Tax Court Decision Subjects LLP Service Providers/Equity Partners to Self-Employment Tax

Posted last week at the National Law Review by Paul A. Gordon and Casey S. August of Morgan, Lewis & Bockius LLP new developments concerning partners in a law firm established as a limited liability partnership (LLP) under state law subject to Self-Employment Contributions Act (SECA) tax on their distributive share of LLP income received in respect of their services.

In a decision issued February 9, the U.S. Tax Court ruled, in part, that the partners of a law firm established as a limited liability partnership (LLP) under state law were subject to Self-Employment Contributions Act (SECA) tax on their distributive share of LLP income received in respect of their services. In doing so, the court determined that the LLP partners could not avail themselves of the exemption from SECA for nonguaranteed service payments to “limited partners.” This ruling illustrates the potential risk for service provider limited partners and limited liability company members of assuming that state law entity and limited liability classifications alone shield them from being subject to SECA tax.

Background

Generally, payments to service providers who are not classified as employees for federal payroll tax purposes are not subject to any payroll tax withholding or payment liability on the part of the payor. Instead, Section 1401 imposes SECA tax on “self-employment” income at the rate of 15.3%, a combination of a 12.4% old-age, survivors, and disability insurance (OASDI) tax and a 2.9% Medicare tax. The OASDI tax is only imposed on the first $106,800 of “net earnings” (which allows for offsets to gross earnings for deductible expenses associated with the creation of the income) for 2011. Subject to certain exemption rules, self-employment earnings include income derived by an individual from any trade or business carried on by such individual plus his or her distributive share of partnership income or loss from any trade or business carried on by a partnership in which he or she is a partner. One of the exemption rules, included in Section 1402(a)(13) of the Internal Revenue Code, excludes from self-employment earnings “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services” (emphasis added). Unfortunately, Congress failed to provide a definition for limited partner in the statute.

In order to resolve this definitional ambiguity, the U.S. Treasury released temporary regulations in 1997 under which partners with either authority to contract on behalf of the partnership or who participate in the partnership’s trade or business for more than 500 hours during the partnership’s taxable year could not be limited partners for Section 1402(a)(13) exemption purposes. In addition, no service partner in a service partnership could be a limited partner. This guidance created political shockwaves so extensive that Congress imposed a 12-month moratorium on Treasury’s ability to issue further guidance under Section 1402(a)(13). Since that time, Treasury has not provided guidance on the limited partner exemption from SECA tax.

Confronted with the dearth of authority on this issue, many tax practitioners have taken the position that all partners in a tax partnership, who are limited partners or limited liability company members under state law, are per se eligible for the Section 1402(a)(13) limited partner exemption. Others, although not required by law, have followed the guidance under the proposed regulations.

Renkemeyer Decision

It was this definition of “limited partner” that was at issue before the Tax Court in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. No. 7 (2011). In that case, the Tax Court addressed an IRS challenge to both (1) the special allocation of the LLP’s (a law firm treated as a partnership for federal income tax purposes) distributive share of income to its partners and (2) the treatment of the LLP distributive share allocations of business income to its service partners (the law partners) as being exempt from SECA tax. After ruling in favor of the IRS on the allocation issue (the petitioner could not produce a partnership agreement supporting the challenged special partnership allocations), the court turned to the SECA tax issue.

The LLP partners argued that the limited partner exemption should apply because (1) the LLP organizational documents designated their interests as limited partnership interests and (2) they enjoyed limited liability under state law. The Tax Court disagreed, reaching the result that would have been required under the temporary regulations. Noting that Congress passed the limited partner exemption prior to the state law advent of LLPs and LLCs, the court reviewed the exemption’s legislative history and determined that the impetus for the exemption was not a limited partner’s individual protection from the partnership’s liabilities, but instead its status as a nonservice investment partner in a traditional limited partnership. In doing so, the court found that Congress did not intend for active service partners, such as the LLP partners, to be exempt from self-employment taxes. Specifically, the court referred to the partners’ minimal LLP capital contributions in exchange for their interests in LLP as indicating that the partners’ distributive share of income arose from the legal services performed on behalf of LLP and “not . . . as a return on the partners’ investments and . . . not [as] ‘earnings which are basically of an investment nature.'” (citing the Section 1402(a)(13) legislative history). Additionally, the Renkemeyer opinion hinted that the same rationale could be applied to prevent members of an LLC from qualifying as Section 1402(a)(13) limited partners.

Implications

Renkemeyer demonstrates the hazards of assuming that state law entity and limited liability classifications should control for purposes of determining eligibility for the Section 1402(a)(13) SECA tax limited partner exemption. That is, there may be danger in taking the per se limited partner exemption position described above. Service providers to tax partnerships (including LLCs treated as tax partnerships) in which they are also equity partners should thus be wary of whether both their service-related payments and guaranteed partnership equity allocations would be considered self-employment income subject to SECA tax.

Selling the Main Street Fairness Act: A Viable Solution to the Internet Sales Tax Problem

Congrats to Michael J. Payne, CPA of Arizona State University Sandra Day O’Connor College of Law one of the winners of the 2011 Spring National Law Review Student Legal Writing Contest. Michael’s topic addresses the tremendous struggle in the regulation of sales tax collection on interstate internet purchases.

I. Introduction

States have long faced issues related to collecting sales and use tax when the seller lives in another state. Initially, disputed transactions involved purchases from mail-order catalogs and telephone orders, but with the advent and explosion of the World Wide Web, states now face a tremendous struggle in the regulation of sales tax collection on interstate internet purchases.

Today, fierce debates between internet retailers, states, and consumers regarding sales taxes on internet purchases are commonplace, yet the key issues remain unresolved. Retailers purport to be exempt from state sales tax requirements when they do not have a physical presence in the state in which their customers reside; states argue sales taxes are due regardless of physical presence; and consumers just want to find the best deal when making purchases, which often means they seek out ways to avoid paying sales taxes altogether.

As a result of fast-moving technological advances and slow-moving legislative actions, a substantial gap has developed in nearly every state between sales tax revenue due and collected. A study from the University of Tennessee estimated that between 2007 and 2012, states will sustain over $52 billion in losses from uncollected taxes on e-commerce sales.¹ In addition to enlarging state budget shortfalls, untaxed interstate sales create an unfair advantage to online sellers who are relieved from the onerous sales tax collection duties imposed on in-state and traditional brick-and-mortar sellers. Thus, online sellers can offer discounts on products purchased from out-of-state residents while still earning higher profits than their in-state competitors.

Two significant constitutional hurdles restrict state regulation of interstate sales taxation: the Commerce Clause and the Due Process Clause, with the former causing the majority of current problems. This article focuses primarily on resolving the Commerce Clause concerns and attempts to reconcile the interests of sellers, consumers, and states. It then proposes the adoption of a bill that was recently introduced in the House of Representatives: the Main Street Fairness Act.²

II. Background

A. The Mechanics of Internet Sales Taxation

A basic understanding of common Internet sales taxation is needed to grasp the ideas discussed in this article. As a general rule, purchasers of merchandise must pay a transaction tax to the state in which they reside, provided that state imposes a sales or use tax.³ When the retailer collects the tax on behalf of the consumer and remits it to the state, it is called a sales tax.When a retailer fails to collect a sales tax, the consumer is obligated to report her purchase to the state and pay an equivalent use tax. The process is simple when the seller is in the same state as the purchaser: the seller collects taxes on local sales and remits them to the state. The more complicated and increasingly more common scenario is when the seller operates from another state; this situation has been the topic of numerous cases, statutes, opinion columns, Internet blogs, and scholarly articles, including this one.

Although state taxation of internet sales is a modern issue, courts have long debated whether the Constitution’s Commerce Clause limits the ability of a state to apply its sales and use tax provisions to out-of-state retailers.⁴ This Part describes the most significant cases.

B. National Bellas Hess, Inc. v. Department of Revenue of Illinois

In 1967, the Supreme Court considered whether a state could require a mail order company to collect and remit sales taxes on sales to residents of that state when that company had no physical presence in the state. In National Bellas Hess v. Department of Revenue of Illinois,⁵ the taxpayer was a mail order company incorporated in Delaware with its principal place of business in Missouri. It was licensed to do business only in those states. The taxpayer maintained no office or warehouse in Illinois, had no employees, agents, or salespeople there, and conducted no significant advertising there. Moreover, all contacts the company had with the residents of the state were through the mail or a common carrier. Illinois attempted to require the taxpayer to collect and remit sales and use taxes from Illinois residents who purchased the company’s goods by mail order.

The Court held that the Commerce Clause requires “some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax.” Mail order transactions alone do not create that minimum connection. The Court reasoned “[t]he very purpose of the Commerce Clause was to ensure a national economy free from . . . unjustifiable local entanglements. Under the Constitution, this is a domain where Congress alone has the power of regulation and control.”⁶

C. Quill Corp. v. North Dakota

Twenty-five years after National Bellas Hess, the Court affirmed in part its prior decision when it faced a similar set of facts in Quill Corp. v. North Dakota.⁷ In Quill, North Dakota attempted to require the taxpayer, a Delaware corporation with no significant tangible property or employees in North Dakota, to collect and remit use taxes from sales to North Dakota customers. The taxpayer solicited business through catalogs and flyers and delivered all its merchandise by mail or common carrier from out-of-state locations. The State argued that its statute subjecting every retailer that solicits business in the state to the tax was constitutional when the retailer had “engage[d] in regular or systematic solicitation of a consumer market in th[e] state.”

The Court disagreed, recognizing two constitutional barriers to a state’s ability to force out-of-state retailers to collect and remit sales taxes: the Due Process Clause and the Commerce Clause. The Court distinguished the Due Process Clause from the Commerce Clause, explaining:

Although the “two claims are closely related,” the Clauses pose distinct limits on the taxing powers of the States. Accordingly, while a State may, consistent with the Due Process Clause, have the authority to tax a particular taxpayer, imposition of the tax may nonetheless violate the Commerce Clause. The two constitutional requirements differ fundamentally, in several ways. . . . [W]hile Congress has plenary power to regulate commerce among the States and thus may authorize state actions that burden interstate commerce, it does not similarly have the power to authorize violations of the Due Process Clause.⁸

The Court concluded that because Quill had purposefully directed its activities at North Dakota, it established minimum contacts with the State, and thus the Due Process Clause did not prohibit the State from imposing its use tax against Quill.

The Court next considered whether the state statute ran afoul of the Commerce Clause. It recognized Congress’ constitutional authority to “regulate Commerce with foreign Nations, and among the several States,”⁹ but also recognized that the “dormant” Commerce Clause¹⁰ reserves to Congress the exclusive power to regulate interstate commerce even when it has not spoken directly on a subject. The dormant Commerce Clause requires that the retailer have a “substantial nexus” with the state before the state can force the retailer to collect and remit sales taxes, which often translates into a bright line physical presence test.

The Court held that North Dakota did not have the power to impose sales taxes on Quill because Quill had no physical presence in the state. It also found that the state’s taxation would unduly burden interstate commerce, noting that “similar obligations might be imposed by the nation’s 6,000-plus taxing jurisdictions,” thus vastly increasing the complexity of sales tax compliance for interstate retailers.

D. Streamlined Sales and Use Tax Agreement

In the shadow of the Quill decision, a new and far-reaching mode of commerce arose: the World Wide Web. Many retailers no longer needed to send catalogs to solicit sales. Instead, they could simply set up websites, make them apparent to search engines, and wait for customers to come to them. The following chart illustrates the historic growth of the Internet:

Year	Estimated Number of Websites	Estimated Percentage of U.S. Households with Internet Access	E-Commerce sales
1992 (Quill)	< 30	< 25%	n/a
2000 (SSUTA)	17,000,000	50%	$27.6 billion
2010	249,000,000	77%	$202.6 billion

The monumental growth in online sales has contributed to the two major problems currently associated with the taxation of remote sales: administrative burdens to sellers and lost revenues to states from general noncompliance. In 1999, state and local governments from twenty-six states responded to these by banding together and implementing a new sales tax system. The group’s goal was to create and implement a method to unify and simplify the collection and remittance of sales taxes across the country, an effort that culminated in the Streamlined Sales Tax Project.¹¹

The Project works through two steps. First, states voluntarily join the Streamlined Sales Tax Agreement by adopting its provisions as state law and conforming to the tax administration procedures set for by the Agreement. Second, interstate retailers voluntarily register with the Project’s online system. Sellers only register once and are thenceforth obligated to collect and remit sales taxes to member states when they sell products to residents of those states.

The Agreement reduces the administrative burden of tax compliance by focusing on two main goals: uniformity and simplification. The Agreement promotes uniformity in multistate sales tax collection at five levels: terminology, tax bases, registration, sourcing, and reporting. It simplifies sales tax collection and reporting by focusing on four areas: limited tax rates, seller liability for incorrectly reported exemptions, simplified tax forms, and electronic tax remittances. Additionally, it provides for sales tax software that, if used, would provide immunity to users from audits and corresponding liability.

A. Congressional Efforts to Regulate Internet Sales Taxes

Although states have been very active recently in attempting to regulate sales tax collection for out-of-state retailers, the power to regulate taxation of interstate commerce ultimately lies in Congress’s hands, as established by the Commerce Clause and reiterated in Quill. Since Quill, Congress has attempted several times to pass legislation that would provide federal authorization for states to mandate sales tax collection from out-of-state retailers, thus allowing states to bypass the substantial nexus requirement imposed by Quill.¹²However, each bill that has been proposed has expired without being voted on by the House or Senate.

B. Recent State Efforts to Bypass Quill’s Substantial Nexus Requirement

Dissatisfied with Congressional efforts (or lack thereof) to increase cooperation with sales tax laws, states have attempted in various ways to establish a substantial nexus between online retailers and their state and thereby satisfy the requirements of the Commerce Clause.

a. Borders Online v. State Board of Equalization

In 2005, the California Court of Appeals held in Borders Online v. State Board of Equalization that Borders’ retail stores in the state acted as authorized representatives of the associated online store when those stores accepted refunds of personal property sold by the internet retailer, thus establishing a nexus sufficient for the imposition of sales and use taxes under the Commerce Clause.¹³

After Borders, remote sellers in California sought clarification on whether their particular fact situations produced sufficient nexus to subject them to California state and local taxation. Courts look at various factors to determine the level of nexus,¹⁴ and consider these factors concurrently. An increasingly relevant factor that courts have examined is the presence of a company’s affiliates in a state, or “attributional nexus.” Courts have long looked at attributional nexus as a way to satisfy the Commerce Clause requirements, although the issue has never been directly addressed by the United States Supreme Court.

b. Amazon.com, LLC v. New York State Department of Taxation and Finance

Most recently, a New York trial court, later affirmed by the New York Appellate Division, weighed in on attributional nexus in Amazon.com, LLC v. New York State Department of Taxation and Finance.¹⁵ In 2008, New York attempted to curtail lost revenues from internet sales by amending the definition of “vendor” in its tax law, thus requiring each of Amazon’s Associates to collect sales taxes. Amazon then brought suit claiming that the Provision violated the Commerce Clause by imposing tax collection obligations on out-of-state entities that had no substantial nexus with the state. The court dismissed Amazon’s complaint for failure to state a cause of action, holding that the statute is not unconstitutional facially or as-applied. The court took a broad view of the substantial nexus requirement when it held that Amazon had created a substantial nexus with the State, even though Amazon had no offices, property, employees, or agents in the state. The court noted that physical presence “need not be substantial;” however, there must be “more than a slight presence.”

SinceAmazon, many New York retailers have terminated associations with in-state retailers and local affiliates to avoid being subject to sales tax collection. One website purports to list sellers that have removed New York affiliates after the passage of New York’s legislation, naming almost sixty remote sellers.¹⁶ The list includes some large companies such as Overstock, KB Toys, ShopNBC, CafePress, and Fingerhut. As a result, the statute may have actually hurt local retailers, the very group it was trying to protect by leveling the sales tax playing field.

c. The Bordersand AmazonFallout

The Amazon ruling has influenced other states to pass similar legislation in attempts to collect their own “Amazon tax.” For instance, in 2009, Rhode Island passed a statute that requires online merchants generating more than $5,000 in sales through in-state affiliates to register and collect sales tax on all its taxable sales in Rhode Island.¹⁷ Like the New York law, Rhode Island’s statute requires that the seller enter an agreement with a Rhode Island resident before the seller would be subject to sales tax collection.

Following the lead of New York and Rhode Island, North Carolina passed a statute¹⁸ enacting its own Amazon tax with a $10,000 floor, explaining that the new law codifies the United States Supreme Court’s 1960 decision in Scripto v. Carson that a state “may require tax collection by a remote retailer that had contracts with ten independent contractors in the state who solicited orders for products on its own behalf.”¹⁹ North Carolina simultaneously modernized its previous terminology by replacing “mail order” with “remote sales.”²⁰ Similar statutes were introduced in eleven other states.²¹

Colorado took its sales tax collection efforts a step further. In addition to enacting its own “Amazon tax,” Colorado’s H.B. 1193 (2010) would require sellers that do not collect sales taxes to send customers that purchase products online annual statements listing total purchases.²² Retailers would also send a copy of all purchases to Colorado’s Department of Revenue so that residents may be held accountable for unpaid use taxes.²³ The bill would authorize Colorado’s Executive Director of the Department of Revenue to issue a subpoena to an out-of-state retailer if that retailer refuses to voluntarily furnish that information. However, this statute is the subject of a recent lawsuit brought by the Direct Marketing Association. A federal court for the District of Colorado recently granted DMA’s motion for preliminary injunction against Colorado, holding that its statute “discriminates patently against interstate commerce” and imposes undue burdens on retailers.²⁴

Oklahoma took a different approach to regulating sales tax collection from out-of-state sellers.²⁵The Oklahoma law obligates certain remote sellers to post on their websites, catalogs, and invoices notice of consumers’ obligations to pay Oklahoma use tax on electronic and mail order purchases of tangible personal property.²⁶ Oklahoma’s law has been criticized as superfluous in application to internet and mail order sellers that have physical presence in the State because current Oklahoma use tax statutes already impose the obligation on those sellers to collect use taxes. Furthermore, the law is criticized as unconstitutional when applied to out-of-state sellers that have no physical presence in the State, because Quill’s interpretation of the Commerce Clause would prohibit Oklahoma from enforcing tax collection responsibilities on a seller with no physical presence in the state.

d. The Case for a Federal Solution

A uniform federal solution is superior to progressive state-by-state attempts to collect sales and use taxes for three reasons. First, states are tiptoeing on the edge of a river of constitutionally-protected consumer privacy matters. Second, strict enforcement of use tax laws at an individual level is hardly tenable given the historic lack of enforcement and the resulting lack of personal accountability. The proposed solutions impose real burdens on people and will discourage online purchases. Can you recall everything you have purchased online in the last year? In the last five years? You may have to if you are in a progressive sales tax collection state. It is much simpler and more intuitive for consumers to pay the tax up front as one swift transaction than to log their purchases, store the information, and file a use tax return with their payment at some later date. The increased hassles of recording each purchase could drive people back into brick-and-mortar stores, nullifying the efforts of Amazon and other remote sellers. For this reason, remote sellers should embrace the Main Street Fairness Act as a means to create certainty and consistency in the marketplace.

Finally, the trending methods of sales and use tax enforcement are completely inefficient. This is a situation in which it makes sense to take collective federal action rather than pursue state collection efforts at the individual taxpayer level. States would be forced to allocate substantial resources toward collection efforts while receiving no greater benefit than if the tax had been collected at the time of sale. With the Main Street Fairness Act, states would incur virtually no additional costs of expansion and would continue to use their existing collection methods. States are already entitled to collect these taxes whether in the form of sales or use taxes; why not utilize retailers with software and systems already in place?

The Center on Budget and Policy Priorities has argued that states’ implementation of the “Amazon law” could be an effective means to require sales tax collection from internet sellers that use affiliate programs.²⁷ However, the Center observed, Amazon laws are only a partial solution to the broader sales tax problem. Not every internet retailer operates an affiliate program, so the Amazon law does nothing to spur collection efforts from the numerous vendors who advertise by other means. The Center concluded that a comprehensive solution will require a federal law empowering states and localities that have streamlined their sales tax collection efforts to require all large remote sellers to collect sales taxes. This would allow states to force collection on remote sellers regardless of whether the sellers have a physical presence in their customers’ states. Such a federal grant of commerce power is the precise objective of the Main Street Fairness Act of 2010.

III. Main Street Fairness Act

The Main Street Fairness Act, sponsored by former Representative Bill Delahunt (D-MA), seeks to “promote simplification and fairness in the administration and collection of sales and use taxes.”²⁸ It would do so by allowing states to force “remote sellers” (companies that sell products online, by mail order catalogs, cable TV shopping, telephone, etc.) to collect sales and use taxes from customers and remit them to states. States acting alone do not have the authority to require a seller with no physical presence in the state to collect taxes on sales to that state’s residents. However, Congress affirmatively possesses the authority to regulate commerce under the Commerce Clause of the Constitution of the United States and Congress may authorize state actions that burden interstate commerce. The Main Street Fairness Act would grant states explicit authority to burden interstate commerce by allowing states to mandate collection and remittance of taxes on remote sales to their residents.

Why should Congress give the Main Street Fairness Act a second glance when a form of the current bill has essentially been rejected every other year for the last seven years? This section will focus on three ways the Main Street Fairness Act would benefit interstate commerce: (1) it would provide states a tool to enforce active yet frequently disobeyed laws regarding sales and use tax reporting and payment; (2) it would level the playing field between Main Street and “e-street;” and (3) it would help to close the enormous budget gap that is growing daily as a result of the disparity between taxes due and taxes actually collected.

A. Enforce Current Laws

The Main Street Fairness Act would grant federal authority to states, thus allowing states to enforce sales and use tax laws that are currently in place but are often not obeyed. Sales or use taxes are legally due on internet sales if the item is otherwise taxable under state law. Generally, retailers collect taxes from customers on behalf of states for convenience. However, when a customer purchases a taxable item and the retailer fails to collect a sales tax, that customer is obligated to pay a use tax and file a use tax return with the state.

People often do not pay use taxes on internet purchases for two reasons. First and most commonly, the average consumer is unaware that a tax is due when she purchases a product from an online retailer such as Amazon or Overstock. In other cases, the consumer may be aware that a tax is due but fails to pay sales or use taxes because he believes the law is not enforced and he will not be caught. This is the more dangerous scenario because in knowingly failing to pay a tax that is legally due, the consumer crosses the line of intentional disregard and is more likely to violate that law again.

In an effort to both inform residents of their obligation to pay use taxes and to actually collect those taxes, many states have started to include a line on their income tax returns where taxpayers are supposed to calculate and declare unpaid taxes. For example, Michigan includes the following line on its individual income tax return: “Use Tax: Use tax due on internet, mail order or other out-of-state purchases,” then references a separate worksheet that is provided to help the taxpayer calculate use tax due.²⁹

Some states have begun to enforce use tax compliance on an individual level, sending tax bills to consumers that had made taxable purchases but failed to pay a tax. Nebraska recently cracked down on a local March of Dimes chapter after the chapter purchased 4,000 t-shirts from an online vendor in Florida. Nebraska tracked purchases for the preceding five years and could collect an estimated $215,000 from the charity, or approximately thirteen percent of the donations. Other states are less stringent, allowing a de minimis exemption for individuals.³⁰

Some states have attempted to enforce sales and use tax compliance by leveraging customers to act as whistleblowers when companies knowingly fail to collect those taxes.³¹ Under these false claim statutes, individual consumers may bring suits on behalf of the state against parties that knowingly violated sales tax laws. If successful, the whistleblower would be entitled to a portion of the state taxes collected.

While states have had some success tackling the noncompliance issue on their own through enacting Amazon laws or similar statutes, the federal government is the sole body that is constitutionally charged with regulating interstate commerce and therefore should provide states with a tool to help them enforce their laws and uniformly tax interstate commerce. If passed, the Main Street Fairness Act could effectively serve as that tool.

B. Level the Playing Field

Perhaps the strongest policy reason for implementing a federal law to delegate Commerce power to states is the inherent unfairness that results from forcing some companies to charge their customers sales taxes while others do not have to charge any sales tax.

Two groups are hurt by current disparities in sales tax enforcement: local retailers and large companies with physical presence in many states. Small local retailers (mom and pop shops) are at a distinct disadvantage when their online competitors do not have to charge customers sales tax. Recent studies indicate that many consumers are beginning to follow a “just looking” trend whereby they test products in local stores by seeing, touching, and feeling them, then rush home to order the same products online where they can avoid paying sales taxes.³² According to one consumer behavior report, seventy-five percent of online consumers sought to purchase from merchants that did not charge sales tax and offered free shipping.³³ The savings are even greater when buying in bulk, thus enticing large organizations to shift their purchasing patterns away from small local retailers to reduce costs in a bad economy.

Ironically, opponents of internet sales tax regulation argue that enforcing sales tax laws would do greater harm than good to small retailers.³⁴Such opponents reason that the last decade has provided an unprecedented opportunity for individuals to start small companies that leverage the Internet to grow quickly, thus spurring the economy and creating jobs.Less than one month after the Main Street Fairness Act was introduced, a group of U.S. Representatives introduced the “Supporting the Preservation of Internet Entrepreneurs and Small Businesses” resolution.³⁵ The Preservation bill focuses on avoiding “any legislation that would grant State governments the authority to impose any new burdensome or unfair tax collecting requirements on small online businesses and entrepreneurs.” Representative Dan Lungren, sponsor of the Preservation bill, commented:

The most effective thing we can do to help our economy recover is to remove the roadblocks standing in the way of our nation’s job creators. At a time when we are trying to foster a sustained economic recovery, it doesn’t make sense to saddle entrepreneurs with tax requirements that stifle growth. The possibility of new taxes being levied on online retailers will have a negative impact on the online marketplace. We should send a clear message that Congress should not burden small businesses with unfair tax schemes.

The Preservation bill is constructed on two false premises. First, it presupposes that federal legislation granting states Congressional authority to collect sales taxes would impose a new tax. As discussed in the previous section of this article, sales and use taxes are already due in nearly every state on online purchases. A federal grant of authority would therefore not impose a new tax, but loosen the handcuffs Quill placed on states to enforce their own laws. Second, the Preservation bill is aimed at protecting small businesses and entrepreneurs. While noble in its purpose, the Preservation bill is simply unnecessary; the Main Street Fairness Act’s small seller exception would exempt from sales tax collection the very businesses the Preservation bill aspires to protect.

Another group that is damaged by the current system is large online retailers that have a physical presence in many states, such as Wal-Mart or Target. Most, if not all, online sales from these stores are subject to sales taxes because they have a physical presence in nearly every state. These companies put appropriate resources into ensuring that the taxes are properly collected and remitted. The inconsistency arises when comparing a company like Wal-Mart to a company like Amazon. Both are large companies that sell products to residents in every U.S. state and territory. However, Wal-Mart has stores in every state, while Amazon only has physical presence in a handful of states, thus creating a real disparity that needs to be addressed.

C. Bridge the Budget Gap

It is no secret that states are struggling to find revenue sources while tax collections are down nationwide. Advocates of internet sales taxation correctly promote the Main Street Fairness Act as a way for states to raise revenue without imposing additional taxes. While allowing states to enforce sales tax collection on all of its residents’ purchases would not solve the current budget crisis, it would allow states to take a healthy step in the right direction.

IV, Conclusion

Regardless of which political party is in the majority, the Main Street Fairness Act should be given consideration as a viable solution to the problems discussed above. Its passage would comport with the constitutional grant of authority over interstate commerce to Congress, while allowing states the freedom to choose whether to voluntarily join the Agreement. This system is ideal because states can preserve their independence by joining or leaving the Agreement at any time, while providing substantial benefits to out-of-state retailers by simplifying and unifying their reporting requirements. The Main Street Fairness Act is the bandwagon heading toward uniformity and fairness in sales tax collection. States just need to jump on.

[1] Donald Bruce, William F. Fox & LeAnn Luna, State and Local Government Sales Tax Revenue Losses from Electronic Commerce, U. Tenn. Center Bus. Econ. Res., Apr. 13, 2009, available at http://cber.utk.edu/ecomm/ecom0409.pdf.

[2] Main Street Fairness Act, H.R. 5660, 111^th Cong. (2010).

[3] Five states do not currently impose a sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon. Richard Stim, Sales Tax on the Internet, http://www.nolo.com/legal-encyclopedia/sales-tax-internet-29919.html.

[4] See, e.g., Quill Corp. v. North Dakota, 504 U.S. 298 (1992), National Bella Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967), Scripto, Inc. v. Carson, 362 U.S. 207 (1960).

[5] National Bella Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967) at 756.

[6] National Bella Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967) at 758–60. (internal citations omitted).

[7] Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

[8] Quill at 305 (internal citations omitted).

[9] U.S. Const. art I, § 8, cl. 3.

[10] The dormant Commerce Clause is a judicially-created doctrine that “rests entirely on the negative implications of the Commerce Clause of Art. I, § 8, cl. 3.” See Kathleen M. Sullivan, Gerald Gunther, Constitutional Law 174 (Thomson West 2007).

[11] Streamlined Sales Tax Governing Board, Registration Frequently Asked Questions, [hereinafter FAQs], http://www.streamlinedsalestax.org/index.php?page=faq. …

[12] Streamlined Sales and Use Tax Act, S. 1736, H.R. 3184, 108^th Cong. (2003); Sales Tax Fairness and Simplification Act, S. 2152, 109^th Cong. (2005); Streamlined Sales Tax Simplification Act, S. 2153, 109^th Cong. (2005); Sales Tax Fairness and Simplification Act, S. 34, H.R. 3396, 110^th Cong. (2007).

[13] Borders Online v. State Board of Equalization, 129 Cal.App.4th 1179, 1189–92 (Cal. App. 2005).

[14] Id. at 664–666, (listing some of the factors courts have examined in searching for substantial nexus: business ownership structure, common logos and names, common merchandise, use of private or branded credit cards, links between affiliates’ websites, credit card reward programs, gift certificates and gift cards, trademarks, goodwill, and return policies).

[15] Amazon.com, LLC v. N.Y. State Dep’t of Tax’n & Fin., 877 N.Y.S.2d 842 (N.Y. Sup. Ct. 2009).

[16] Id.; NYaffiliates.com, Merchants Removing NY Affiliates, http://www.abestweb.com/forums/showthread.php?t=105869 (last visited Nov. 29, 2010).

[17] R.I. Gen. Laws -§ 44-18-15 (2009); see also State of Rhode Island and Providence Plantations Department of Revenue, Important Notice: Definition of Sales Tax “Retailer” Amended, available at http://www.tax.state.ri.us/notice/Retailer_definition_NoticeC.pdf.

[18] N.C Gen. Stat. § 105-164.8(b)(3) (2009).

[19] North Carolina Department of Revenue, Sales Tax Law Changes, Form E-505 (8-09), Part II: Other Legislative Changes, available at http://www.dornc.com/downloads/e505_8-09.pdf.

[20] N.C Gen. Stat. § 105-164.3(33c) (2009).

[21] Jennifer Heidt White, Safe Haven No More: How Online Affiliate Marketing Programs Can Minimize New State Sales Tax Liability, 5 Shidler J. L. Com. & Tech. 21 (2009), (listing the following states as having introduced versions of the affiliate tax: Connecticut, Maryland, Minnesota, Tennessee, California, Hawaii, Mississippi, New Mexico, Vermont, Virginia, and Illinois).

[22] H.B. 10-1193, 67^th Gen. Assem., 2^nd Reg. Sess. (Colo. 2010), available at http://www.leg.state.co.us/clics/clics2010a/csl.nsf/fsbillcont3/B30F5741….

[23] Id.

[24] Direct Marketing Ass’n v. Huber, Order Granting Motion for Preliminary Injunction, 2011 WL 250556, Civil No. 10-cv-01546-REB-CBS, (D.Colo. 2011).

[25] 2009 OK H.B. 2359, (Feb. 1, 2010) available at http://webserver1.lsb.state.ok.us/textofmeasures/textofmeasures.aspx.

[26] Edward A. Zelinsky, The Paradoxes of Oklahoma’s Amazon Statute: Weak Duties, Expansive Coverage, Often Superfluous, Constitutionally Infirm, Cardozo Sch. L., Inst. Advanced L. Stud., Working Paper No. 315, at 17 (Oct. 2010).

[27] Michael Mazerov, Center on Budget and Policy Priorities, New York’s “Amazon Law”: An Important Tool for Collecting Taxes Owed on Internet Purchases, 1, July 23, 2009, http://www.cbpp.org/files/7-23-09sfp.pdf.

[28] H.R. 5660 at 1.

[29] 2009 Michigan Individual Income Tax Return MI-1040, line 25, available at http://www.michigan.gov/documents/taxes/MI-1040_305378_7.pdf.

[30] Minnesota, for example, exempts individuals with total purchased under $770 from paying the use tax, which is equivalent to $50 of use tax liability. Four other states have similar exemptions for individuals. See Nina Manzi, Use Tax Collection on Income Tax Returns in Other States, Research Department, Minnesota House of Representatives, *2, June 2010, available at http://www.house.leg.state.mn.us/hrd/pubs/usetax.pdf.

[31] Leslie J. Carter, Blowing the Whistle on Avoiding Use Taxes in Online Purchases, 2008 U. Chi. Legal F. 453–54 (2008).

[32] Google Retail Advertising Blog, Trend to Watch: Research & Purchase Process is Multi-Channel, (March 3, 2010), http://googleretail.blogspot.com/2010/03/trend-to-watch-research-purchas….

[33] Sara Rodriguez, Economic Climate Shifts Consumers Online, PriceGrabber.com (March 25, 2009), https://mr.pricegrabber.com/Economic_Climate_Shifts_Consumers_Online_Mar….

[34] Congressman Daniel Lungren, Lundgren Introduces Resolution to Protect Small Businesses and Entrepreneurs from New Sales Taxes, Feb. 16, 2011, http://lungren.house.gov/index.cfm?sectionid=39&sectiontree=6,39&itemid=759.

[35] H.R. 1570, 111^th Cong. (2010), available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills….

Planning Opportunities Under the New Estate and Gift Tax Law

Recently posted at the National Law Review by Julia L. Frey, Matthew R. O’Kane, and Norma Stanley of Lowndes, Drosdick, Doster, Kantor & Reed, P.A. – some highlights of the recent tax changes impacting estate plans:

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 increases the lifetime exemptions for the estate, GST and gift taxes to $5,000,000 per person and reduces the top tax rate to 35%.

The increased gift tax exemption allows you to make tax-free gifts of your estate which might otherwise be subject to gift tax. 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 his or her use. This is an immediate planning opportunity for those who wish to take advantage of the tax law changes.

The new law may also alter many estate plans. For example, assume your 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 upon the estate’s value) 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 you would want to happen.

The new law provides for “portability” of the estate tax exemption. Under prior law, if the estate of the first spouse to die did not use that spouse’s exemption, it was lost. Now, a surviving spouse may elect to add the deceased spouse’s unused 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, the surviving spouse would now be able to elect 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).

While the new tax law is a step in the right direction, it only applies through December 31, 2012. Whether your estate is above or below the new exemption amount, it is important to make sure your estate plan is up-to-date to ensure your intent is carried out and to maximize all of the planning options currently available to you. In addition, if a family member passed away in 2010, there could be new planning opportunities available that may benefit the estate.

IRS Announces Second Special Voluntary Disclosure Initiative for Taxpayers With Undisclosed Offshore Accounts

Posted this week at the National Law Review by Keith R. Gercken of Sheppard Mullin – updated information on 2011’s tax amnesty program for off shore accounts:

The Internal Revenue Service announced on February 8, 2011 the creation of a second special voluntary disclosure initiative for U.S. taxpayers with undisclosed foreign bank and other financial accounts. This new program is a follow-on to the IRS’ original voluntary disclosure initiative that closed on October 15, 2009. The 2009 program reportedly attracted some 15,000 voluntary disclosures by taxpayers with previously undisclosed offshore accounts, and has been viewed within the government as a success in getting taxpayers “back into the U.S. tax system” by offering them the ability to avoid or significantly mitigate various the criminal and civil penalties that would otherwise have potentially applied had their failure to disclose been discovered by the IRS on audit.

As background, U.S. persons are generally required to file an annual information statement with the IRS disclosing any beneficial interest in, or signatory authority over, bank or other financial accounts located outside the U.S. This information statement is filed on Form TD F 90-22.1, and is generally referred to as an “FBAR” (Foreign Bank Account Report). From an accountholder perspective the failure to file FBARs as required can potentially lead to a large array of both civil and criminal penalties – including monetary penalties of up to 50% of the unreported account balance (per year) and criminal penalties if the failure to file was willful.

The new 2011 program represents a second chance for taxpayers who did not take advantage of the original 2009 voluntary disclosure program. While the penalty structure offered by the IRS this time around is slightly less favorable than under the original 2009 program, it still offers taxpayers an opportunity to significantly reduce their penalty exposure. Highlights of the new 2011 program include the following:

The program covers the years 2003 through 2010.
There is an August 31, 2011 deadline to submit all required information to the IRS, including delinquent or corrected FBARs and amended income tax returns reporting any previously unreported income.
In lieu of the normal 50% per year penalty, a participating taxpayer must pay a 25% penalty on the highest aggregate account balance in the undisclosed offshore account during the period covered by the voluntary disclosure. In limited cases, this 25% penalty may be reduced to 12.5% or 5%.
Participating taxpayers must pay all delinquent taxes relating to any unreported offshore income, together with applicable interest and a 20% accuracy-related penalty.
Participating taxpayers must pay any other applicable civil penalties associated with a failure to file returns or failure to pay taxes during the period covered by the voluntary disclosure.
The program includes a generally favorable alternative resolution procedure to enable participating taxpayers to calculate their tax liability associated with investments that may have been made in “passive foreign investment companies” (e.g., foreign mutual funds) through their undisclosed offshore accounts.
Participating taxpayers must fully cooperate with the IRS in providing information on offshore financial accounts, institutions and facilitators.
The IRS will not initiate criminal prosecution of taxpayers who fully comply with the terms of the program.

The IRS remains focused on the potential evasion of U.S. income tax that is facilitated by hiding funds in offshore accounts, and has been increasingly aggressive in pursuing U.S. taxpayers who have failed to properly file FBARs and pay taxes on offshore income. As offshore financial secrecy continues to erode, the IRS has become increasingly able to obtain information relating to U.S. taxpayers directly from foreign banks. As a result, taxpayers with undisclosed offshore accounts that did not previously take advantage of the 2009 voluntary disclosure program may wish to consider the potential advantages of participating in this new 2011 program.

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.

Background

Renkemeyer Decision

Implications

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I. Introduction

II. Background

A. The Mechanics of Internet Sales Taxation

B. National Bellas Hess, Inc. v. Department of Revenue of Illinois

C. Quill Corp. v. North Dakota

D. Streamlined Sales and Use Tax Agreement

A. Congressional Efforts to Regulate Internet Sales Taxes

B. Recent State Efforts to Bypass Quill’s Substantial Nexus Requirement

a. Borders Online v. State Board of Equalization

b. Amazon.com, LLC v. New York State Department of Taxation and Finance

c. The Bordersand AmazonFallout

d. The Case for a Federal Solution

III. Main Street Fairness Act

A. Enforce Current Laws

B. Level the Playing Field

C. Bridge the Budget Gap

IV, Conclusion

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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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