign corporation.

In addition to the inability to defer taxation on its share of a CFC’s subpart F income, one of the pitfalls of a U.S. shareholder owning stock in a CFC is that subpart F income is treated as ordinary income to the U.S. shareholder (currently taxed at a maximum federal income tax rate of 39.6 percent), regardless of whether the CFC is resident in a jurisdiction that has an income tax treaty with the United States.  Therefore, the U.S. shareholder would not be able to repatriate its profits at qualified dividend rates.

Among other things, subpart F income generally includes passive investment income (e.g., interest, dividends, rents and royalties) and net gain from the sale of property that gives rise to passive investment income.  Gain on the sale of stock in a foreign corporation, for example, falls within this category.  Consequently, when a CFC sells stock of a lower-tier corporation, the U.S. shareholders of the CFC will have to include their share of the gain from the sale as subpart F income, which will be taxed immediately at ordinary income rates.

Check-the-Box Elections

Pursuant to the “check-the-box” entity classification rules, a business entity that is not treated as a per se corporation is an “eligible entity” that may elect its classification for federal income tax purposes.  An eligible entity with two or more members may elect to be classified as either a corporation or a partnership. An eligible entity with only one member may elect to be classified as either a corporation or a disregarded entity.

Generally, the effective date of a check-the-box election cannot be more than 75 days prior to the date on which the election is filed.  However, Rev. Proc. 2009-41 provides that if certain requirements are met, an eligible entity may file a late classification election within 3 years and 75 days of the requested effective date of the election.  These requirements may be met if:

  1. The entity failed to obtain its requested classification solely because the election was not timely filed
  2. The entity has not yet filed a tax return for the first year in which the election was intended
  3. The entity has reasonable cause for failure to make a timely election

The conversion from a corporation into a partnership or disregarded entity pursuant to a check-the-box election results in a deemed liquidation of the corporation on the day immediately preceding the effective date of the election.  Distributions of property in liquidation of the corporation generally are treated as taxable events, as if the shareholders sold their stock back to the corporation in exchange for the corporation’s assets.  As a result, the corporation shareholders would recognize gain on the liquidating distributions to the extent the fair market value of the corporation’s assets exceeds the basis of the shareholders’ shares.  In addition, subject to limited exceptions, the corporation generally would recognize gain on the liquidating distribution of any appreciated property.

Converting Subpart F Income into Qualified Dividends

A CFC that elects to convert from a corporation into a partnership or disregarded entity generally would recognize Subpart F income on the deemed liquidation, to the extent it holds property that gives rise to passive investment income (such as stock in subsidiary corporations).  The subpart F income inclusion rules only apply, however, when the foreign corporation has been a CFC for a period of 30 uninterrupted days in the given taxable year.  Where the election is made effective as of January 2, the liquidation of the foreign corporation would be deemed to occur on January 1 of that year.  Because the foreign corporation would be deemed to have been liquidated on January 1, it would not have been a CFC for 30 days during the year of liquidation.  As a result, subpart F income would not be triggered on the deemed liquidation of the foreign corporation.

In addition, as a result of the check-the-box election, a U.S. shareholder of the foreign corporation would recognize gain on the deemed liquidation as if the shareholder sold its stock back to the corporation in exchange for the corporation’s assets.  Section 1248(a) provides, however, that when a U.S. person sells or exchanges its shares in a foreign corporation that was a CFC during the 5-year period prior to disposition, the gain from the sale is recharacterized as a dividend to the extent of the allocable share of the earnings and profits of the foreign corporation.  To the extent the foreign corporation is resident in a country with which the U.S. has an income tax treaty, its individual U.S. shareholders would be eligible for the reduced qualified dividend income tax rate on such dividend.

This may be illustrated by the following example:

A, a U.S. individual, is the sole shareholder of X, a foreign corporation resident in a country with which the United States has a comprehensive income tax treaty.  X owns 40 percent of the shares of Y, another foreign corporation.  In October 2013, X sells all of its shares of Y.  X is a CFC and the net gain from the sale of the Y shares constitutes subpart F income.  As a result, the gain would have to be included in A’s gross income as ordinary income.  Instead, X files a retroactive check-the-box election pursuant to Rev. Proc. 2009-41 to be treated as a disregarded entity as of January 2, 2013.  The election results in a deemed liquidation of X on January 1, 2013.  Because X has not been a CFC for a period of 30 uninterrupted days in 2013, however, subpart F income is not triggered on the deemed liquidation of X.  In addition, the gain recognized by A on the deemed liquidation of X is recharacterized as a dividend and subject to tax at the reduced rates applicable to qualified dividend income.

As a result, the combination of Section 1248(a) and the retroactive check-the-box rules allows individual U.S. shareholders of a CFC to convert gain that would be realized upon the sale of the CFC’s assets from subpart F income (taxed as ordinary income at rates up to 39.6 percent) to qualified dividend income (currently taxed at 20 percent).  Following the deemed liquidation of the foreign corporation, because all of the assets would be deemed to have been distributed to the shareholders in complete liquidation of the corporation, and the shareholders would recognize gain on the receipt of the assets, the basis of the assets would be stepped up to fair market value, reducing or eliminating gain recognized upon the subsequent sale of the assets of the former CFC.

Article By:

Jeffrey L. Rubinger
Nadia E. Kruler
Joshua Kaplan
Of:
Bilzin Sumberg Baena Price & Axelrod LLP

Tax Tip: Free Federal Filing Program

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Did you know that an individual may use free online tax preparation software and e-filing if he or she qualifies? This may be useful knowledge for your young adult children, even if you are not eligible.

The Free File Alliance is a nonprofit coalition of industry-leading tax software companies that have partnered with the IRS to help millions of Americans prepare and e-file their federal tax returns for free.

There are more than a dozen software options (brand-name software) available to assist a taxpayer with a 2013 adjusted gross income (“AGI”) of $58,000 or less at no cost. Choose your software carefully because some companies offer free state tax preparation and e-filing, whereas others do not.

Even though an individual’s gross income may be higher than $58,000, the individual may still qualify for this service because his or her gross income (e.g., salary, dividends, interest, alimony, and rental income) is reduced by various deductions, the most common being contributions to an IRA or qualified plan, to calculate the individual’s AGI.

70% of American taxpayers are eligible for this service and 98% of users would recommend this program to others.

If your AGI is higher than $58,000, free File Fillable Forms are available for federal returns only, including free e-filing. This service was recently extended to be available for use until October 2015. Go to www.irs.gov/freefile to begin.

Article By:

Robin L. Miskell
Of:
Dickinson Wright PLLC

Tax Court Holds that a Trust can Qualify for the "Real Estate Professional Exception" of Section 469(c)(7)

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The Tax Court recently handed down its decision in Frank Aragona Trust v. Commissioner, ruling that a trust can qualify for the real estate professional exception of Section 469(c)(7). By taking into account the actions of the trustees, a trust can be considered to be materially participating in real estate activities. This means that losses from real estate activities can be treated as nonpassive and therefore deductible in determining the trust’s taxable income. This decision is especially relevant to trusts that own business as it affects the application of the passive activity loss rules in Section 469 and whether income from those activities is subject to the new 3.8% net investment income Medicare surtax under Section 1411.

The Frank Aragona Trust (the “Trust”) was a Michigan trust that owned several pieces of real property and was also involved in the business aspects of developing and maintaining the property. The Trust had six trustees, three of whom were also employees of Holiday Enterprises, LLC (the “LLC”). The LLC was owned 100% by the Trust. The LLC also employed other professionals.

The Trust had losses in 2005 and 2006 from its real estate activities and deducted those losses(on the basis that they resulted from nonpassive activities) on its income tax returns. In issuing a notice of deficiency for those tax years, the Service determined that the real estate activities were passive under Section 469 and therefore any related losses were not deductible.

In general, real estate rental activity is considered passive regardless of whether the taxpayer materially participates in the real estate business. However, there is an exception for “real estate professionals” under Section 469(c)(7). Before the Tax Court, the Trustees argued that the Trust was a “real estate professional” as defined in Section 469(c)(7) so that the losses were considered to be from nonpassive activities and therefore deductible. To qualify for the real estate professional exception, a taxpayer must pass two tests. First, more than one-half of the personal services performed in a taxable year must be performed in real property trades or businesses in which the taxpayer materially participates. Second, the taxpayer must perform more than 750 hours or services during the taxable year in real property trades or businesses in which the taxpayer materially participates. The Service argued that the regulations to Section 469(c)(7) define “personal services” as “work performed by an individual in connection with a trade or business [emphasis added].” Because the trust was not an individual, it could not perform personal services and therefore did not fall under the Section 469(c)(7) exception.

The Tax Court rejected the Service’s argument that the trust could not be considered an individual under Section 469(c)(7) and the associated regulations. Further, the Court found that the Trustees’ participation in the real estate activities met the material participation requirements of Section 469(c)(7) because they were regular, continuous and substantial. The Court determined that the participation of the Trustees should be considered in determining whether the taxpayer (the Trust) materially participated in the real estate activities. The Service argued that the activities of the Trustee should only apply if they are performed in their capacity as Trustees (as opposed to employees of the LLC). Here, the Court looked to Michigan law, under which trustees are required to administer trusts solely for the benefit of the trust beneficiaries. The Court explained that the Trustees could not simply stop acting as Trustees because they were also employees of the LLC, so that their activities in other capacities could be considered in whether the Trust was a material participant in the real estate activities.

In summary, a trust may be able to qualify for the real estate professional exception of Section 469(c)(7). If the trust qualifies for the exception, losses from the associated real estate activities may be deductible on the trust’s income tax return. This distinction has increased importance with the application of the new 3.8% net investment income Medicare surtax under Section 1411.

Article By:

Albert W Gortz
George D Karibjanian
David Pratt
Mitchell M Gaswirth
Andrew M Katzenstein
Henry J Leibowitz
Of:
Proskauer Rose LLP

 

U.S. Tax Court Rejects Internal Revenue Service's (IRS) Restrictive View of Trust Material Participation

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The U.S. Tax Court recently issued a taxpayer favorable opinion regarding how a trust materially participates in its activities. The court’s holding will make it easier for trusts to currently deduct expenses against non-passive income and to exclude income from the reach of the new 3.8% net investment income tax.

In Frank Aragona Trust v. Comm’r, the court held that in determining whether a trust materially participates in its activities, the activities of the trustees, including their activities as employees of the businesses owned by the trust, should be considered. The court’s opinion directly conflicts with recent IRS guidance that only a trustee’s time spent acting in a fiduciary capacity counts toward the trust’s material participation – a standard that would be very difficult for most trusts to meet. See Technical Advice Memorandum 201317010.

In Frank Aragona Trust, a Michigan trust owned rental real estate activities and engaged in holding and developing real estate. The trust conducted some of its activities directly, and others through its wholly-owned business, Holiday Enterprises, LLC. The trust had six trustees, three of whom worked full-time for Holiday Enterprises. The IRS argued that the participation of the trustee-employees should be disregarded. The court disagreed and concluded that the participation of the trustee-employees should be counted and further, that the participation of the trust’s six trustees was sufficient to meet the material participation standard. The court based its decision, in part, on the fact that Michigan law requires trustees to “administer the trust solely in the interest of the trust beneficiaries” even when they are participating through a business wholly-owned by the trust. This decision provides helpful authority for trusts, their trustees and their advisors in navigating the complex passive activity loss and net investment income tax rules.

However, the decision in Frank Aragona Trust does not answer all of the outstanding questions regarding material participation of trusts. In recently finalized regulations implementing the net investment income tax, the Treasury Department and the IRS requested public comments on rules regarding material participation of trusts, which indicates that the IRS may finally undertake a formal project to provide long-awaited guidance on this issue.

Article By:

Michala P. Irons
Randal J. Kaltenmark
William M. Pope
Douglas S. Robson
Howard J. Rubin
Of:
Barnes & Thornburg LLP

IRS Clarifies How Plan Sponsors Should Handle Same-Sex Spouses in Qualified Retirement Plans

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On April 4, 2014, the IRS issued Notice 2014-19, requiring that qualified retirement plans apply “spouse” and “marriage” to same-sex spouses just as the plan would to opposite-sex spouses and establishing criteria for what plan amendments are needed and the timing for doing so.

Background

In September of 1996, Congress enacted the Defense of Marriage Act (DOMA), which provided that same-sex marriages would not be recognized under federal law. On June 26, 2013, however, the U.S. Supreme Court held in the Windsor case that DOMA’s treatment of such marriages was unconstitutional. Following Windsor, the IRS issued Revenue Ruling 2013-17 on August 29, 2013 (effective September 16, 2013), requiring same-sex marriages legally performed under state law to be recognized for federal tax purposes in any state regardless of whether the state recognizes the validity of same-sex marriages. This Revenue Ruling further provided that individuals who entered into registered domestic partnerships, civil unions, or other similar relationships under state law did not qualify as “spouses” and that these relationships did not qualify as “marriages” for federal tax purposes.

The newly issued April 4 Notice gives further guidance respecting qualified retirement plans on a wide range of subjects including qualified joint and survivor annuity rules, the Retirement Equity Act’s spousal beneficiary safeguards, required minimum distribution calculations and timing, control group determinations, ESOP rules, and the QDRO exceptions to the Code’s anti-alienation rules.

Notice 2014-19

The new IRS Notice describes when qualified retirement plans must be in administrative and documentary compliance with Windsor and the August 2013 Revenue Ruling. Plan sponsors and recordkeepers must have been administering their retirement plans consistent with Windsor as of June 26, 2013, even if these plans did not contemplate valid same-sex marriages. The corollary to this is that failing to recognize same-sex marriages before June 26, 2013, will not disqualify a plan. Furthermore, because last summer’s Revenue Ruling was not effective until September 16, 2013, there will be no risk of disqualification during the gap period between the effective date of Windsor and September 16 for plans that recognized same-sex marriages only if a participant was domiciled in a state that recognized same-sex marriages. The IRS further clarified that plan sponsors could operate their plans prior to June 26, 2013 to reflect Windsor on some or all qualification requirements without risk of disqualification so long as the basic qualification rules were satisfied, i.e., plan sponsors could be more generous than the Code required if it was feasible administratively.

From a documentation standpoint, all qualified retirement plans must be consistent with Windsor and both the IRS Revenue Ruling and the new Notice. Depending on how a plan uses or defines the terms “spouse” and “marriage,” plan amendments may or may not be needed. If a plan uses or defines these terms in a neutral manner without reference to “opposite-sex” or DOMA and they can be reasonably construed in harmony withWindsor and the IRS guidance, then no plan amendment is likely needed. However, if a plan couches the terms “spouse” and “marriage” in accordance with DOMA or inconsistently with Windsor, then the plan will need to be amended retroactively to June 26, 2013 to maintain its qualified status.

The deadline for adopting any needed amendments is generally going to be December 31, 2014, although for some plan sponsors, the amendment deadline could be later depending on their unique circumstances.

Next Steps

In response to Notice 2014-19, plan sponsors will need to review the terms of their retirement plans to ensure each plan contains a proper definition of “spouse” and “marriage” and to timely amend their plans, as necessary. Additionally, plan sponsors should confirm the administrative aspects of their plans with their recordkeepers. Based on all of this, Notice 2014-19 is welcome news as it provides certainty: individuals can better plan their benefits and retirements, recordkeepers can confidently begin any needed programming and website changes, and plan sponsors can undertake any needed revisions to their plan documents, summary plan descriptions and other communications.

Article By:

Jorge M. Leon
Kirk A. Pelikan
Charles P. Stevens
Of:
Michael Best & Friedrich LLP

Illinois Trust Taxation Deemed Unconstitutional

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In Linn v. Department of Revenue, the Illinois Fourth District Appellate Court reviewed the state’s statutory framework for taxing trusts. Linn v. Department of Revenue, 2013 Il App (4th) 121055.  On constitutional grounds, the court limited Illinois’ power to impose taxes under its “once subject to tax, forever subject to tax” regime.

This case creates planning opportunities to minimize Illinois income taxes.  However, it should be noted that the Linn case applies to trusts that pay Illinois income tax on trust dividends, interest, capital gains or other income retained by the trust and not distributed to a beneficiary.  This case does not apply to income distributed to an Illinois beneficiary; that income clearly can be taxed by Illinois.

Illinois Trusts

Illinois trusts are subject to a 5 percent income tax plus a 1.5 percent personal property replacement tax.  A nonresident trust is subject to taxation only on income generated within Illinois or apportioned to the state.  Resident trusts, on the other hand, are subject to tax on all income, regardless of the source of that income.  For an individual, state income taxation on a resident basis generally requires domicile or residence within the taxing state.  With respect to a trust, one or more of the grantor, trustees and beneficiaries may have contacts with a state sufficient to uphold as constitutional a tax on all of the trust income.

Illinois defines a resident trust based solely on the domicile of the grantor. 35 ILCS 5/1501(a)(20).  A resident trust means:

  • A trust created by a will of a decedent who at death was domiciled in Illinois or
  • An irrevocable trust, the grantor of which was domiciled in Illinois at the time the trust became irrevocable.  For purposes of the statute, a trust is irrevocable when it’s no longer treated as a grantor trust under Sections 671 through 678 of the Internal Revenue Code.

The Illinois statute would forever tax the income generated by the trust property, regardless of the trust’s continuing connection to Illinois.  One can analogize the Illinois statute to a hypothetical statute providing that any person born in Illinois to resident parents is deemed an Illinois resident and subject to Illinois taxation no matter where that person eventually resides or earns income.  Many lawyers believe that the Illinois statute is unconstitutional.

Linn

Linn involved a trust established in 1961 by A.N. Pritzker, an Illinois resident.  The trust was initially administered under Illinois law by trustees who lived in Illinois.  In 2002, the trustee exercised a power granted in the trust instrument to distribute the trust property to a new trust (the Texas Trust).  Although the Texas Trust generally provided for administration under Texas law, certain provisions of the trust instrument continued to be interpreted under Illinois law.  The Texas Trust was subsequently modified by a Texas court to eliminate all references to Illinois law, and the trustee filed the Texas Trust’s 2006 Illinois tax return as a nonresident.  At that time:

  • No current trust beneficiary resided in Illinois;
  • No trustee or other trust officeholder resided in Illinois;
  • All trust assets were located outside Illinois; and
  • Illinois law wasn’t referred to in the modified trust instrument

The Illinois Department of Revenue (the IDR) asserted that the trust was a resident trust for 2006 and that, as such, the trust pay Illinois income tax on all income.  The trustee countered that the imposition of Illinois tax under these circumstances was unconstitutional as a violation of the due process clause and the commerce clause.  The court held the statute was unconstitutional based on due process grounds (not reaching the commerce clause arguments), and stated that the following are the requirements for a statute to sustain a due process challenge:  (1) a minimum connection must exist between the state and the person, property or transaction it seeks to tax during the period in issue and (2) the income attributed to the state for tax purposes must be rationally related to values with the taxing state. Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992).

This was the first case in Illinois on this issue so the court cited cases from other jurisdictions, including Chase Manhattan Bank v. Gavin, 733 A. 2d 782 (Conn. 1999), McCulloch v. Franchise Tax Board, 390 P.2d 412 (Cal. 1964), Blue v. Department of Treasury, 462 N.W.2d 762 (Mich. Ct. App. 1990) and Mercantile-Safe Deposit & Trust Co. v. Murphy, 242 N.Y.S.2d 26 (N.Y. App. Div. 1963).  Gavin, which upheld the application of the Connecticut income tax on the undistributed income of a lifetime trust created by a Connecticut grantor, was cited at length by the court.  A critical fact in that case was that the beneficiary resided within the state for the year in question and the court assumed that the beneficiary would receive all trust property shortly.  In Linn, the court noted, there were no Illinois beneficiaries.  Relying on Blue and Mercantile, the court found that a grantor’s residence within a state isn’t itself enough to satisfy due process.

The IDR argued that significant connections with Illinois existed, maintaining that the trust owed its existence to Illinois law and listing legal benefits Illinois provides to the trustees and beneficiaries. The IDR cited some cases that involved trusts created by a will (i.e.,testamentary trusts).  The Illinois court disagreed with the testamentary trust cases the IDR relied on, finding that a lifetime trust’s connections with a state are more attenuated than in the case of a testamentary trust.  Further, the court found that the Texas Trust wasn’t created under Illinois law, but rather by a power granted to the trustees under the original trust instrument.  The court proceeded to dismiss the trust’s historical connections to Illinois and focused on contemporaneous connections, finding that “what happened historically with the trust in Illinois courts and under Illinois law has no bearing on the 2006 tax year.”  Linn at ¶30.  For 2006, the court concluded that the trust received the benefits and protections of Texas law, not Illinois law.

Steps to Consider

The IDR did not appeal the Linn decision to the Illinois Supreme Court.  We anticipate that additional cases will test and define the boundaries of the Linn decision.  Of course, Illinois might change its statute. For the time being, however, the Linn decision is binding authority for trustees of trusts that can eliminate all contact with Illinois.

Trustees of resident trusts with limited contacts to Illinois (in particular, those trusts without trustees, assets or non-contingent beneficiaries in Illinois) should consider the following issues.

  • Review state taxation:  The trustee should review connections to Illinois and consider whether actions could be taken to fall within theLinn holding.  Contacts with other states and those states’ rules for taxing trusts should also be reviewed.
  • File Illinois return with no tax due:  Pending guidance from the IDR, the trustee could consider filing an IL Form 1041, referencing theLinn case and reporting no tax due.  For each tax year, a tax return must be filed in order to commence the running of the statute of limitations.  An Illinois appellate court decision that supports the taxpayer’s position will ordinarily provide a basis for the abatement of tax penalties. 86 Ill. Admin Code Section 700.400(e)(8). However, if the facts are not exactly like those in Linn, a penalty cold be imposed on the trustee.  A safer method for trusts when the facts are not the same as in Linn would be to file and pay the Illinois tax in full but then file a claim for refund.  This should eliminate penalties but likely will result in a dispute with the IDR.
  • Amend prior tax returns:  The trustee could consider filing amended tax returns for prior years and claim a refund.  A trustee that has timely filed prior year tax returns may file an amended tax return at any time prior to the third anniversary of the due date of the tax return, including extensions.  For example, the 2010 tax year return may be amended at any time prior to October 15, 2014.

Other Considerations

Given the holding in Linn and uncertainty regarding trust tax law, trusts that offer flexibility and can adapt to changing circumstances may have a distinct advantage.

  • Officeholders:  Carefully consider the residency of trustees and other trust officeholders (such as investment advisers) and provisions regarding the appointment and removal of those officeholders.
  • Decanting provision:  Consider providing the trustee with broad authority to distribute trust property in further trust.
  • Lifetime trusts:  While the legal basis for the continued income taxation of a testamentary trust may also be questionable, testamentary trusts can be avoided by creating lifetime trusts.
  • Situs and administration:  Consider establishing and administering the trust in a state that doesn’t assess an income tax against trust income.
  • Governing law:  Consider including trust provisions that allow the trustee to elect the laws of another state to govern the trust.
  • Discretionary dispositive provisions:  Consider including discretionary rather than mandatory trust distribution provisions, as some states may tax a trust based on the residence of beneficiaries with non-contingent trust interests.
  • Division provisions:  Consider including provisions authorizing a trustee to divide a trust without altering trust dispositive provisions.  This type of provision may allow a trustee to divide a trust into separate trusts and isolate the elements of a trust attracting state taxation.  For example, a trust may simply be divided into two separate trusts, one trust for the benefit of a child and his descendants that live in Illinois and a second trust that might not be subject to Illinois taxation, for a child and his descendants that don’t live in Illinois.
Article By:

James H. Cundiff
L. Timothy Halleron
Of: 
McDermott Will & Emery