This article originally appeared in NYS Society of CPA’s Nassau Chapter Newsletter October 2017.
written by Tax Partner Yvonne Cort
The Internal Revenue Service Office of Appeals (“Appeals”) is an independent organization within the IRS. It is intended to be fair, impartial, and objective. One goal of Appeals is to settle as many cases as possible without going to the United States Tax Court. According to the IRS, the issues of over 100,000 taxpayers are heard by Appeals each year.
Due to budget constraints, the IRS recently decided to cut back on face-to-face conferences with taxpayers at Appeals. There has been considerable pushback on this issue from tax professional groups. According to the National Taxpayer Advocate, limiting face-to-face meetings will increase rather than reduce costs overall for the IRS. In-person conferences are often influential in reaching a resolution. With fewer cases settled at Appeals, additional taxpayers will pursue litigation, at a higher expense to the taxpayer and the IRS. In September 2017, it was announced that in-person conferences will again be available for taxpayers upon request.
Tax practitioners should be aware of the opportunities and limitations of working with Appeals. It may be helpful to look at some of the current procedures.
Thirty-Day Letter: In the field examination context, when the auditor and the taxpayer disagree, the first step should be to request a conference with the auditor’s manager. If that is unsuccessful, the auditor may issue a Revenue Agent Report (RAR) with a cover letter allowing thirty days to file a formal written protest. Known informally as a “30-day letter,” it provides the taxpayer with the opportunity to challenge the auditor’s adjustments at Appeals. This is distinct from the subsequent “90-day letter” which is the Statutory Notice of Deficiency, providing the right to file a Petition in U. S. Tax Court.
There are certain required elements in the formal protest to Appeals, such as attaching the document with the proposed changes, listing the reasons for disagreement, and stating the facts and law to support the taxpayer’s position. The protest must be signed under penalties of perjury.
AJAC: The Appeals Judicial Approach and Culture (AJAC) Project has clarified Appeals policies. The role of Appeals is not to investigate, but to settle disputes. The Appeals Officer generally does not raise new issues or reopen issues where the taxpayer and the auditor have come to an agreement. If the taxpayer submits new information or evidence, the matter may be sent back to audit to be developed further.
Video Conference: In July, 2017, the IRS announced that it was starting a pilot program for virtual web-based video conferences for taxpayers and their representatives. It remains to be seen whether a video conference can achieve the same results as in-person attendance.
Early Referral and FTS: The Office of Appeals can assist in other ways. The Early Referral program allows a taxpayer to request a problematic issue to be heard at Appeals, while the rest of the audit continues with the auditor. Fast Track Settlement utilizes a specially trained Appeals Officer as a mediator between the auditor and the taxpayer, with a goal of an expedited settlement in sixty days. Although FTS is not a new program, recently it has become more widely available for Small Business/Self-Employed audits.
Conclusion: The right to an appeal in an independent forum is guaranteed by the Taxpayer Bill of Rights. As tax professionals, we need to know and understand administrative appeals, so we can take action when appropriate to do so on behalf of our clients.
July 24, 2017 by Peter Sanders
Capell Barnett Matalon & Schoenfeld LLP (“CBMS”) has advised all kinds of business owners and not-for-profit corporations in various matters. Nobody enters into an agreement intending to go to court due to a dispute, but sometimes issues arise when one party may not be able to honor their commitments. In those situations, retaining legal counsel can be a wise, strategic decision.
Hiring a lawyer does not mean you’re on the offensive and looking to initiate a lengthy legal battle. Oftentimes, having a lawyer on your side can actually reduce your risk of setting foot in court.
Below are some ways in which a lawyer can identify specific issues and ultimately help you avoid litigation.
- You’ll spend a little and save a lot. There are plenty of ways for you to cut corners to save your business some money, but legal advice should not be one of them. No matter the size of your operation, using templated forms for contracts, leases and operating agreements can have long-term consequences and costs. Leases in particular are often entered into without enough advance consideration. Stark differences in negotiating advantage can be mitigated by engaging counsel early on. The drafting party may have hidden advantages or limitations laced in a form’s language, which skilled lawyers can identify. The cost of not doing so far outweighs the investment. Wouldn’t you spend a few hundred or thousand dollars up front to save tens of thousands later?
Even more important is ensuring that the agreement allows you to do business as you intend, and grow as your needs change.
- You can communicate effectively. If you sense that something’s awry with another party, you should reach out to convey your concern. Your lawyer can be your communicator and help you avoid unpleasantness. For example, if you’re a landlord with a tenant that is two months late on rent payments and is unresponsive, involving a lawyer shows you’re serious while maintaining a distance that allows you to continue an amicable relationship once the issue is resolved. The opposite is also true. If you are having difficulties honoring your commitments, ignoring those realities in the hopes they go away often ends badly. Communicating with the other side and being honest instills confidence that you are trying to resolve the problem without harmful intentions.
- You’ll understand the other side’s point of view. In business, issues will undoubtedly arise. It could involve a client, customer, employee or another company. A qualified lawyer will have a range of experiences from which to draw when advising you, and can help you see things from the other side. It’s human nature to adopt your own position, but a lawyer can help you think strategically and sympathetically. This is how you can keep a dispute from snowballing into a court date.
- You gain a new trusted counsel or confidant. You can create an arrangement to retain certain legal services throughout the life of your business or operation. This way, you’ll know that a brief phone call or email exchange will help you if your company is growing, shrinking, relocating, selling or needs to renegotiate its lease agreement. It’s better to have conversations about any of these other issues with a lawyer first. He or she will help you make smart decisions and avoid potential disputes.
By hiring a lawyer, you should gain peace of mind that you will be protected from contracts or situations that put you at a disadvantage. This will keep you out of court and focusing on running your business.
CBMS has a successful track record representing clients in and out of the courtroom. To learn more about our litigation practice and our lawyers, visit here.
by Stuart Schoenfeld and Monica Ruela
The need to protect your assets is particularly critical as you approach retirement age. We often advise clients who are in their 60s or nearing retirement to be cautious and strategic when making asset transfers and gift-giving. Many are surprised to learn that those gifts could disqualify them from receiving Medicaid benefits, should they need to live in a nursing home or facility.
In New York, the Medicaid Rules stipulate that Medicaid benefits for nursing coverage will not be granted to an applicant who has made gifts of their assets in the five years prior (“five-year look-back”) to requesting Medicaid coverage. For this reason, Medicaid generally questions transactions in excess of $2,000. As a part of the Medicaid application process, our lawyers thoroughly review a client’s financial records for the last five years.
This meticulous review process gives us a chance to determine whether there will be any issues with the Medicaid application that we need to address before submission. The state Medicaid agency conducts the same investigation of your assets to determine if certain assets were transferred during the look-back period for less than fair market value.
Some Good News, First
It’s important to know that this guideline only applies to applicants seeking nursing home Medicaid coverage. Community-based or home care Medicaid recipients are unaffected by the five-year look-back period. This in itself is often misunderstood by many would-be applicants; they are deterred from applying for community Medicaid because they mistakenly believe this financial threshold cancels everyone’s eligibility.
Why Do These Asset Transfer Rules Exist?
The rules were established to stop people from taking advantage of the Medicaid process and its resources. The rules prevent scenarios where an elderly person needing care moves into a nursing home, gifts their assets to their children, and then applies for Medicaid.
Nursing home care is more costly than home-based or community care and Medicaid does not want you to impoverish yourself in order to qualify. With no five-year look-back for community care, Medicaid is encouraging people to take care of their loved ones at home rather than in a nursing home.
Certain Exceptions Apply
Every situation differs and it’s always best to consult a qualified elder care and Medicaid lawyer to assess yours. Some further details about asset transfer exceptions include:
- When Medicaid reviews your financial statements, it excludes retirement assets like IRAs and 401K plans from your total resources. In certain situations, the family residence may be exempt as well.
- Transferring assets to a spouse and/or handicapped or disabled children usually remain exempt from penalties. Certain transfers to children may also be exempt.
Generally speaking, people are living longer and retiring in their mid-to-late 60s. That is why we often advise clients to be mindful of the five-year look-back and how it relates to creating an effective asset protection plan. We can help provide cautious estate planning strategies that can help keep your Medicaid eligibility unaffected.
If you have questions regarding Medicaid Transfer Rules, contact us.
Utilizing the Estate and Gift Tax Exemption Before It’s Too Late
Absent action from Congress, the federal estate and gift tax exemption will revert back to $1 million in 2013. Given this looming uncertainty, individuals should take advantage of the current $5.12 million exemption before the end of 2012 by making gifts. In addition, New York State does not currently impose a gift tax, making this an opportune time for New Yorkers to consider gifting strategies.
High-net-worth married couples often hesitate to make outright gifts for fear of losing income and control over assets. One technique couples can use to help alleviate these concerns is to create mutual lifetime credit shelter trusts for the benefit of each spouse. A lifetime transfer to a credit shelter trust would ordinarily be considered a taxable gift to the trust beneficiary, but because the gift is less than or equal to the exemption amount, the gift is a tax-free transfer. The ability to customize the trust instrument according to each spouse’s unique needs and desires, while also providing each spouse with some degree of control, is an attractive feature of the credit shelter trust.
For example, consider Jack and Jill, a husband and wife with a net worth of $20 million and two adult children. Theyare concerned about the possible loss of the current exemption, and would like to reduce the amount of estate taxes that their children will have to pay. Jack and Jill also wish to maintain their cash flow and control over their assets. This dual concern for financial security and control prevents them from currently making gifts to their children.
Lifetime credit shelter trusts might be the ideal instrument for such a couple. Credit shelter trusts allow for creativity and flexibility; the trust can be drafted in a way that ensures each spouse income during life, while still allowing the couple to take advantage of the current exemption. For example, Jack could fund a lifetime credit shelter trust for Jill’s benefit with $5 million of assets, a transfer that would be tax-free under the current exemption. All income would be paid to Jill for her life, with principal distributed according to an “ascertainable standard.” Upon Jill’s death, the trust funds would be available to their children and might be either distributed or held in further trust. In addition, assuming that Jack (the settlor) has not retained any prohibited powers over the trust, its value would not be included in his estate. The trust would also be drafted to avoid inclusion in Jill’s estate. Similarly, Jill could use her $5 million exemption to fund a lifetime credit shelter trust for Jack’s benefit.
Acting as Beneficiary and Trustee
One common question that arises when a couple wishes to retain control of their assets is whether a spouse can act as both beneficiary and trustee without incurring adverse tax consequences, such as inclusion of the trust assets in her estate. For example, perhaps Jill, as beneficiary, would like to retain a higher degree of control over the trust assets by participating as trustee. In Revenue Ruling 78-398, the IRS determined that a trust beneficiary who was also named as the sole trustee could have some discretion to make distributions of principal to herself. In that case, the trust assets were not included in her estate because her powers as trustee were limited by an ascertainable standard—namely, only as necessary for her “maintenance and medical care.” As described below, the Treasury Regulations are even more permissive.
This ruling was recently confirmed by Estate of Chancellor v. Comm’r (T.C. Memo 2011-172). In Chancellor, the surviving spouse acted as both beneficiary and trustee of a credit shelter trust created by her husband. The trust instrument provided that the trustee could distribute trust principal to the beneficiary-spouse for her “maintenance, education, health care, sustenance, welfare or other appropriate expenditures.” The Tax Court ruled that the spouse, as both beneficiary and trustee, could exercise her power to make distributions to herself without the trust being included in her estate because her power was limited by an ascertainable standard.
Traditionally, “ascertainable standard” has been defined by Internal Revenue Code (IRC) section 2041 and Treasury Regulations section 20.2041-1 as relating to the beneficiary’s “health, education, sup- port, or maintenance.” These are broad standards, and the Treasury Regulations also permit the trustee to exercise discretion to support the beneficiary’s “accustomed manner of living.” Use of these specific terms is not required, but caution is advised when using alternative terms.
For example, in Chancellor, the IRS asserted that the trustee-beneficiary’s estate should have included the trust because the standard did not relate solely to her health, education, support, or maintenance, but also considered the spouse’s “welfare and other appropriate expenditures.” After examining the settlor’s intent and the applicable state law, the Tax Court ultimately ruled that the power to invade was limited by an ascertainable standard and did not include the trust in the decedent’s estate. This case highlights the importance of careful drafting by illustrating that the IRS may take action if the trust instrument strays from using the exact language contained in the regulation.
An alternative to using an ascertainable standard is to appoint an independent trustee. The independent trustee could act as the sole trustee, or, if the couple wishes to retain more control, the independent trustee could instead act as a co-trustee with the beneficiary. As a co-trustee, the independent trustee could be empowered to make those discretionary distributions that beneficiaries might not be able to make without risking inclusion of the trust in their estates.
Returning to the example above, perhaps Jill feels constrained by a standard limiting her to distributions only for her health, education, maintenance, or support. She could instead, or in addition, appoint a trusted friend to act as an independent trustee. This friend could make those distributions that Jill feels she needs but would otherwise not be necessary for her health, maintenance, education, or support. By using an independent trustee, Jill would not be exercising a power that would risk inclusion of the trust in her estate. IRC section 674(c) generally describes independent trustees as persons who are not immediate family or subordinates or employees of the settlor or trustee. Consideration should be given to appropriate trustee appointment and removal powers.
A third consideration is to include a “five-by-five power.” Under a five-by-five power, as defined by IRC section 2041(b)(2), beneficiaries can retain limited withdrawal powers over principal without the entire trust being taxed in their estates. This ability to withdraw principal must be limited to an annual amount that does not exceed the greater of either $5,000 or 5% of the trust principal.
Reciprocal Trust Doctrine
Mutual lifetime credit shelter trusts do have a hidden danger: the IRS’s reciprocal trust doctrine. This danger can be avoided through careful drafting. Reciprocal trusts are those created by two individuals for the benefit of each other. Application of the reciprocal trust doctrine allows the IRS to “uncross” the trusts and to treat each as a self-settled trust, or one created solely for the settlor’s benefit. As such, the trust is included in the settlor’s estate, obviating one purpose for which the trust was initially created.
For example, if Jack funds a trust with $5 million for the benefit of Jill, and Jill funds an identical trust with $5 million for the benefit of Jack, such trusts would be reciprocal. The IRS could then use the reciprocal trust doctrine to uncross the trusts, deeming Jack to be the beneficiary of the trust that he created and Jill to be the beneficiary of the trust that she created, thereby resulting in estate inclusion.
According to the U.S. Supreme Court in U.S. v. Grace (395 U.S. 316, 324–25 ), the reciprocal trust doctrine applies when two trusts are interrelated and the settlors are left “in approximately the same economic position” as before the creation of the trusts. For example, in Grace, trusts created by a husband and wife for the other’s benefit were deemed to be reciprocal because each settlor was in the same basic economic position and because the trusts were “substantially identical in terms and were created at approximately the same time.”
The doctrine has also been applied when spouses held crossed trustee powers over identical trusts, but did not have an economic interest. In Estate of Bischoff v. Comm’r (69 T.C. 32 ), the couple executed identical trusts for the benefit of their grandchildren and named the other spouse as trustee. Distributions of principal and income were made in the sole discretion of the trustee. If such a power had been held by the settlor, the value of the trust would have been included in the settlor’s estate under IRC sections 2036(a)(2) and 2038(a)(1). Here, the Tax Court ruled that the trustee powers were reciprocal and uncrossed the powers, deeming the spouses to be the trustees of the trusts they created. Thus, each trust was deemed to be part of the settlor’s estate under IRC sections 2036(a)(2) and 2038(a)(1). In its decision, the Tax Court stated that it was not necessary for the settlor to have an economic interest in the property transferred in order for the reciprocal trust doctrine to apply; it was enough for the settlors to have crossed trustee powers.
To avoid the reciprocal trust doctrine, each trust must be materially different. The IRS does not define material differences, and careful drafting is essential. Although certainty is impossible, the following non-exhaustive list of examples of material differences might provide assistance:
- Different times of execution
- Different distribution schemes
- Different trustees
- Appointment of an independent trustee in one trust
- Different or additional beneficiaries
- Inclusion of a five-by-five power in one trust
- Inclusion of a limited power of appoint- ment in one trust
- Different remainder interests
- Different times of termination.
Each family situation is different and presents opportunities for innovation and creative drafting. For example, in an appropriate situation, one trust might appoint the spouse and children as trustees, whereas the other trust names only the spouse as trustee. Perhaps Jack’s trust allows Jill to invade principal for her health, maintenance, education, and support, whereas Jill’s trust grants Jack a more limited withdrawal power over principal. Alternatively, Jack’s trust might grant the remainder to the children outright, whereas Jill’s trust might hold the remainder in trust for their children and grandchildren, thereby utilizing her generation-skipping transfer tax exemption.
Case law indicates that material difference is not a particularly stringent standard, but prudence is always recommended. In Estate of Levy v. Comm’r (T.C. Memo 1983-453), the reciprocal trust doctrine did not apply to two trusts simultaneously created by a husband and wife because the trust terms were not identical; the trust instrument for the wife’s benefit granted her a special power of appointment, whereas the trust for the husband’s benefit granted him no such power. The wife’s special power of appointment was found to have “objective value” that resulted in the trusts having “very different legal consequences.”
Similarly, in Private Letter Ruling 200426008, the IRS chose not to apply the reciprocal trust doctrine to trusts executed by a husband and wife for the benefit of the other spouse and their child. Each trust contained a life insurance policy on the settlor’s life and named the other spouse as trustee. The trusts were similar in many respects, but also had several important differences. Under his trust, the husband could only receive distributions three years after his wife’s death and only when his net worth and income fell below specified levels. Under her trust, the wife could only receive distributions after the death of their child and only up to $5,000 or 5% of the trust principal. Furthermore, the wife was given a limited power of appointment that could only be exercised after their child’s death. Of course, like all private letter rulings, this decision was limited to the parties at issue and cannot be cited as precedent. The ruling does, however, highlight the types of differences that the IRS will examine in determining whether the reciprocal trust doctrine applies.
In the case of mutual lifetime credit shelter trusts, the parties should strive to avoid the reciprocal trust doctrine by including significant material differences between the trust instruments. These differences need not be arbitrary. Given the general flexibility of the credit shelter trust, material differences can be incorporated by tailoring each trust to the respective beneficiary’s needs. For example, if Jack is elderly or in poor health, Jill’s trust for his benefit might be funded with fewer assets or have a more restrictive distribution scheme. This technique likely has the dual benefits of adapting the trust to accommodate the couple’s unique situation and avoiding the reciprocal trust doctrine. Couples might also consider including a limited power of appointment in the trust that names the spouse and children as trustees. This will help protect the spouse and ensure that the children exercise discretion in their parents’ best interests. The key is to avoid estate inclusion and application of the reciprocal trust doctrine. Careful drafting will achieve both goals, while also protecting each spouse and providing a degree of control.
Another consideration might include drafting the trusts to utilize the generation-skipping transfer tax exemption. The trust may provide that the trust corpus remain in further trust for the benefit of the settlor’s children and grandchildren. The settlor might then allocate his generation-skipping transfer tax exemption to the trust. This will allow the trust assets and any future appreciation to ultimately pass to his grandchildren without imposition of the generation-skipping transfer tax. It is important to note that the current generation-skipping transfer tax exemption, which is equal to the estate tax exemption, is similarly scheduled to revert back to $1 million on January 1, 2013.
Lifetime credit shelter trusts are ideal ways to take advantage of the current estate and gift tax exemption. Their use allows married couples to make gifts while retaining some financial control and a source of income. Credit shelter trusts also allow for flexible and creative drafting, a characteristic that can help avoid inclusion of the trust in the beneficiary’s estate and avoid application of the reciprocal trust doctrine. Because the fate of the $5.12 million estate tax exemption hangs in the balance, couples should act before the end of the year.
New York State conducts residency audits to establish whether a taxpayer is a New York State resident, a nonresident, or a part-year resident in order to determine the correct amount of that taxpayer’s tax obligation.
If you live in more than one place and one of them is in New York, you should prepare for a New York State residency audit. The burden of proof generally is on you to support your claim that you are not a NYS resident. The same rules apply if you have a place in New York City and elsewhere in New York State, and you claim that you are not a New York City resident.
Understanding Your Residency
There are two ways to be a New York State resident: either you are domiciled in New York, or you are deemed to be a statutory resident of New York.
Domicile means a permanent home, or the principal establishment to which a taxpayer intends to return whenever absent.
A statutory resident is not domiciled in New York State but maintains a permanent place of abode there for substantially all of the taxable year, and spends in the aggregate more than 183 days of the taxable year in the state. For example, you might live in New Jersey, but commute to Manhattan on workdays and also own a house in the Hamptons to use on summer weekends. In that case, an auditor could argue you should be taxed as a New York resident.
Statutory residency is a separate consideration from domicile, which we’ll further discuss in a future post.
Scenario: Establishing New Domicile
Let’s say you are a native New Yorker who’s fortunate enough to own two homes, one in New York and the other in Florida; you spend the time between November and March enjoying the good weather in Florida, and the rest of the year in New York. The state considers you a New Yorker, and you’re subject to paying taxes on your worldwide income.
But if you were a nonresident of New York, you’d be subject to tax only on that portion of your income attributable to (“sourced to”) New York. Let’s say you spend more time in Florida than in New York and want your taxes to show that you are a Florida resident. Be careful: spending time in Florida is not enough. To establish a new status as a Floridian you must change your domicile, which involves simultaneously lessening your ties to New York and strengthening your ties to Florida. An auditor from the New York State Department of Taxation and Finance initially will consider five primary factors in determining your domicile. You can take steps that might sway the determination in your favor.
1. Home. Which residence is bigger or more expensive? Which is rented or owned? How much have you invested into their upkeep and maintenance? The numbers and dollars don’t lie. Usually, you’re going to put the money and effort into your primary home.
2. Active Business Involvement. If you’re still working, where are your active business interests? An auditor may not be persuaded that you are a Florida resident, if you remain deeply involved in your New York-based businesses.
3. Time. This is where most people get confused. The 183 days refers only to statutory residents. As a general guideline, you should be able to prove that you spend significantly more days out of New York and in your Florida home. If you spend five months in New York, three in Florida and four months traveling, the auditor will see your time in New York as the most prevalent. Documents like bills, phone records, receipts, and passports should support your claims.
4. Near & Dear. Where do you keep valuable items, like family heirlooms, jewelry, cars and art collections? An auditor will assume you’ll want to be in close proximity to the items that have monetary or sentimental value.
5. Family. Where does your family reside? Where do your minor children attend school? It may be difficult to show that a spouse, minor children or dependents have a separate domicile from yours.
Useful, But Not Determinative
You might think that obtaining a Florida driver’s license and voter registration will show a New York State auditor that you are no longer a New Yorker. While these can be helpful, they do not have the weight of the primary factors above and are not determinative. Other factors in this category include where your car or boat is registered, physical location of safe deposit boxes, and citation of domicile in legal documents such as a will or trust.
A Note On What Does Not Affect Your Residency
There are other misconceptions about residency audits that should be addressed.
● Your accountant’s location does not impact your status. He or she can have an office in New York even if your domicile is in another state.
● Your burial plot is also not a factor during a residency audit. Your eternal resting place will not be considered maintaining ties to New York.
● A passive interest in a New York partnership is not considered in evaluating domicile.
You’ll know that the State is looking at your situation if you receive a nonresident audit questionnaire in the mail. Unless you fully understand the rules, you should always consult a legal or tax professional before completing it.
There are other issues and circumstances that can influence an auditor when determining your residency and we can help you plan accordingly and mitigate tax risk. Contact Capell Barnett Matalon & Schoenfeld at (516) 931-8100 or visit here to schedule a consultation.
On May 11, 2017, Renato Matos and John Osborn presented a webinar on Negotiating Architect and Construction Contracts as part of the Faith-Based Webinar Series.