Recent developments: FLPs, option income and home office depreciation.

In A. Strangi Estate (No. 03-60992), the Fifth Circuit Court of Appeals affirmed the Tax Court and decided July 15, 2005 that the full value of assets transferred by Albert Strangi to a family limited partnership (FLP) was includible in his gross estate under IRC Sec. 2036(a)(1).

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This statute requires such a result where a decedent makes a transfer of property (except in a case of a bona fide sale for adequate and full consideration) under which the decedent retained for life the possession or enjoyment of, or the right to the income from, the property.

Two months before his death, Strangi created the FLP and its corporate general partner. He transferred approximately $10 million of investment assets to the FLP for a 99 percent limited partnership interest. The new corporation owned by Strangi and his daughter (on behalf of herself and siblings) contributed approximately $100,000 for a 1 percent general partnership interest.

The Fifth Circuit held that there was an implied agreement between Strangi and his children that he would retain the property's enjoyment after the transfer because:

1. The FLP's disbursements to meet the needs of Strangi and his estate;

2. His continued occupation of his residence after it was transferred to the FLP, where the accrued rent was unpaid for more than two years; and

3. Strangi's transfer of almost all his liquid assets to the FLP, leaving him with insufficient assets to meet his personal needs.

The court also rejected the estate's argument that the transfer was a bona fide sale since it lacked a substantial non-tax purpose.

Nonstatutory Option Income

Rev. Rul. 2005-48 (IRB 2005-32, 8/8/05) holds that an employee (E) who exercises a nonstatutory option before the end of a six-month "lock-up period" must recognize income from that exercise even if E's sale of the stock is restricted under the insider trading rules.

Facts: E is granted a nonstatutory option to purchase 100 shares of her employer's (X's) stock for $10 a share on Jan. 2, 2005. X sells its stock in an initial public offering on May 1, 2005.

As required by the underwriting agreement, E agrees not to dispose of any options or stock from May 1-Nov. 1, 2005, the lock-up period.

On May 1, 2005, X adopts an insider trading compliance program under which insiders, such as E, may trade X shares only between Nov. 5-Nov. 30, 2005.

X's stock is trading at more than $10 a share on Aug. 15, 2005. On that date, E exercises her option. E's rights in the resulting stock received are not conditioned upon future performance of substantial services.

However, on Aug. 15, 2005, E possesses material non-public information concerning X that would subject her to liability (under Rule 10b-5 under the 1934 Securities and Exchange Act) if she sold X stock while possessing this information.

Additional Holding: The amount of E's compensation income is determined without regard to the stock-transfer restrictions imposed by the underwriting agreement and the insider trading compliance program.

Other Points: Regs. Sec. 1.83-3(j) will be amended to explicitly set forth Rev. Rul. 2005-48's holdings.

This ruling also states that its conclusions are consistent with Tanner, 117 TC 237 (2001), aff'd No. 02-60463 (CA-5, 3/26/03); but see Robinson, 805 F.2d 38 (CA-1, 1986), rev'g 82 TC 444 (1984).

An Aug. 2, 2005 e-mail, IRS Guidewire, states that the IRS will not follow Robinson--except for cases arising in the First Circuit.

Statutory Option Income

In Robert J. Merlo, TC Memo 2005-178 (July 20, 2005), the Tax Court held that Merlo could not avoid recognizing alternative minimum taxable income upon the exercise of an incentive stock option because of his employer's policy against insider trading, which subjected Merlo to possible termination. This risk was not a substantial risk of forfeiture.

The Tax Court rejected Merlo's reliance on Robinson.

Home Office Depreciation

The instructions for the 2004 IRS Form 8829 "Expenses for Business Use of Your Home," Page 3, and the 2004 IRS Publication 587 "Business Use of Your Home," Page 10, both indicate that depreciation for business use of a home is based on the 39-year recovery period for nonresidential real property.

Nevertheless, the following question for the 2004 Annual Liaison Meeting between the IRS and CalCPA's Committee on Taxation (COT) was submitted by Peter Goldberg, CPA, Los Angeles and reviewed by Al Arias, CPA, San Diego (both COT members):

If a portion of a residence qualifies for the home office deduction, but the entire residence qualifies as a residential rental property (under Sec. 168(e)(2)(A)'s 80 percent test), is depreciation claimed over 27.5 years?

The IRS' written response stated that a 27.5-year recovery period would apply.

However, at the meeting, Brian Casaly, IRS technical advisor, SBSE, Southern California, indicated that the response conflicted with the Form 8829 instructions and Publication 587.

But Joe Calderaro, the SBSE's Northern California technical adviser, believing the response was correct, persevered with the IRS National Office to resolve this issue.

After several months of study, the National Office issued C.C.A. 200526002 specifying a 27.5-year recovery period for this situation.

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].

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By Stuart R. Josephs, CPA