Spring 2014 Editor: Julius Giarmarco, J.D., LL.M. Tenth Floor Columbia Center 101 West Big Beaver Road Troy, Michigan 48084-5280 (248) 457-7000 Fax (248) 457-7219 www.disinherit-irs.com Assistant Editor: Salvatore J. LaMendola, Esq. TAX COURT DECISION CUTS 3.8% NII TAX FOR MANY TRUSTS By Julius Giarmarco, J.D., LL.M. On March 27, 2014, the Tax Court in Frank Aragona Trust v Commissioner, 142 T.C. No. 9 (2014), held that a trust materially participated in its rental real estate business and, therefore, could deduct the losses it incurred in those activities as non-passive losses. The Frank Aragona Trust was formed by Frank Aragona (a Michigan resident) during his lifetime. After his death, the trustees of the Trust were his five children plus an independent trustee. Three of the children were also employees of an LLC which was wholly owned by the Trust. Two of those three children were part owners of other LLCs in which the Trust was a majority owner. The Trust incurred substantial losses, but the IRS disallowed those losses due to its conclusion that the Trust could not meet the material participation test of IRC Section 469. IRC Section 469 prohibits the offsetting of losses from passive activities against non-passive income. However, there is an exception (IRC Sec. 469(c)(7) (B)) if the taxpayer meets both of the following tests: 1. More than one-half of the personal services performed in the trade or business by the taxpayer are performed in businesses in which the taxpayer materially participates on a regular, continuous and substantial basis; and 2. The taxpayer performs more than 750 hours of services for the trade or business. In Frank Aragona Trust, the IRS made two arguments. First, the exception did not apply to trusts because personal services are defined under the Treasury Regulations Sec. 1.469-9(b)(4) as work performed by an individual (not a trust) in a trade or business. Alternatively, the IRS argued that even if trusts in general can come within the exception, the Frank Aragona Trust did not (because it failed to materially participate). The Tax Court disagreed with the IRS s first argument because the IRC Section 469(c)(7)(B) exception uses the word, taxpayer, as opposed to natural person (which term is used in another part of the Treasury Regulations under IRC 469). Thus, the Tax Court concluded that Congress did not intend to exclude trusts from the IRC Sec. 469(c)(7) (B) exception. With respect to the IRS s alternative argument, the Tax Court noted that there was no regulatory guidance for determining how a trust might materially participate. The IRS reserved Temp. Regs. Sec. 1.469-5T(g) for that purpose in 1988, but has yet to issue any guidance. Therefore, the Tax Court had to make its own determination. The IRS s position was that the trustees services as employees of the businesses had to be disregarded. In other words, according to the IRS, a trustee can only materially participate if he/she is doing so in his/her fiduciary capacity. In response, the Tax Court held that under Michigan law the trustees had a fiduciary duty to conduct the business for the beneficiaries benefit, and their activities as employees could be considered in determining the Trust s material IN THIS ISSUE: TAX COURT DECISION CUTS 3.8% NII TAX FOR MANY TRUSTS TRUSTS AND DIVORCE IN MICHIGAN IRS NOTICE 2014-19 AND ITS APPLICATION TO QUALIFIED RETIREMENT PLANS FOR SAME-SEX COUPLES
2 participation. The Tax Court also found that the Trustees activities met the material participation test and, therefore, the losses were deductible. Equally as important as allowing losses to be deducted, the Frank Aragona Trust ruling allows trusts to avoid the 3.8% Net Investment Income Tax under IRC Sec. 1411 when it comes to profits generated by trust-held businesses organized as pass -through entities. For trusts and estates, the NII Tax is 3.8% of the lesser of (1) the undistributed net investment income for the tax year, or (2) the excess of (a) the undistributed adjusted gross income for the tax year, over (b) $12,150 (for 2014). NII does not include, however, income from active, trade or business activity, or the disposition of property held in an active trade or business. Unfortunately, the Final Regulations under IRC Sec. 1411 did not address how a trust or estate can materially participate in the conduct of a trade or business (deferring instead to future guidance under the IRC Sec. 469 regulations). Because of the lack of regulatory guidance, the Tax Court s opinion in Frank Aragona Trust is quite significant. It s the only judicial opinion since the enactment of the NII Tax to be handed down on the issue. It s important to note, however, that the Tax Court s decision by its terms only covers situations in which the trustee is materially participating in the trade or business activity. Unfortunately, the Tax Court did not go as far as a Texas U.S. District Court did in Mattie K. Carter, 256 F Supp 2d 536 (Tex. 2003), which counted participation of trust employees in determining whether the trust materially participated in the trade or business. The Tax Court said, We need not and do not decide whether the activities of the trust s non-trustee employees should be disregarded. Thus, while the Tax Court did not say that non-trustee employees can give trusts material participation, it did not rule it out either. Future litigation will have to settle that issue. Nevertheless, the Frank Aragona Trust decision is a big taxpayer win. It is also likely to be appealed by the IRS. TRUSTS AND DIVORCE IN MICHIGAN By Salvatore J. LaMendola, Esq. Introduction The Berlinger case (2013 Fla. App. LEXIS 18908, Nov. 27, 2013) decided late last year in Florida caught the attention of many estate planning and asset protection professionals. The reason was the successful garnishment of the trustee of an inherited irrevocable trust for an ex-spouse s $16,000 per month alimony award. While justice was probably served in this particular case - the beneficiary claimed lack of funds to support his wife of 30 years while living high on the hog with his new wife completely at the trust s expense - the divorce protection that irrevocable trusts are supposed to provide has been cast into doubt, at least in Florida for now. This article will cover how inheritances held in trust (or not) are protected (or not) when it comes to divorce in Michigan. First, the two-stage divorce process the pre-judgment division of assets (including alimony awards) and the post-judgment enforcement of the same will be reviewed. Then, some tips for strengthening current trusts will be offered. The Pre-Judgment Division of Assets At present, there are two systems of property division in the United States: the dual-classification system and the all-property system. Under dualclassification, the parties assets are divided into two distinct categories: (1) marital or community property; and (2) separate or non-marital property. Separate property is generally awarded to the spouse who owns it. Marital property is divided equitably (which is not the same as equally) among the spouses. Under the all-property system, the court has the power to make an equitable division of all property, regardless of when and how acquired. Since Michigan is a dual-classification state,
3 inheritances face two points of attack in the property division stage: (1) classification as marital property; and (2) classification as separate property, but falling under either of two exceptions that makes separate property vulnerable. Marital property classification most commonly arises from an heir s commingling inherited funds with his/ her spouse. The classic example is using inherited money to pay off the debt against the marital home. Another is using an inheritance to upgrade to a larger co-owned marital home. Inheritances not held in trust are far more vulnerable at this stage, since there is no trustee on the scene to ensure that commingling does not occur. If not classified as marital property, the next point of attack is the establishment of either of the two exceptions to the general rule that gives separate property to its owner. These exceptions are the insufficiency exception (the non-owning spouse s inability to suitably support and maintain herself in her accustomed standard of living without a portion of the separate property) and the contribution exception (the non-owning spouse s showing acquisition, improvement, or accumulation of value due to his efforts). The classic example of this exception is a wife s managing a household and caring for young children, thereby enabling her husband to invest long hours to build up a business left to him by his parents. A recent example of the insufficiency exception occurred in the Haines case (2009 Mich. App. LEXIS 2568, Dec. 15, 2009, unpublished) where the exwife s post-divorce income was to drop to less than one-third of what the couple enjoyed while married. In that case, though classified as separate property, the court nonetheless used the insufficiency exception to invade the ex-husband s LLC received by gift (but not in trust) for $250,000 to help the exwife make ends meet. Using trusts can provide an extra layer of defense for separate property at this stage. In Haines, the court refused to invade a second gifted LLC that was held in trust because the future value of the trust (which allowed only discretionary distributions prior to termination when the husband turned 50) could not be determined. Lastly, before turning to the post-judgment enforcement process, it should be noted that in cases where both the insufficiency and contribution exceptions cannot be established, the fact of a sizable inheritance in only one spouse s column will not go unnoticed by the court when marital property division and alimony awards are decided. A lopsided division and/or very generous alimony award in the non-inheriting spouse s favor should be expected for the court to achieve the equitable result it seeks. Whether an inheritance is held in a trust or not will have no impact on that outcome, but, as will be seen, trust-held inheritances can provide far greater protection post-judgment against future alimony claims. Post-Judgment Enforcement If left untouched in the division process, and if no alimony was awarded to the non-inheriting spouse, the inheritance is home free (whether held in trust or not). However, if alimony was awarded, a claim to enforce payment of the same will almost certainly be successful against assets not held in trust. This is because at this stage, the non-inheriting party plays the role of creditor rather than ex-spouse. And, as any other creditor, she can attach gifts, inheritances, and all other property directly owned by the former spouse. On the other hand, where a trust is involved, the result is far less certain. In Michigan, trusts are classified as either: (1) spendthrift (contains provisions preventing the transfer of the beneficiary s interest to any other person), (2) support (contains provisions providing for the beneficiary s support), or (3) discretionary (contains provisions allowing distribution to the beneficiary to be made, but not mandating any stated times or amounts). Note that a trustee s power to distribute income or principal for a beneficiary s health, education, maintenance, and support does not automatically result in support trust classification. In fact, due to the language that the quoted phrase will typically be couched in, the more likely classification will be as a discretionary trust. Relative to spendthrift and support trusts, exspouses with alimony claims are categorized as super-creditors who, unlike regular creditors, must be paid by the trustee directly when a trust distribution is due. To illustrate, assume that the spendthrift trust left to him by his parents must distribute $50,000 to Ben when he turns 35. If Ben is
4 $20,000 in arrears in alimony on his 35 th birthday, his ex-spouse, Jenny, who has garnished Ben s trustee for the same amount, receives from the trustee the first $20,000 of the $50,000 due. As a super-creditor, Jenny does not have to wait for distribution to Ben to occur before trying to collect. That is for mere regular creditors. Similarly, if Ben s trust were a support trust, Jenny would have the same advantage with respect to the amount due Ben in excess of that needed for his support. Continuing the example, if Ben s trust were a discretionary trust, Jenny would have no special privileges. Like every other creditor, she would have to wait until the time, if ever, a distribution directly to Ben is made. Since indirect payments don t count, if the Trustee is permitted to make distribution to or for the benefit of Ben, the Trustee can continue to pay Ben s MBA tuition directly to his school without worry of Jenny or any other creditor causing problems. Strengthening Existing Trusts Before proceeding with some tips on making existing trusts as divorce proof as possible, two points are worth noting. First, strengthening existing trusts may ironically encourage the event from which protection is sought. The theory is that a beneficiary who knows that she bears no risk of financial loss upon divorce will be less incentivized to work to preserve the marriage. In fact, she may even be even more inclined to get out of the marriage sooner. Second, in this area, there are no absolutes, only better or worse. Even if all of the following tips are implemented, the mere fact that a divorce occurs in an all-property state rather than a dual-classification state could make a big difference in how assets are divided. Judges have a lot of power in these cases. That said, no matter the venue of the pre-judgment division proceedings, Michigan trust law will still apply to Michigan trusts during the post-judgment enforcement stage. When it comes to divorce-proofing trusts, the following is a good rule of thumb: the more distant the beneficiary is from trust assets, the better. As seen above, using discretionary trust provisions, which give a beneficiary no right to force a trustee s hand, is essential. The somewhat common 5/5 withdrawal right (the beneficiary s ability to annually withdraw the greater of 5% of the trust principal or $5,000, no questions asked) that are sometimes layered on top of discretionary provisions might be re-considered. Sprinkle provisions allowing discretionary distributions to the beneficiary and/or his descendants (with no preference for the former) are to be favored. Finally, arm s length trustees (rather than mere yes men ) are to be preferred. Trusts lacking one or more of these features can be amended (if the settlor is still alive and not disabled) or decanted (if the settlor is deceased) accordingly. Conclusion In mid-february, it was announced that Berlinger will be re-heard. A reversal is expected by many members of the Florida bar. Short of that, Florida law will likely be amended to correct the problem. As seen above, the keys to protecting assets in the first stage of the divorce process are non-commingling and non-ascertainable valuation. Trusts are a better way to accomplish the former and possibly the only way to accomplish the latter. Thus, using any kind of trust for an inheritance is a good start. But since alimony super-creditors are only trumped by discretionary trusts in the second stage of the process, use of such trusts with beneficiaries as distant from the assets as possible is the best way to protect inheritances at both stages of the divorce process in Michigan. IRS NOTICE 2014-19 AND ITS APPLICATION TO QUALIFIED RETIREMENT PLANS FOR SAME-SEX COUPLES By Thomas P. Cavanaugh, J.D. In Windsor v. United States, 570 U.S., 133 S. Ct. 2675 (2013), decided on June 26, 2013, the U.S. Supreme Court struck down one aspect of the Federal Defense of Marriage Act by holding that it violated the Due Process Clause rights of legally married same-sex couples. On August 29, 2013, the IRS promulgated Revenue Ruling 2013-17 which applied the holding of the Windsor decision to tax
5 laws that apply to married couples. In its ruling, the IRS provided that, starting on September 16, 2013, it would recognize the validity of a marriage consummated by a same-sex could as long as the marriage was valid in the jurisdiction where the ceremony was performed. In other words, legally married same-sex couples would be considered married for retirement plan purposes. The Services also announced that same-sex married couples could rely on the Windsor opinion s holding retroactively and, therefore, were permitted (but not required) to amend tax returns for any tax year that was open under the statute of limitations. However, Revenue Ruling 2013-17 did not address whether or not the Windsor decision might retroactively affect a plan s status as qualified. In response to these concerns, the IRS and Treasury Department, on April 4, 2014, jointly released Notice 2014-19. In a nutshell, the Notice was intended to provide guidance on the application of the Windsor decision and Revenue Ruling 2013-17 to retirement plans qualified under section 401(a) of the Internal Revenue Code. Treasury retroactively applies the rule of Revenue Ruling 2013-17 for retirement plan purposes to the date of the Windsor decision. In other words, the Notice requires qualified plans to recognize, as of June 26, 2013, the rights of samesex spouses, including benefits available under ERISA. For example, under a defined benefit plan, legally married same-sex couples must be given the right to receive a joint and survivor annuity (or a pre-retirement survivor annuity). With defined contribution plans, legally married same-sex couples must be given the right to receive the death benefit payable upon the death of the participant-spouse. Additionally, same-sex couples will be able to utilize the more favorable qualified minimum distribution rules, and the roll-over rules. Qualified plans which define spouse consistent with the Defense of Marriage Act (i.e., opposite sex marriage couple) must be amended to cover samesex couples who are married in a jurisdiction that recognized their marriage, regardless of their state of residence. If a qualified plan does not define spouse, it does not have to be amended. The benefits available to legally married same-sex couples through qualified plans only extend back to June 26, 2013. However, the Notice permits (but does not require) plan amendments to allow such benefits before that date. Unless a longer period is available under Revenue Procedure 2007-44, all plan amendments must be completed by December 31, 2014. It is interesting to note that the U.S. Supreme Court held that DOMA was unconstitutional which essentially means that DOMA was never valid law. Yet, in its application of Windsor, the Treasury is giving limited retroactive effect (i.e., June 23, 2013) to qualified plans. This newsletter is designed to provide accurate (at the time of printing) and authoritative information with regard to the subject matter covered. It must not be used as the basis for legal or tax advice. In specific cases, the parties involved must always seek out and rely on the counsel of their own advisors. Thus, responsibility for modifying and guiding any party s action with respect to legal and tax matters is placed where it belongs - with his or her own advisors. CIRCULAR 230 DISCLAIMER: NONE OF THE ARTICLES IN THIS NEWSLETTER ARE INTENDED OR WRITTEN BY THE VARIOUS AUTHORS OR GIARMARCO, MULLINS & HORTON, P.C., TO BE USED, AND THEY CANNOT BE USED, BY YOU (OR ANY OTHER TAXPAYER) FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU (OR ANY OTHER TAXPAYER) UNDER THE INTERNAL REVENUE CODE OF 1986, AS AMENDED.