WHAT EVERY PLANNER NEEDS TO KNOW ABOUT THE COURT SYSTEM

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1 Diversity of opinion helps us be more successful! Your Success Matters! Therefore Prudential is pleased to provide you with material that offers different views and opinions on various subjects. Please note that these opinions are not necessarily those of Prudential. Leimberg s Think About It is distributed as a courtesy to our representatives at The Prudential Insurance Company of America. Prudential expressly disclaims responsibility for any content and advises that your clients should consult with their accountant, tax advisor and/or legal advisor to confirm the accuracy of these analyzes and for advice concerning their particular circumstances. WHAT EVERY PLANNER NEEDS TO KNOW ABOUT THE COURT SYSTEM Preparing my Tax Return is too difficult for a mathematician. It takes a philosopher! Albert Einstein One of the great understatements of all time was:... for anyone not familiar with the inner workings of tax administration, the array of IRS guidance may seem, well, a little puzzling at first glance. At first glance? The author of that gross understatement, rivaled only by Noah's statement that, it looks like rain, was the IRS! Even Albert Einstein found our tax laws among the most complex of all human tasks and that was years before things got REALLY complicated. (Our problems with major complexity and rapid tax law change started shortly after Wilber Mills landed up with Fanny Fox in the Tidal Basin perhaps a story before your time.) Complex or not, every financial services professional must have a working knowledge of the fundamentals of income tax law. And a strong grasp of the basics is essential to sophisticated estate, financial, employee benefit, retirement, and charitable planning. This issue of THINK ABOUT IT reflects some of the materials from my recently released book, TOOLS AND TECHNIQUES OF INCOME TAX PLANNING and focuses on the general (but important) sources of federal tax law. Next month, I'll follow up with some of the key concepts in income tax planning. IFS-A / ED. 01/06 / EXP. 07/07 / PAGE 1

2 GENERAL SOURCES OF FEDERAL TAX LAW The five places planners must use as sources of understanding and applying federal income tax law are: 1. Internal Revenue Code ( Code ), 2. Treasury Regulations ( Regs ), 3. IRS Rulings (both Public and Private), 4. Technical Advice Memoranda (TAMs), and 5. Court Decisions Of these, the more important ( primary ) authorities are the Code (i.e. Congress' statutes) and the case decisions of various courts. Let s examine each in more detail: THE CODE The Code is THE law. That means the IRS, the Courts, and yes, you and your clients MUST comply with it! If the Code were crystal clear and answered every tax question, the job of CPAs, Attorneys, and other financial advisors and planners would be relatively simple. But the reality is that there are many issues and questions that occur constantly that are not addressed or not even anticipated in the Code. This is the reason, as I will explain in more detail below, the Treasury and IRS cover a great deal of tax law in the form of regulations, rulings, and procedures. When a professional article makes a reference to an income tax law in the Code, the citation (cite) starts with the section of the Code where it can be found. For instance, Code Section 101 pertains to Certain Death Payments (i.e., Life Insurance Death Benefits); Code Section 1035 covers Certain Exchanges of Insurance Policies. (You can find the actual text of the Code at To be more specific, the author of a tax article will then refer to the subsection and perhaps to the paragraph and/or subparagraph. For instance, if you were reading an article on the transfer for value rule (such as the two articles Avoiding the Tax Trap of the Transfer for Value Rule and Transactional Analysis of the Transfer for Value Rule by Larry Brody and myself in the October and November 2005 issues of Estate Planning Journal, or you might find reference to IRC Sec. 101(a)(2)(B). IFS-A / ED. 01/06 / EXP. 07/07 / PAGE 2

3 Here are the relevant parts of the Code: 101(a) PROCEEDS OF LIFE INSURANCE CONTRACTS PAYABLE BY REASON OF DEATH (a)(1) GENERAL RULE. --Except as otherwise provided in paragraph (2), subsection (d), and subsection (f), gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. 101(a)(2) TRANSFER FOR VALUABLE CONSIDERATION. --In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by paragraph (1) shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee. The preceding sentence shall not apply in the case of such a transfer (a)(2)(A) if such contract or interest therein has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such contract or interest therein in the hands of the transferor, or 101(a)(2)(B) if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. So a reference to IRC Sec. 101(a)(2)(B) would refer to the safe harbor exception to the transfer for value rule, where a policy or an interest in a policy is transferred to certain parties. You'll note that a transfer to a co-shareholder, co-officer, or director is NOT among the safe harbor parties! REGULATIONS The Code is THE law. That means the IRS, the Courts, and yes, you and your clients MUST comply with it! Regulations (Regs.), which rank just below the Code, (and in the case of regulations issued under the express direction of Congress are treated essentially as if they were on the same level of importance as the Code), are followed by the IRS and given great respect and weight by the courts. Regulations may be issued by either the Treasury Department or the IRS (or both), and used to amplify the Code and to help taxpayers and their advisors interpret and comply with the law. To provide guidance to the taxpayers or practitioners, the Regs contain many useful examples that help them understand (and perhaps predict) how the IRS will interpret the wording of the Code. IFS-A / ED. 01/06 / EXP. 07/07 / PAGE 3

4 To research the Income Tax Regulations, you could buy a set from the government printing office, a private firm such as Commerce Clearing House (CCH), Research Institute of America (RIA), or click on Tax Research Sites and then select Tax Regulations. You can also find Treasury Regulations at Each section in the Income Tax Regulations is preceded by the number 1 (as in Chapter 1 of the Code), and co-ordinate with the Code Section you are searching. For example, Reg. Sec (b) pertains to transfers for value (specifically, the impact of a mere pledge or assignment of a life insurance policy, or an interest, as collateral security). Regulations can be Proposed (the initial IRS opinion), Final (this is the official IRS interpretation and has the effect of law), or Temporary. REVENUE RULINGS Since it is impossible for the Code and Regs to cover the tax consequences of every conceivable fact pattern, the IRS answers taxpayers' requests for interpretation of a doubtful point of view through rulings. A Revenue (Public) Ruling (Rev. Rul.) is the IRS' official interpretation of the Code or Regs and states how the IRS would apply the tax law to a specific set of facts. Revenue Rulings are issued in response to a particular problem the IRS anticipates will likely impact many taxpayers. Revenue Rulings are designed to help provide a uniform application of tax law to taxpayers under the same facts and circumstances as stated in the ruling. In terms of weight, Revenue Rulings rank below the Code and the Regulations and, therefore, do not have the force and effect of law but they are used by both the Service and taxpayers as precedent. Courts are not bound by them. Revenue Rulings (as well as IRS Notices, and Announcements) are cited by first stating the year, followed by the number of the ruling (or notice, announcement) for that year, which issue it was published in the Internal Revenue Service Cumulative Bulletin, and page number. For instance, Announcement is shown as IRB IRB 1, which provides for a settlement initiative under which taxpayers have until January 23, 2006 to resolve the tax treatment of certain abusive 412(i) plans and other transactions. It is the 80th of IRS announcements, notices and revenue ruling issued in 2005, published in the 46th issue of the Internal Revenue Bulletin, and it starts on page 1. IFS-A / ED. 01/06 / EXP. 07/07 / PAGE 4

5 PRIVATE LETTER RULINGS Private Letter Rulings (PLRs or Let. Ruls) are next in relative importance. Even though they are called private, most PLRs are released to the public (with a deletion of anything that could be used to identify the specific taxpayer as well as trade secrets, and certain classified information). A PLR is the IRS answer to a very specific set of facts and questions posed by a taxpayer's counsel to the Service. So PLRs provide the IRS's interpretation, generally to a particular proposed transaction, or to one where a tax return has not yet been filed. Assuming the taxpayer fully and accurately described the facts of the transaction and executes it as described in the requesting letter to the Service, the IRS is bound by its response TO THAT TAXPAYER IN THAT PARTICULAR SITUATION. As we have emphatically stated a PLR obtained by one party or person may not be relied upon as precedent by other taxpayers or IRS personnel. In fact, it may not be used by the same taxpayer in different circumstances. PLRs are cited by year, the week the IRS releases it, and numbered in sequence of all the rulings issued in that week. For example, PLR , pertains to an IRS denial of a request by a surviving husband to waive the 60-day rollover rule, in order to redeposit IRA distributions he was not entitled to receive. It was issued in 2005, released in the 47th week of the year, and the 24th ruling issued that week. TECHNICAL ADVICE MEMORANDA Technical Advice Memoranda (TAMs) provide the IRS interpretation of the proper interpretation and application of tax laws, regulations, and revenue rulings, as well as final determination of the specific issue(s) in the specific case to which the advice pertains. TAMs are provided by the Office of Chief Counsel not in response to a taxpayer request, but rather in answer to a query from an IRS regional or area director. TAMs are usually responses to technical or procedural issues that arise during tax return examinations or claims for refunds. Citations for TAMs are similar to PLRs; TAM , the well-known equity split-dollar TAM, was released in It was issued during the fourth week of the year, and was the first TAM issued that week. THE COURT SYSTEM Tax decisions come down from several courts; tax practitioners must keep informed on the federal level of decisions from the Supreme Court, The U.S. Court of Federal Claims, The United States Courts of Appeals, and The United States Tax Court, as well as some tax cases that originate in federal district courts. These decisions are reported in official reports of the respective courts and reprinted by private services such as Commerce Clearing House as United States Tax Cases (U.S.T.C.) and by Prentice Hall as American Federal Tax Reports (A.F.T.R.). IFS-A / ED. 01/06 / EXP. 07/07 / PAGE 5

6 THE SUPREME COURT Most of us have heard the phrase, I'll take it all the way to the Supreme Court! but few of the thousands of tax cases that arise each year ever make it to the top of the legal pyramid. If the taxpayer does get the highest court in the land to hear the case, once it is decided, the IRS and every court in the country are bound to follow that decision in future cases with similar facts and issues. Cases that the Supreme Court will agree to hear based on a writ of certiorari (request to be heard) are generally those dealing with an issue of the constitutionality of a Code provision, a conflict between decisions of various courts of appeals on a particular issue, or an issue deemed to be of great public importance. An example of a Supreme Court Decision is the recent Richard Gerald Rousey, et ux., Petitioners v. Jill R. Carroway, U.S. Supreme Court No (April 4, 2005), a rare unanimous United States Supreme Court decision which gave (selective) creditor and bankruptcy protection to IRAs. Most Supreme Court cases are eventually cited in a format like this: United States v. Estate of Grace, 395 U.S. 316 (1969). The name of the case, which involved the reciprocal trust doctrine, is Grace. It was officially reported in volume 395 of the United States Supreme Court Reports. The case began on page 316 and was decided by the Supreme Court in UNITED STATES COURT OF FEDERAL CLAIMS The U.S. Court of Federal Claims is an important court in several ways. First, to challenge a tax deficiency in this court, a taxpayer has to first pay the tax, then file a claim with the IRS for a refund of the claimed amount, wait until the IRS denies that claim or, if later, for six months after filing for a refund, and then must sue the U.S. for a refund. Second, cases before this court are heard by traveling judges. The purpose of such peripatetic judiciary is to hear cases at times and places that are easier and less expensive for taxpayers. Citations to the Court of Federal Claims are by year, volume, and page. So, for example, in Okerlund v. United States, 53 Fed. Cl. 341 (2002) which involved the valuation of stock in a closely-held corporation for gift and estate tax purposes, the case was decided by the Court of Federal Claims, and can be found in the 53rd volume of the Federal Claims Reporter starting on page 341, and the decision was handed down in IFS-A / ED. 01/06 / EXP. 07/07 / PAGE 6

7 UNITED STATES COURTS OF APPEALS These 12 Appeals Courts are very important since the Supreme Court (in most cases) is the only place higher and so few cases are actually heard by that court; as a result, an Appeals Court will almost always be the court of last resort. Furthermore, when a U.S. Court of Appeals hands down a verdict, all the Tax Courts and District Courts in that circuit are bound by its decision. However, note that: 1. Courts of Appeal are not bound by the decision of a Court of Appeals in another circuit, and 2. A Tax Court is bound to follow a Court of Appeals decision only if an appeal upward could be made to that particular court of appeals, and 3. The Service is not bound by a Court of Appeals decision in cases other than that decided by the Court. There are actually 13 of these Appeals courts. They are divided geographically into the 1st through 11th Circuits and there is a D.C. Circuit and a Federal Circuit with nationwide jurisdiction. You know a citation refers to a U.S. Courts of Appeals decision if you see F.2nd or F.3rd; for example, SEC v. Mutual Benefits Corp., F.3rd, This is a recent case which held that interests in life settlement contracts are securities. Note the citation (which will be in the third series of the Federal Reporter) is so new that the space for the volume number is blank (as is the page number) until it is printed. UNITED STATES DISTRICT COURT As is the case with The United States Court of Claims, to contest a tax deficiency in a U.S. District Court (of which there are many spread geographically throughout the U.S., at least one in each state), a taxpayer must pay the tax, file a refund claim with the IRS, wait until the earlier of a six month period or the date the Service denies the claim, and sue the government for a refund. Typically, a single judge hears the case. Unlike any other court, a taxpayer can request a jury trial in the U.S. District Court. Federal courts will typically follow the decisions of a District Court even though they are not bound to do so. And District Courts will usually follow decisions it has made with respect to other taxpayers in the same district with the same problem. However, a District Court decision is not binding on the IRS in its dealing with other taxpayers. Appeals for a decision in a United States District Court may be made to the Court of Appeals for the Circuit in which the District Court is located and from there to the Supreme Court. But, we point out if the decision is reversed on appeal, all the district courts in that circuit must follow the decision of the court of appeals in deciding future cases. IFS-A / ED. 01/06 / EXP. 07/07 / PAGE 7

8 U.S. TAX COURT The Tax Court, as its name implies, is a court designed principally for taxpayers who are appealing tax deficiencies. Taxpayers particularly like the U.S. Tax Court because it offers a chance to contest an IRS determination of deficiency without first having to pay a tax! The trade-off between taking a case to Tax Court and U.S. District Court where a trial by jury is an option often is based solely on the ability to fight the battle without paying the tax first. The Service will not be bound by the holding in a Tax Court decision except, of course, in the very case in which a decision against it has been rendered. This is why the Service will often litigate other cases with the same issues in other courts or even in the same court with different taxpayers. When the IRS loses a case, it will often send a signal to other taxpayers that it isn't giving up and will not follow the Tax Court's decision in other cases. This is called non-acquiescence ( nonacq. ). On the other hand, if the Service is willing to throw in the towel on a particular principle, it reports in its Internal Revenue Bulletin as an acquiescence ( acq. ). Once a Tax Court holds against the Service, precedent has been established. For this reason, the IRS will often agree to a settlement in what it considers a close case. There is a small case division of the Tax Court that is designed to expedite (and therefore lower the time and expense of) deficiencies of $50,000 and under. The process is much less formal and proceeds more quickly than other Tax Court cases. The downside to the taxpayer is that decisions of the small case division may not be appealed, nor may they be treated as authority in other cases. This procedure is optional at the request of the taxpayer. Trials of the Tax Court are conducted in cities throughout the country. Taxpayers who lose in the Tax Court (or the Service, if it loses) can appeal to the U.S. Court of Appeals in the region of the country where the taxpayer lives. This is important to know because, if various Courts of Appeal hold a difference of opinion as to how a provision in the tax law is interpreted, the Tax Court must follow the decisions of the same Court of Appeals to which the taxpayer may appeal. This material is for internal use only and is provided courtesy of The Prudential Insurance Company of America, Newark, NJ. The discussion of strategies does not imply that a recommendation of a specific planning concept should be implemented. References to legal and tax considerations are made but are not meant to provide advice in this regard. Please remind clients that legal and tax advice, including the preparation of legal and tax documents, should come from an attorney and/or a tax advisor such as an accountant. These advisors can determine how best to utilize such product or technique. Prudential Financial Planners can prepare financial plans incorporating many of the strategies discussed above. Financial Services Associates and producers can work as knowledgeable members of clients professional teams to provide suitable products. Insurance is issued by The Prudential Insurance Company of America, Newark, NJ. Securities are offered by Pruco Securities, LLC. All are Prudential Financial companies located in Newark, NJ. Investment advisory services offered through Prudential Financial Planning Services, a division of Pruco Securities, LLC. Stephan R. Leimberg is not affiliated with Prudential and Prudential makes no representation as to the accuracy of the cites. Prudential Financial and the Rock logo are registered service marks of The Prudential Insurance Company of America and its affiliates. IFS-A / ED. 01/06 / EXP. 07/07 / PAGE 8

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