IRS relaxes bona fide residency test for individuals living in US territories

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1 IRS relaxes bona fide residency test for individuals living in US territories Authors: Mark Strong, Senior Manager, Private Client Services, Ernst & Young LLP (McLean, VA) Ashley Weyenberg, Manager, Private Clients Services, National Tax Department, Ernst & Young LLP (Washington, DC) US citizen and US resident taxpayers who live in US territories, but frequently travel globally i.e., outside the US and the respective US territory may benefit from the additional flexibility for determining their annual tax residence. In late August, the IRS issued proposed regulations supplementing the rules that determine whether an individual is a bona fide resident of a US territory. Prop. Treas. Reg (c). Inhabited US territories include Puerto Rico, US Virgin Islands, Guam, American Samoa, and The Commonwealth of the Northern Mariana Islands. Background Under Section 937(a), an individual is a bona fide resident of a US territory if the individual meets: (1) a presence test; (2) a tax home test; and (3) a closer connection test. To satisfy the presence test, an individual must be present in the US territory for at least 183 days during the tax year ( 183-day rule ), unless otherwise provided in regulations. Treas. Reg contains alternatives to the 183-day rule. A taxpayer who does not satisfy the 183-day rule will meet the presence test if the individual satisfies one of the following distinct tests: (1) The individual is present in the US territory for at least 549 days during the 3-year period consisting of the current tax year and the two immediately preceding tax years, provided the individual is present in the US territory for at least 60 days during each tax year of the 3-year period. (2) The individual is present in the United States no more than 90 days during the tax year. (3) The individual has no more than $3,000 of earned income from US sources and is present for more days in the US territory than in the United States during the tax year. (4) The individual has no significant connection to the United States (e.g., permanent home, voter registration, spouse, or minor child) during the tax year. Even if the individual is not physically present in a US territory, current regulations allow certain days to count toward an individual s total days of presence in a US territory for purposes of the presence test ( constructive presence ).

2 Proposed regulations The proposed regulation creates an additional alternative rule for calculating days of constructive presence in a US territory for purposes of the presence test in Treas. Reg. Section (c)(1). Under the additional rule, an individual would be considered present in a US territory for up to 30 days during which the individual is outside of both the United States and the respective home US territory (30-day constructive presence rule), subject to two limitations. First, if the number of days the individual is considered to be present in the United States during the tax year equals or exceeds the number of days that the individual is considered to be present in the US territory during the tax year, the proposed 30-day constructive presence rule would not apply. The number of days an individual is considered to be in the United States as opposed to the US territory would be determined without taking into account any days for which the individual would be treated as present in the US territory under the proposed 30-day constructive presence rule. For example, as illustrated in the proposed regulations, H, a US citizen. In each of the years 2016 and 2017, H spends 195 days in Possession N and the balance of the year in the United States. In 2018, H spends 130 days in Possession N, 100 days in foreign countries, and 135 days in the United States. H is present in Possession N for only 520 days (less than the required 549 days) during the three-year period of 2016 through 2018, so he cannot treat 30 of the days spent in foreign countries as days of presence in Possession N. Second, the 30-day constructive presence rule would not apply for purposes of determining the minimum 60 days of presence in the US territory that is required for the 549-day test under Treas. Reg. Section (c)(1)(ii). For example, again as illustrated in the proposed regulations, H, from above, spends 195 days in Possession N and the balance of the year in the United States in both 2016 and In 2018, H spends 130 days in Possession N, 110 days in foreign countries, and 125 days in the United States. Because H is present in Possession N for at least 60 days in each of taxable years and is present in the Possession for more days than he is in the US, 30 of the days spent in foreign countries during 2018 are treated as days of presence in Possession N. Thus, H will be treated as being present for 160 days in Possession N for 2018; he meets the three-year required day count with 550 days (more than the required 549 days) during the three-year period of 2016 through Until final regulations are published in the Federal Register, taxpayers may rely on the proposed regulations for tax years beginning on or after August 27, 2015.

3 Practice pointers Congress originally enacted Section 937 to introduce firmer residency requirements to curb a perceived abuse of special income exemptions for US taxpayers residing in US territories. Lawmakers and the IRS believed that US citizens and US residents were permitted to claim such exemptions without spending significant time in the territories themselves, to justify the tax benefits. The proposed regulations however, redirect the focus from curbing tax avoidance to assisting frequent travelers in maintaining US territory residence, notwithstanding extended periods of absence from both the United States and US territory. The rules relax the presence requirement permitting taxpayers to manage the realities of today s global world, such as working in certain industries or traveling for personal or healthcare reasons. Tax planning by way of residence in US territories has received extensive media coverage in recent years, with a primary focus on Puerto Rico s actions to provide lower income tax rates (33%-0%) to attract US investors. See Individual Investors Act, Act. 22 (2012) (Puerto Rico also enacted the Export Services Act, Act. 20 (2012) that reduces tax implications for entities). The benefits of moving to Puerto Rico can prove beneficial, but very few clients will receive the maximum tax advantages. While a US person who is a bona fide Puerto Rican resident is exempt from US federal income tax on Puerto Rican source income, there is a large exception; during the first 10-years of Puerto Rican residence, the US taxes capital gains realized from assets owned prior to commencing Puerto Rican residence. Additionally, in order to take benefit from a tax exemption in Puerto Rico on Puerto Rican source income, the individual has to apply for a tax exemption decree. Additional information on residence in US territories can be found in IRS Publication 570.

4 Proposed Regulations Anticipated on Further Limiting Valuation Discounts By Raj A. Malviya, Miller Johnson Introduction: Planning With Valuation Discounts An important component of effective estate and tax planning for clients is properly utilizing valuation discounts when transferring closely-held business interests to family members. When such interests are transferred, the two most common discounts applied to reduce the value of the interest for transfer tax purposes are (i) lack of control due to the transferor s minority interest in the closely-held interest and (ii) lack of marketability due to the closely-held interest not being readily sold or traded in the marketplace. While utilizing valuation discounts in transactions can be an effective planning tool when done properly, there is tax authority and guidance that severely complicate these transactions. Revenue Ruling and Enactment of Section 2704 Before 1993, the IRS took the position that a minority interest discount was not available in valuing an interest in an entity that was controlled by family members. The IRS then issued Rev. Ruling (revoking Rev. Rul ), taking the position that a family s control of the entity, i.e. family attribution, would not be considered in valuing the gifts of minority interests. As a result of this ruling, family controlled entities, such as family limited partnerships (FLPs) and limited liability companies (LLCs) became popular estate planning vehicles to help suppress the value of interests being transferred. Even before Rev. Ruling was issued, Section 2704 of the Internal Revenue Code was enacted in 1990 to curtail the use of valuation discounts in connection with transfers of interests in family-controlled entities to family members. The worry was that families creating these entities were imposing restrictions on the transferred interests to reduce the value for transfer tax purposes to the transferor without reducing the economic benefit to the transferee family members. Under Section 2704, the transfer of an interest in a partnership or corporation to a family member triggers certain rules that seek to determine whether the transferor s family controls the entity before the transfer, either via gift or at death. If so, Section 2704(b) prevents certain applicable restrictions on the transferred interest from reducing its value for transfer tax purposes. In general, an applicable restriction is any restriction that limits the ability of the corporation or partnership to liquidate, but does not include any restriction imposed by federal or state law. Importantly, because of the state law exception, some states have changed their laws so the state law imposes the restriction and is the default. Additionally, several key Tax Court decisions have limited the applicability of Section 2704(b) where a non-family member received an interest, even a minority one, under the rationale that any liquidation required the consent of such non-family member. 1

5 Proposed Amendment To Section 2704 Since the inception of family controlled entities, the IRS has attempted to persuade the courts and Congress that these entities have no purpose other than to shrink value and avoid taxes. Despite its persistence, the IRS has had only limited success with valuation challenges under Section 2704(b) to date. Most IRS challenges have relied on the assumption of family attribution. It is anticipated that forthcoming Regulations under Section 2704 will be used as a substitute for what Congress or Courts have been willing to do. These anticipated Regulations were hinted at in a few places, including the Obama Administration s fiscal year (FY) budget proposals. The 2013 FY proposal indicated a forthcoming amendment to Section 2704 that would result in further restrictions on or even elimination of valuation discounts on transfers of interests in family-controlled entities. The proposal would create an additional category of restrictions that would be essentially be disregarded when valuing an interest in a family-controlled entity. In other words, any identified restriction on an interest would not reduce the value of the interest. The amendment would apply to a transfer of an interest to a family member, if after the transfer, the restriction would lapse or could be removed by the transferor or the transferor s family. Among other things, The 2013 FY budget proposal provided that disregarded restrictions would include restrictions on a transferee being able to become a full-fledged partner or member of an LLC and even limitations on a holder s right to liquidate that holder s interest. The latter is more restrictive than the scope of what appears to be addressed through regulations. The good news is that the 2013 FY budget proposal indicated there would be regulation authority to create safe harbors under which the governing documents of a family-controlled entity could be drafted to possibly get around the application of Section 2704(b). Additionally, the 2013 FY budget proposal indicated the new legislation would include provisions dealing with the interaction of the marital and charitable deductions, thus, possibly creating increased deductions if the valuation of the interest in the familycontrolled entity is higher. Anticipated Regulations Many estate and tax planning practitioners believe that legislative action will be required to impose additional restrictions on valuing interests in family controlled entities. However, some interpret Section 2704(b)(4) to provide broad legislative authority for the Secretary to issue Regulations covering disregarded restrictions. That interpretation may or may not include the authority to issue Regulations limiting discounts for other reasons. Only time will tell. While there has been quite the buzz in the estate and tax planning community on the anticipated regulations, as of this writing, they have not been released yet. At the May ABA Tax Section Meeting in Washington DC, Ms. Cathy Hughes, Estate and Gift Tax Attorney of the U.S. Department of Treasury s Office of Tax Policy commented that the Section 2704 proposed regulations have been a project that has long been on the 2

6 IRS priority guidance plan and that they will have a dramatic impact on the valuation of interests in closely-held limited partnerships and limited liability companies transferred to family members. Ms. Hughes commented at the September ABA Joint Tax and RPTE CLE Meeting in Chicago that there is still significant work to be done on the proposed regulations but that the IRS was getting close to completing the project. Some commentators to the anticipated regulations have also suggested that there will be carve-outs to entities that are operating businesses, but also noting that classifying a business as operating vs. passive can be a complicated analysis. While practitioners are hopeful to see guidance issued soon, the effective date of the anticipated regulations may pose a perceived deadline on completing transfers in family-controlled entities. If and when the proposed regulations are issued, it is not clear when they will be effective. The effective date is important and could create a limited window of time in which to accomplish transfers without being impacted by the regulations. Treasury Regulations are typically effective on the date final regulations are issued. But in very rare instances, proposed regulations provide that they will be effective when finalized, retroactive to the date of the issuance of the proposed regulations. If this is the case with the anticipated Section 2704 Regulations, they would be effective immediately. Takeaways If they have not already done so, advisors who are assisting their clients in transferring interests in family controlled entities to family members (or trusts for the benefit of family members) and want to consider utilizing valuation discounts as part of the planning transactions should alert their clients of the anticipated regulations. The rumors about the legislation are not adverse for every client, however. For example, additional limitations on valuation discounts may actually benefit the client and the next generation with higher deductions and basis step up. But for those clients who will clearly benefit from utilizing valuation discounts, prompt action is warranted. MJ_DMS v1 3

7 RPTE Alert By: Molly R. Soiffer The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (the Act ) added new filing requirements for estate tax returns filed after July 31, Under this law, executors who must file estate tax returns must also furnish a statement of value of the property listed on said return to the Secretary of the Treasury and the beneficiaries of an interest in the decedent s estate. This statement must be filed by the earlier of thirty (30) days after the estate tax return is filed or thirty (30) days after the estate tax return is due. The IRS has already extended this deadline for statements related to estate tax returns due before January 30, For those estates, the statement is due by February 29, 2016 (Notice ). Note that until a final determination is made as to the value of the decedent s interest in property (as defined by the Act), an individual receiving such an interest will be able to rely on the aforementioned statement of value in determining the 1014 basis of the property. Molly R. Soiffer Associate Bove & Langa Ten Tremont Street, Suite 600 Boston, MA soiffer@bovelanga.com

8 Estates Must Now Request Closing Letters from IRS By: Stephanie L. Moll In the past, when an estate of a deceased taxpayer filed a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, the Internal Revenue Service would automatically issue an estate tax closing letter, signifying that the Return had been accepted by the IRS. At that time, the estate could be assured that, unless the estate took an action that re-opened the estate tax return to review, no additional estate tax would be imposed by the IRS. Recently, a change was made on the IRS website that indicates this procedure has been changed. Per When can I expect the Estate Tax Closing Letter? For all estate tax returns filed on or after June 1, 2015, estate tax closing letters will be issued only upon request by the taxpayer. Please wait at least four months after filing the return to make the closing letter request to allow time for processing. For questions about estate tax closing letter requests, call (866) Based on this information, if the executor of an estate desires certainty regarding whether the IRS has accepted the Form 706 as filed, the executor must either request a closing letter from the IRS (at least four months after filing the Form 706) or wait for the three-year statutory period of limitations to pass without notice from the IRS that it is reviewing the return

9 The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 By Lauren Ahern On August 1, 2015, the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 ("Act") became effective. The Act includes changes to the Internal Revenue Code to address the issue of basis consistency and to enact a new reporting requirement for Executors. The Act amends IRC Sec to create the new Sec. 1014(f) which states that the basis of property received from a decedent shall not exceed its final determined value for estate tax purposes or, for property the value of which has not been determined for federal estate tax purposes, the value identified in a statement furnished by the Executor pursuant to IRC Sec The Act limits the rules imposed in Sec. 1014(f) to that property which, by its inclusion in the decedent's estate, increased the estate's tax liability. The Act further amends IRC Sec and replaces it with a new Sec entitled "[b]asis information to persons acquiring property from a decedent." The new Sec imposes reporting requirements on Executors of decedent's estates, requiring them to furnish statements to the Secretary and to each person who acquires any interest in any property included in the decedent's estate for federal estate tax purposes a statement which identifies the value of the property as reported on the return as well as such other information the Secretary may prescribe. Section 6035 requires Executors to furnish such statements no later than thirty (30) days after the date on which the return was required to be filed (including extensions, if any) or thirty (30) days after the date the return is actually filed. The Act endeavors to create uniformity in basis reporting between estates and beneficiaries; it states that there will be an "inconsistent estate basis" if the basis of property claimed on a return exceeds the basis as determined under Section 1014(f). Statements furnished under new Section 6035 are required to be made for any returns filed as of August 1, However, effective August 21, 2015, the IRS has issued Notice which delays the due date for filing such statements under Sec until February 29, 2016; presumably to allow the Treasury Department and the IRS to issue guidance which implements the new reporting requirements.