TaxClinic.

PRACTICAL ADVICE ON CURRENT ISSUES

EMPLOYEE BENEFITS & PENSIONS

Long-arm Care, Planning

As the U.S. population ages, many practitioners will deal with longterm care planning for their elderly clients or their 'clients' aging parents. Most older people wish to stay in their homes for as long as possible. However, the reality is that many of these people will some day require assistance with their daily personal needs., Clients may wish to explore various options for long-term care, including how to fund it, various types of facilities available and how to select a care facility.

With medical costs skyrocketing and individuals living longer, people must carefully consider how best to fund an extended stay in a long-term care facility. Generally, there are five options for funding long-term care:

1. Medicare;

2. Medicare supplemental insurance ("medigap" insurance);

3. Medicaid;

4. Long-term care insurance; and

5. Personal savings.

Medicare

Medicare generally is available to individuals who are at least 65 years old and eligible for Social Security benefits; are less than 65 years old, disabled and eligible for Social Security benefits for more than 24 months; or are in end-stage renal disease (permanent kidney failure). Medicare is limited and covers only skilled nursing facility care (SNF), home health services following a hospital or SNF stay, or hospice care. Also, specific requirements apply even for these Medicare-covered costs.

Medicare Supplemental Insurance

Also known as "medigap" insurance, Medicare supplemental insurance is privately-obtained insurance that covers Medicare deductibles and copayment amounts. There are 10 traditional types of policies (Types A through J) and two new high-deductible plans that are variations of Plans F and J. (Note: Policy types may vary in Massachusetts, Minnesota and Wisconsin.) Most medigap plans cover a portion of the costs of skilled nursing care when covered by Medicare. Likewise, most plans exclude nursing home coverage.

Medicaid

Medicaid is available to individuals with limited income and assets; needy individuals who qualify for Medicaid generally will have all long-term care expenses paid for. Income and asset limitations are fairly restrictive and vary by state. Income cap states, for instance, limit a Medicaid applicant's income to $1,482 or less per month (in 1998) based on Federal guidelines. The asset limitation, in most states, is $2,000, excluding "exempt assets." Some exempt assets include (but are not limited to) one home, one car, limited household items and furniture, and term insurance. Some clients may try to transfer assets to their children or heirs in an effort to qualify for Medicaid benefits. States will disallow benefits when transfers of assets occur within 36 months of the date a Medicaid applicant applies for benefits (60 months for some trusts). Additionally, transfers for less than fair market value may be subject to a penalty period. Theoretically, criminal penalties may be imposed on advisers suggesting asset transfers made solely for purposes of qualifying for Medicaid benefits (although there are questions about the legality of these penalties).

Long-Term Care Insurance

Long-term care insurance may be purchased through private insurance companies and may be appropriate for people who want to preserve their personal assets. Most policies require some type of waiting period before benefits will begin. The cost of a long-term care policy may be prohibitive to certain clients, and costs increase as the client's age increases. A long-term care policy should be evaluated using "activities of daily living" (ADLs). There are six ADLs, such as eating, bathing and dressing. Policies should specify that benefits commence when a policyholder is unable to perform or remember to perform a given number of ADLs for himself (e.g., three of the six AGEs). Long-term care premiums are deductible as medical expenses, subject to the 7.5% adjusted gross income floor and age-based limitations

There are three basic types of care facilities:

1. Assisted living facilities (ALFs);

2. Continuing care retirement communities (CCRCs); and

3. Nursing homes.

ALFs. ALFs generally are for individuals requiring help with certain ADLs, but who do not require skilled medical care. Many ALFs provide clients with a sense of independence, while assisting them with meals, medical reminders, cleaning and laundry services. They often offer apartment-type rooms to which older people bring their own furniture and belongings. However, when an individual requires skilled medical care, many ALFs require that the individual be moved to a nursing home.

CCRCs. CCRCs are community-type facilities that provide levels of care commensurate with a resident's needs. All levels of care are available in CCRCs, which make them appealing to many individuals. CCRCs usually provide social activities, as well as meals, cleaning/laundry services, transportation, crafts, physical therapy, security and infirmary services. CCRCs may be paid for by a monthly fee (similar to rent), an entrance fee plus a monthly charge, or an ownership interest.

Nursing homes. Nursing home care is required when individuals are unable to live independently because of physical or mental impairment. Nursing care facilities should be carefully evaluated, including an analysis of staffing (to determine if it is sufficient to provide adequate care to all residents). Generally, a nursing home must provide a given number of beds for Medicare patients.

Provisions vary significantly from state to state, and practitioners must carefully examine the rules and laws governing their state before giving specific advice. It also is advisable to have an elder law attorney review any contract for an assisted-living facility prior to a client signing an agreement. Additional resources include:

* Continuing Care Accreditation Commission (www.ccaconline.org);

* American Association of Home & Services for the Aging (202-783-2242);

* Administration on Aging (www. aoa.dhhs.gov);

* Assisted Living Facilities Association of America (703-691-8100);

* Assisted Living Network (888-532-9280);

* Long-term Care Quote (800-587-3279); and

* Medicare/Medicaid Services (www. hcfa.gov).

From Marilyn M. Falkenhagen, CPA, Maxwell Locke & Ritter, P.C., Austin, TX

Nondiscrimination Safe Harbors for Sec. 401(k) Plans

The Small Business Job Protection Act of 1996 (SBJPA), effective for tax years beginning after 1998, provided an alternative for plan sponsors to satisfy their Sec. 401(k) plan nondiscrimination requirements. Plan sponsors who elect to make safe harbor contributions can avoid discrimination testing for their plans. The SBJPA provision treats the actual deferral percentage (ADP) test for employees' elective deferrals as being met if the sponsor elects either of two types of safe harbor contributions. The safe harbor (Sec. 401(k)(12)(B)) is a matching contribution, requiring contributions of 100% of an employee's elective deferrals up to 3% of compensation, and 50% of an employee's elective deferrals from 3% to 5% of compensation. The first matching contribution rate for any highly compensated employee (HCE) may not be greater than the rate for nonhighly compensated employees (NHCEs).

Some variation is permitted in the matching formula if the matching contributions for each level of elective deferrals are at least equal to the rates computed under the formula described. Also, alternative matching formulas may not provide for a higher rate of matching as the level of elective deferrals increases. For example, if a Sec. 401 (k) plan currently provides for matching contributions of 150% of elective deferrals up to 2% of compensation, and 50% of elective deferrals from 3% to 4% of compensation, it would not be necessary to modify that formula to meet the safe harbor requirements. A participant would not receive a lower rate of matching contributions at any level of elective deferrals under the plan's current formula than under the safe harbor provided in Sec. 401(k)(12)(B). Therefore, no modification of the plan's formula would be needed.

The second safe harbor (Sec. 401(k)(12)(C)) is a nonelective contribution of at least 3% of compensation for NHCEs. The contribution is mandatory for all eligible NHCEs, even if they do not elect to make salary deferral contributions.

Regardless of which type of safe harbor contribution is elected, the contribution must be fully vested and subject to the distribution restrictions applicable to elective deferrals under a Sec. 401(k) arrangement. One additional requirement is that plan sponsors must provide eligible employees with notice prior to the beginning of each year, informing them of their rights and obligations under the arrangement.

In addition to the safe harbor described for ADP testing, the SBJPA also provides a safe harbor for meeting the actual contribution percentage (ACP) test. The ACP test applies to matching contributions and employee after-tax contributions.

The ACP safe harbor (Sec. 401(m) (11)) first requires a plan to meet the ADP safe harbor described above. In addition, the plan must meet the following three requirements:

1. Matching contributions may not be made for elective deferrals or employee after-tax contributions greater than 6% of compensation;

2. The matching contribution rate may not increase as the rate of elective deferrals or employee after-tax contributions increases;

3. The matching contribution for HCEs at any rate of elective deferrals or employee after-tax contributions may not be greater than the matching contribution for NHCEs.

The discrimination safe harbors may be beneficial to employers whose matching or nonelective contributions presently equal or exceed the safe harbor requirements or are not significantly less. These employers should consider the effect of 100% vesting of employer contributions. On the other hand, employers who would increase their matching or nonelective contributions to meet the safe harbor requirements should consider whether to incur the increased contribution costs, to have potentially greater allowable elective deferrals for HCEs and avoid the administrative burden of discrimination testing.

The safe harbors may make Sec. 401(k) plans more attractive to small employers, whose HCEs may have previously wanted to make maximum elective deferrals but would probably have been limited (due to low deferral rates by the NHCEs). If an employer currently sponsors a profit-sharing plan, its contribution costs for NHCEs may decrease by converting to a safe harbor Sec. 401(k) plan, while at the same time permitting maximum elective deferrals--currently $10,000 per year--for each of the HCEs.

The Sec. 401(k) safe harbors offer additional options for plan sponsors. Employers and their advisers should consider the safe harbor alternatives as they design and maintain retirement plans to benefit plan sponsors and their employees, and to comply with IRS requirements.

From Lorna Doversberger, CPA, MT, Anderson & Whitney, P.C., Greeley, CO

Roth IRAs in Estate Planning

As the Taxpayer Relief Act of 1997 (TRA '97) worked through committees, there was much concern and debate on the future of Social Security and its relationship to the national savings rate. The intent was to encourage individuals to save for special purposes, and the Roth individual retirement account (IRA) emerged as one of the most significant additions to the Code.

Key benefits of the Roth IRA include nontaxable distributions and the absence of a required beginning distribution date. Issues of deferrals, minimum distributions, penalties, qualifications, assumptions, advantages, irrevocable elections, contribution deadlines and tax rates have been focal, as software seems to have proliferated from every imaginable source to assist individuals in evaluating where to direct their contributions and rollovers.

Funded by annual contributions from earned income, the Roth IRA is the focus of working taxpayers. The maximum contribution is $2,000, and is limited by income, filing status and compensation. Keeping in line with the congressional intent, there is neither an age nor plan participation limit. Individuals are indeed encouraged to save today to supplement retirement income.

Although it was called the "Taxpayer Relief Act of 1997" the real impetus behind the TRA '97 was balancing the budget. To enhance immediate revenue, the provision to roll over and report income over a four-year spread attracted much attention. This rollover is frequently referred to as a conversion because it is a taxable event; a traditional rollover from one IRA to another is not taxable. By the end of 1998, taxpayers will know if they qualify to make the conversion. Plus, because of the limitations placed on rolloverfunded Roth IRAs, they have emerged as attractions to retired as well as working taxpayers. Once the calculations have been evaluated and the incredibly complex rules have been examined, the advantage of paying tax now rather than later becomes apparent--not so much from a saving-to-supplement-retirement-income viewpoint, but considering the benefits of the ultimate transfer of wealth between generations.

The assumption that there is no advantage in paying taxes now versus later comes under scrutiny Perhaps the most significant variable is the unpredictability of the tax bracket. Since 1913, income tax rates have ranged from 7% to 94%. The provision: to take the rollover into income in 1998 allows for a four-year spread. However, the rollover remains available in future years without the spread. If taxpayers are unable to meet the 1998 adjusted gross income (AGI) limitation to qualify for the rollover (Sec. 408A(c)(3)(B)(i) limits AGI to $100,000), the opportunity to report income gradually may be lost. But there is no reason to abandon the quest to pass the wealth, as there remains the issue of Federal estate tax and the complicated income in respect of a decedent calculation.

After retirement needs have been evaluated, the AGI hurdle overcome and the conversion benefits addressed, designated beneficiary choices are made, making it evident that the estate tax will increase (because no distributions have been factored in). There is no history to use in making assumptions and no promise that provisions will not be tinkered with in subsequent laws. Investment returns and inflation factors are mere predictions. As the Roth IRA appreciates, the transfer tax becomes the focus of estate planners, as they seek to create sophisticated vehicles to shelter such ever-increasing assets.

The lack of provision for required minimum lifetime distributions and irrevocable elections, with regard to beneficiaries, remains the real attraction in using the vehicle for estate planning. The IRS Restructuring and Reform Act of 1998 lists a number of technical corrections; none have substantial effect. Most significantly, the taxpayer may elect to have the 1998 conversion entirely included in income currently, rather than ratably over four years. Absent such election, the converted amount is included in gross income over the four-tax-year period beginning in 1998.

When the owner of the Roth IRA dies, there will have been no required beginning date and the benefit will be distributed according to Sec. 401(a)(9)(B). Distribution options include provisions for a surviving spouse or designated beneficiary. If payable to an estate, the entire distribution will be completed by December 31 of the calendar year that includes the fifth anniversary of the owner's death. Accordingly, a taxpayer who has made an irrevocable election at age 70 1/2 may choose to convert a benefit to a Roth IRA, thereby taking advantage of an opportunity to change beneficiaries and eliminate an irrevocable election. Feasibly, distributions could be multigenerational.

Sec. 401(a)(9) allows for the creation of either a revocable or an irrevocable trust as the beneficiary of a Roth IRA. A trust can be of tremendous value if properly drafted. In addition to having tax-free distributions, the benefit could be removed from an estate by means of a current gift. Of course, plan distributions will be to a trust, and earnings on the distributions will be subject to income tax. But if earnings are distributed, a distributed net income deduction is available to the trust. Planning will encompass complex reviews of the generation-skipping transfer (GST) tax and allocation of the GST tax exemption, as well as computation of the immediate gift tax implication.

The multitude of variables and unpredictability of future tax and investment-return rates make the decision to pay tax now and form irrevocable trusts a problematic one. Careful planning is extremely important, and apprehensive taxpayers may want to consider hedging. Once the four-year spread on reporting conversion income has passed, transfers of benefits could be staggered over a number of years. Many states have conformed to the Federal provisions, but this is always subject to change.

It has taken most of 1998 for taxpayers to consider and test scenarios regarding retirement plan selections. The technical corrections codified a few ambiguities. Perhaps the macroeconomic effect of tax revenues over the next four years will keep Congress busy tinkering with the Roth IRA. What was envisioned as a supplement to Social Security income on retirement has grown to be perhaps the most efficient estate planning vehicle.

From Rosemary F. Ervin, CPA, R.D. Hunter and Company LLP, Paramus, NJ

ESTATES, TRUSTS & GIFTS

Checks for Noncharitable Gifts Paid After Decedent's Death Are Includible in Gross Estate

In Est. of Newman, 111 TC No. 3, the Tax Court ruled that checks for noncharitable gifts written prior to a decedent's death but paid by the bank after her death were includible in her gross estate. The Tax Court thereby declined to extend further the relation-back doctrine, which the court applied in an earlier case to provide favorable gift and estate tax consequences for certain year-end noncharitable gifts. Est. of Newman is important for all clients with assets sufficient to create an estate tax liability.

Secs. 2031 and 2033 specify that all property to the extent of the decedent's interest therein is included in the gross estate; such property includes bank deposits under Regs. Sec. 20.2031-5. If the checks are completed gifts during the decedent's lifetime, the funds represented by those checks are excludible from a decedent's gross estate. However, Sec. 2001(b) requires post-1976 taxable gifts to be added to the taxable estate, with $10,000 per donee per year exempted from the gift tax under Sec. 2503(b). Using this exemption allows property to escape both gift and estate taxes (because a taxable gift occurs only if the gift exceeds $10,000 per donee per year).

A gift is complete if a donor has parted with dominion and control, leaving the donor no power to change its disposition (Regs. Sec. 25.2511-2(b)). Local law determines whether the donor can change the gift's disposition. However, case law indicates that no state recognizes the mere delivery of a check to be a completed gift of the underlying funds, because the donor can stop payment on the check or withdraw the funds. The gift, therefore, remains incomplete until the drawee bank pays the check.

The relation-back doctrine developed by the Tax Court allows a gift by check to be treated as complete for tax purposes. Under this doctrine, checks mailed to charitable donees prior to the donor's death are excluded from the gross estate, even though the bank does not pay them until after death. Also, checks mailed to charitable donees by year-end receive an income tax deduction for that year.

In Est. of Metzger, 100 TC 204 (1993), aff'd, 38 F3d 118 (4th Cir. 1994), the Tax Court extended the relation-back doctrine to year-end noncharitable gifts when the donees deposited the checks by December 31 of the first year, and the checks cleared the bank shortly thereafter in the second year. The court required the donees to have deposited the checks within a reasonable time (within 30 days) after issuance by the donor to establish unconditional delivery. This decision allowed the donor to receive the annual gift exclusion for these checks in the first year. Because the donor had also made additional $10,000 gifts to the same donees in the second year, the donor avoided taxable gifts in that year that would have been added to his taxable estate.

In Est. of Newman, Simon and Sarah Newman granted their son, Mark, a power of attorney in 1985; the power of attorney document did not refer to the power to make gifts. Simon died later in 1985. In 1992, six checks to noncharitable donees totaling $95,000 were drawn on Sarah's checking account; they were dated September 23 or 24 and signed by Mark. Sarah died on September 28, and the checks cleared her bank between October 1-7. The IRS included the $95,000 in Sarah's gross estate, resulting in a deficiency of $46,724. The IRS argued that the gifts were incomplete at Sarah's death, because she maintained control of the underlying funds until her death; the IRS also claimed that Mark did not have the authority to make gifts. The estate argued that the relation-back doctrine should be applied to relate the payment of the checks back to the date of their issuance (which was prior to Sarah's death). Also, the estate argued that, because Sarah was too sick to stop payment on the checks, the gifts were complete.

The Tax Court ruled that the gifts were includible in the gross estate. First, the court ruled that the gifts were incomplete; the mere possession of a power to revoke a gift was controlling, not the ability to exercise it. Second, the court ruled that it would not apply the relation-back doctrine when noncharitable gifts were made by check and the donor died before the checks cleared. The court pointed out that, for charitable donees, the donor's estate would receive an offsetting deduction under Sec. 2055 if the check were included in the gross estate. Therefore, the result would be the same as excluding the check with no deduction. However, there is no deduction for gifts to noncharitable donees. Also, the court expressed concern that applying the relation-back doctrine for noncharitable gifts would foster estate tax evasion. A donor could issue a check to a noncharitable donee who would agree not to cash the check until after the donor's death. This would effectively allow a $10,000 bequest per donee free of estate tax. The court noted that in Est. of Metzger, the donor was still alive when the checks cleared; therefore, there was no potential for such evasion.

Because the Service prevailed, the court did not rule on Mark's authority to make gifts. If a power of attorney is used, it should explicitly authorize both charitable and noncharitable gifts. In Est. of Goldman, TC Memo 1996-29, the Tax Court found that, under New York law, a power of attorney could not be expanded by implication. Therefore, if the power of attorney did not explicitly authorize gifts, the gifts were invalid and the amounts were includible in the decedent's gross estate (regardless of when the checks cleared).

In advising clients about the tax advantages of making lifetime gifts to relatives and friends, CPAs should point out that checks must be paid by the drawee bank prior to the donor's death. Of course, cashier's checks should be used if death is imminent, the donor is competent or there is a power of attorney, and the bank is open. However, the best approach is for donors to make gifts by check at the beginning of each year, and the checks should be promptly cashed, avoiding the issues in Est. of Metzger and Est. of Newman.

From Peter C. Barton, MBA, CPA, J.D., Professor of Accounting, University of Wisconsin-Whitewater, Whitewater, WI (not associated with AFAi)

Family Tax Planning After the TRA '97

The Taxpayer Relief Act of 1997 (TRA '97) contains dozens of partially or entirely phased-out provisions for taxpayers whose incomes exceed specific thresh-olds. Because of these thresholds, many (if not most) taxpayers are precluded from establishing a Roth individual retirement account (IRA) or converting a regular IRA to a Roth IRA. Additionally, they are ineligible to take advantage of the most highly publicized new credits of the TRA '97, including the Hope and Lifetime Learning Credits. Careful and creative planning, however, can help clients avoid the TRA '97 phaseout provisions.

The adjusted gross income figures and other phaseout thresholds include:

                Single/Head of
                  Household        Joint

Roth IRA          $95,000-        $150,000-
annual            110,000          160,000
contribution

IRA rollover      $100,000        $100,000
to a Roth IRA

Hope Credit       $40,000-         $80,000-
                   50,000          100,000

Lifetime

Learning          $40,000-         $80,000-
Credit             50,000          100,000

In the past, family tax-planning techniques were generally limited to high-income bracket clients as a way to accumulate wealth at lower tax brackets. This was done by using the lower-income brackets of other family members. The new relatively low phaseout thresholds make it more attractive for middle-income tax clients to consider family tax planning for both educational purposes and Roth IRAs, and encourage tax advisers to consider the value of these planning techniques for assisting both high- and middle-income clients.

Clients have the following choices in planning for their children's education costs:

1. Parents pay on a "pay as you go" basis out of current income;

2. Parents pay out of a pre-funded education costs budget;

3. Student pays for college out of his own earnings;

4 Third parties pay, in the form of scholarships, grants, loans or gifts from grandparents and other relatives.

Income-shifting techniques often used for educational planning costs include:

1. Gifts of cash under the Uniform Gifts to Minors Acts;

2. Gifts of appreciated stock to minors;

3. Gifts to trusts for the benefit of minors;

4. Below-market-rate loans;

5. Children on the parents' payroll;

6. Family partnerships, limited liability companies and S corporations.

Education Credits

Both high- and middle-income clients, who plan on paying for college educations for their children, should consider a gifting plan that will enable them to create a large enough portfolio for the child or grandchild (student) so that the student will have taxable income that results in a Federal tax bill at least as high as the allowable educational credits. This allows the family to benefit by the educational credits on the student's personal income tax return. Another taxpayer cannot claim the student as a dependent, and the student must pay enough of his own qualifying educational costs to use the new credits on his tax return. Of course, the family has to decide whether gifts to the student should be made in trust or outright.

Other families may not wish to create any assets for the student through gifting, but may still benefit from educational credits. If the student has a part-time job, the family can let him pay for any part of his own qualifying educational costs. This technique enables the student to benefit from the educational credit on his own tax return. Again, another taxpayer cannot claim the student as a dependent.

Roth IRA

A family may be able to use the TRA '97 Roth IRA provisions to fund their child's education by employing high-school and college-age children in the family business. A child with $2,000 of wages or other earned income is eligible to contribute fully to a Roth IRA. These earnings will be taxed for Social Security purposes (tax-free for Social Security purposes, if paid by the parents' sole proprietorship), but can be arranged to generate little or no income taxes.

Under the Roth IRA rules, this planning can also result in the accumulation of a tax-free down payment on a child's first home. Of course, the funds deposited in the Roth IRA need not come directly from the child's earned income. In many cases, the parents or grandparents will want to give the annual Roth IRA contribution to the employed child.

The most attractive planning may be to create a combination of earned and unearned income for the student, allowing him to pay for a large enough share of the qualified education costs to maximize the educational credits and deposit $2,000 into his own Roth IRA account.

Residence Sales

The TRA '97 also has made very generous changes to the rules on the sale of principal residences. In certain situations, family tax planning can multiply the benefits of these rules.

The new rules of Sec. 1034 are extremely attractive; a dynamic gift-giving program for residential rental property could result in multiple property sales for a family, all of which could be tax-free. For example, a wealthy client with the goal of giving significant sums from his taxable estate could gift his rental properties to his three adult children. As long as the children make the homes their principal residences under Sec. 1034 and meet the occupancy and ownership tests, they can later sell those homes with virtually no Federal tax consequences (other than the tax on the post-May 6, 1997 depreciation deductions).

There are a number of interesting tax-planning ideas attractive for both high- and middle-income taxpayers. Tax advisers are responsible for identifying when clients might benefit from this type of planning and giving them the option of arranging their financial affairs in a way that allows them to maximize their benefits.

From Kevin Camperell, Robert T. Burson, Ronald A. Mitchell and Michael Young, Grice, Lund & Tarkington, Encinitas, CA

Roth IRA Life Insurance Planning Strategies

Life insurance is an integral part of many estate plans. The beneficiaries receive the proceeds income tax-free and maybe even estate tax-free, if the insured did not retain incidents of ownership at death. In addition, many are not yet aware of available planning strategies using life insurance and traditional individual retirement accounts (IRAs) and the new Roth IRAs. Although IRAs are not permitted to purchase life insurance, they often are integrally involved in tax- and estate-planning strategies in which life insurance plays a crucial role. Life insurance can provide liquidity for estate taxes, so funds do not have to be withdrawn from an IRA account to pay the taxes.

Federal estate taxes become payable when a taxable estate exceeds the unified credit amount. If assets are needed at death to pay estate taxes and are withdrawn from a Roth IRA, such a withdrawal diminishes the tax-free benefit of having established a Roth IRA in the first place. This is when life insurance comes into play; it can ensure that the funds necessary to pay estate taxes will be available without having to make a withdrawal from a Roth IRA.

To exclude insurance proceeds from the decedent's estate tax return, the decedent must have not retained any incidents of ownership at the time of death. Incidents of ownership include the power to change beneficiaries, the power to change trustees of an irrevocable insurance trust that owned the policy, the power to surrender the policy and the power to borrow against the policy's cash value.

IRA owners must be careful as to the source of the funds used to purchase life insurance. Roth IRA owners should use all non-Roth IRA sources first before withdrawing from a Roth IRA. Because Roth IRA assets are forever shielded from income tax, they are likely to be the Roth IRA owner's most valuable assets from a tax standpoint.

One source that should be considered is assets in a regular IRA account. Because the combined estate and income tax payable on a regular IRA can easily reach 80% or more if the funds are withdrawn at death, it may make sense for the traditional IRA owner to withdraw amounts from the traditional IRA and give these amounts to his heirs. If the gifts are used by the heirs to purchase life insurance on the IRA owner's life, the ultimate proceeds payable on the death of the IRA owner will not be subject to either income or estate tax.

If a person wants to use this strategy but has not yet reached age 59 1/2, he can take substantially equal distributions over his life without incurring the 10% penalty, IRA accounts can be divided into two separate IRAs to produce the necessary payment amounts. Anyone opting for this method must understand the importance of continuing the payments until age 59 1/2 (but, in no case, less than five years).

Although IRA accounts are not permitted to own life insurance, qualified plans can purchase life insurance if the plan allows this type of investment and meets certain other requirements. Life insurance purchased through a qualified plan is included in a decedent's estate. For this reason, anyone with life insurance in a qualified plan may want to consider ways to get the life insurance out of that plan and into an entity that would not provide the insured with an incident of ownership.

An insurance policy cannot be rolled into an IRA and generally is taxable on distribution, up to the policy's cash surrender value. Once the policy is out of the qualified plan, the insured can give the policy to the policy beneficiaries. This will remove the death proceeds from tine insured's estate (as long as the insured survives for three years after the date of the gift).

If the insured sells the policy to a third party for the policy's fair market value, the proceeds are not subject to estate tax, even if the death of the insured occurs within three years of the sale; the three-year rule applies only to gifts within three years of death.

If a sale occurs, however, the purchaser will have to pay income tax on the proceeds, unless the purchaser is the insured, a partner of the insured, a partnership in which the insured is a partner or a corporation in which the insured is a shareholder or officer.

Life insurance payable through a life insurance trust or purchased by a person other than the insured generally is not included in the decedent's estate.

In summary, a Roth IRA, combined with life insurance not owned by the IRA owner to cover the estate tax liability created on the IRA owner's death, may provide a valuable asset to the Roth IRA owner's heirs.

From Darlene Plumly, CPA, Mann Frankforst Stein & Lipp, P.C., Houston, TX

Recent Case Recognizes Built-In Capital Gains Tax for Valuation Purposes

The repeal of the General Utilities doctrine by the Tax Reform Act of 1986 (TRA '86) makes it virtually impossible for a taxable corporation or an S corporation subject to the built-in gains tax to sell or distribute appreciated assets without incurring a taxable gain. This is not a problem for a partnership or a limited liability company, because these entities are taxed on an aggregate (rather than on an entity-level) basis.

In valuing companies, a discount for the inherent built-in capital gains tax liability was not normally recognized by the courts, because the gain often could be avoided or minimized in a liquidation (Est. of Frank A. Cruikshank, 9 TC 162 (1947)). Likewise, the cost of liquidation, including sales commissions or income taxes paid, normally was not taken into account for valuation purposes when the prospect of liquidation was speculative (Charles W. Ward, 87 TC 78 (1986), and Frederic G. Krapf, Jr., Ct. Fed. Cls. (1996)).

In 1989, the IRS reaffirmed its position in Letter Ruling (TAM) 9150001, stating that a corporation's inherent built-in capital gains tax liability could not be considered in valuing the corporation's stock--despite the repeal of the General Utilities doctrine--in the absence of evidence that a liquidation was actually contemplated.

Many professionals vehemently disagreed with this ruling; it clearly contradicted the language of Rev. Rul. 59-60, which was the basis for valuing companies and generally acknowledged that liquidation costs should be considered in valuing a business.

TAM 9150001 also seems contrary to the Service's own manual, which notes that, while prior case law indicates that prospective capital gains taxes and liquidation expenses are speculative and not includable in the valuation, subsequent to passage of the TRA '86, such a tax liability on liquidation is not necessarily speculative; see IRS Valuation Guide for Income, Estate and Gift Taxes (January 1994), pps. 9-15 and 9-16.

Because Regs. Sec. 20.2031-1(b) defines fair market value (FMV) as the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of all relevant facts, it seems reasonable that some discount should be appropriate, as the built-in capital gains tax will certainly reduce the price that a knowledgeable buyer would be willing to pay. It is unreasonable to believe that a willing buyer would not consider the unavoidable future taxes on a closely held corporation's asset in determining FMV. This is economic reality, even though it flies in the face of TAM 9150001.

In Est. of Davis, 110TC No. 35, the Tax Court recently held that the FMV of minority blocks of common stock should reflect a discount or adjustment for the corporation's built-in capital gains tax for gift tax purposes.

In this case, the taxpayer gave to his two sons shares in ADDI&C, which was primarily a holding company for various assets held by the taxpayer. The taxpayer admitted that ADDI&C had not adopted a formal plan of liquidation, nor was there any stated intention by ADDI&C to liquidate and distribute its assets (which included highly appreciated stock in Winn Dixie Stores). Nevertheless, the taxpayer's experts sought a discount or adjustment for all or a portion of the agreed-upon built-in capital gains tax of $26.7 million.

Contrary to a recent decision in which the built-in capital gains tax was not recognized for valuation purposes (Irene Eisenberg, TC Memo 1997-483), the Tax Court in Davis found it necessary to apply a discount or adjustment for the built-in capital gains tax, because it is what a hypothetical willing buyer and seller would have done at the valuation date. The court distinguished this from other cases, because all of the experts for both parties were of the opinion ADDI&C's built-in capital gains tax should be taken into account as a factor in ascertaining the FMV of the minority blocks of stock. While the Tax Court did not allow a discount or adjustment for the full amount of ADDI&C's built-in capital gains tax, it did allow an adjustment of $9 million. This represented approximately a 15% discount that was added to the lack of marketability discount, giving further credence to the fact that this issue must be specifically identified and argued by the taxpayer's experts.

From Roger W. Lusby, III, CPA, CMA, Frazier & Deeter, LLC, Atlanta, GA

Roth IRA for Estate Planning

Roth individual retirement accounts (IRAs) are the rage of retirement planning. Lost in the shuffle is that Roth IRAs can also be powerful estate planning tools.

Example: Over the years, a married couple, B and T, have accumulated substantial IRAs. They have both just turned 65 and retired. Their combined IRA total is approximately $500,000. In addition, they have liquid assets of over $300,000, own their own home (worth approximately $200,000) and have no outstanding debts, B receives a pension of approximately $1,000 a month, and B and T receive combined Social Security of approximately $1,500 a month. They have two children, ages 32 and 35, and two grandchildren. While they do not anticipate needing funds from their IRAs, they want to make sure that they are available.

Because B and T currently do not need their IRA funds, converting them to Roth IRAs for better control of distributions appears an obvious choice. There are no required distributions from a Roth IRA; B and T will thus have better control of their finances and allow their IRAs to continue to grow tax-free.

B and T must also decide who will be the beneficiary of their IRAs when they die. This is a very difficult choice; B and T want to make sure that they will always be financially independent and not reliant on their children. Therefore, like most people, B and T want each other to be their IRA beneficiaries. This would provide maximum financial security for the couple. On the death of either, tine surviving spouse can roll over the IRA into an individual IRA.

However, the conversion to a Roth IRA offers B and T another planning opportunity. Because a Roth IRA does not have a required beginning date, it enables its owner to change beneficiaries, regardless of age. The new beneficiary can be a trust for the benefit of either or both of B and T's children; B and T could even make their grandchildren the beneficiaries. If properly structured, distributions would be made over the life expectancy of the oldest beneficiary. During this time, funds would continue to accumulate tax-free. Of course, on the owner's death, the IRA will be included in the decedent's estate.

Like many Roth IRA situations, this strategy is still evolving. However, considering the effort put forth in gift and estate tax planning, this strategy should be evaluated for many taxpayers.

From Michael D. Koppel, CPA, Gray, Gray & Gray, Boston, MA

EXPENSES

Qualified Long-Term Care Services

Effective for expenses incurred after Dec. 31, 1996, deductible medical expenses include unreimbursed expenses for "qualified long-term care services." Under Sec. 213(d)(1), these expenses include necessary diagnostic, preventive, therapeutic, curing, treating, mitigating and rehabilitative services. However, they also include expenses that many may have overlooked since the law was originally introduced. Maintenance or personal care services required for chronically ill individuals are now deductible. These expenses must be provided under a plan of care prescribed by a licensed health care practitioner on an annual basis. This is an important change, as these types of expenses can add up quickly.

A chronically ill individual is defined as an individual certified within the preceding 12-month period by a licensed health care practitioner as meeting one of the following three tests:

1. Unable to perform, without substantial assistance from another individual, at least two activities of daily living (i.e., eating, toileting, transferring, bathing, dressing and continence) for at least 90 days due to a loss of functional capacity;

2. Having a level of disability (as determined by regulations) equivalent to the level described in the first test; or

3. Requiring substantial supervision to protect such individuals from threats to health and safety because of severe cognitive impairment.

It is important to note that, if the person meets any of these tests but does not obtain certification of this fact from a licensed health care practitioner, the maintenance or personal care services expenses will not qualify for deduction. A licensed health care practitioner is a physician, a registered professional nurse or a licensed social worker.

Maintenance or personal care services are defined as care, the primary purpose of which is providing needed assistance with any of the above disabilities. These expenses may include meal preparation, household cleaning and other similar services that the chronically ill person is unable to perform. If performed by a spouse or relative, no deduction is allowed unless the spouse or relative is a licensed professional with respect to those services.

From Darlene Plumly, CPA, Mann Frankfort Stein & Lipp, P.C., Houston, TX

GAINS & LOSSES

Favorable Rules for Sale of C Stock

Two related provisions provide for the favorable treatment of gain from the sale of certain C stock. If the stock qualifies as qualified small business (QSB) stock, the sale may qualify for either 50% exclusion of gain or the rollover of gain to an investment in QSB stock in a new corporation. The 50% gain exclusion requires a five-year holding period, while the rollover of gain requires only a six-month holding period.

The 1993 Revenue Reconciliation Act introduced a 50% exclusion of gain for sale or exchange of QSB stock (Sec. 1202). Because of the "sale or exchange" language in Sec. 1202, a taxable exchange of stock, a redemption qualifying for exchange treatment under Sec. 302(b) and a liquidation of a corporation may qualify for the 50% exclusion, provided the corporation and the taxpayers' stock otherwise qualify. The stock must be held for more than five years and must be issued to the taxpayer by the corporation after Aug. 10, 1993. Thus, 1998 is the first year that a sale or exchange will qualify for the 50% exclusion.

New Sec. 1045, added by the 1997 Taxpayer Relief Act of 1997, provides for the rollover of capital gain from the sale of QSB stock. When the requirements of Sec. 1045 are satisfied, gain from the sale of QSB stock is recognized to the extent that the amount realized from the sale is greater than the cost of QSB stock purchased during the 60-day period beginning on the date of the sale. This provision requires only a six-month holding period to qualify.

Critical to the application of either of these provisions is the definition of QSB stock. To qualify, the stock must be C stock acquired by original issue from the corporation. The stock must be acquired in exchange for money, property or services rendered to the corporation (other than as an underwriter). Certain types of businesses will not qualify, including professional corporations (e.g., health, law and engineering), and corporations whose principal asset is the skill or reputation of employees, banking, finance and insurance, farming, mineral production and hotels and motels. The corporation must use at least 80% of its assets in an active business other than a prohibited business, for substantially all of the period for which the stock is held. Not more than 10% of corporate assets may be invested in real estate not used in the active business or in stock or securities of nonsubsidiary corporations. Finally, gross assets may not exceed $50 million before and immediately after the issuance of stock. Value is measured by adding cash and the adjusted basis of other assets.

Additional requirements and exceptions for purposes of qualifying as QSB stock include limitations on redemptions; aggregation of a parent and subsidiary controlled group with 50%, rather than 80%, ownership constituting a controlled group; lookthrough of a parent corporation to its subsidiary corporations in determining assets and activities; qualifications as to computer royalties; conversion of stock to other stock in the same corporation; treatment of stock held in passthrough entities; and stock acquired in a transfer, to and from, another entity. Interestingly, when property is transferred to a corporation for stock in a Sec. 351 transfer, the stock is treated as having been acquired on the date of the exchange (no tacking of holding periods), and the basis of the stock acquired is considered to be not less than the fair market value of the property transferred.

The effective tax rate for gain from sale of stock subject to the 50% exclusion may not be as low as one would expect. Gain subject to the 50% exclusion is taxed as 28% gain, rather than at the 20% long-term gain rate. This gives an effective rate of 14% (compared to 20% for most long-term gains). Also, 42% of the amount excluded is a tax preference for purposes of the alternative minimum tax.

An alternative to the 50% exclusion is the elective rollover of gain from sale of QSB stock. The qualifications for the stock of the corporation being sold are generally the same as for the 50% exclusion, the primary exception being the holding period for the stock sold is only six months to roll over gain. The taxpayer seeking to roll over gain has only 60 days front the sale to acquire QSB stock. The taxpayer's basis in the replacement stock is reduced by the gain deferred under the rollover rule. The holding period for the replacement stock includes the holding period for the stock sold, but not for purposes of computing a subsequent six-month holding period. For purposes of only the rollover election, the active business requirement need only be met during the initial six-month period after the taxpayer holds the replacement stock. Gain not fully absorbed by rollover should qualify for the 50% exclusion if the longer holding periods are met.

Sec. 1045 refers to the "sale" of QSB stock, rather than to a "sale or exchange." While this may cast some doubt on other transactions (such as a liquidation or redemption of stock), the Conference Report refers to a "sale or exchange" to describe the rollover of gain.

The stated purpose of these provisions is to encourage investments in new ventures, small businesses and specialized small business investment companies. For a taxpayer with a C corporation that fits all of the complex requirements, the 50% exclusion and the rollover of gain can provide additional tax savings when disposing of stock in the corporation. These benefits are available, regardless of the original intent in forming the corporation.

From Cecil M. McPherron, CPA, MT, Anderson & Whitney, P.C., Greeley, CO

INDIVIDUALS

Divorce, Child Custody and the Dependency Exemption

The Tax Reform Act of 1986 simplified rules for dependency exemptions for children of divorced parents by generally ,allowing the custodial parent to take the exemption. The law allows very narrow exceptions to this general rule. The rules appear to make this area quite clear; however, many divorce instruments (agreements and court decrees) still address the questions of which parent gets the dependency exemption, and what happens when the exemption is awarded to the noncustodial parent in the divorce instrument and the parents do not comply with the Service's requirements. Several Tax Court memorandum decisions help to address this issue.

Dependency exemption disputes may arise in the course of a routine IRS audit. However, they may also arise when divorced or separated parents disagree over the terms of their divorce instrument, or when one party simply chooses to ignore the terms of the divorce instrument. One taxpayer may claim a child for the same tax year for several provisions, such as the dependency exemption, earned income credit, filing status, etc. The Service's computer matching programs can easily detect this type of error. Both parties claiming the dependent will receive an IRS notice indicating that more than one taxpayer claimed the child, asking them to check their records and correct any errors.

Sec. 152(e)(1) provides that the custodial parent is entitled to the dependency exemption for children of divorced parents. The custodial parent is defined as the parent with custody for the greater portion of the calendar year. There are three exceptions that may allow a noncustodial parent to claim the exemption:

1. The custodial parent may sign a written declaration that he will not claim the child, and the noncustodial parent must attach this declaration to his return for the tax year in question. The Service provides Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents. The declaration must be made on Form 8332 or must conform substantially to that form.

2. The parties have executed a multiple support agreement. The multiple support agreement applies when no one person contributes over half of the child's support during the year. This exception does not apply in most divorce cases; the parents usually provide all of the child's support.

3. The parents may be operating under an unmodified pre-1985 divorce instrument. If that instrument provides that the noncustodial parent is entitled to the exemption and that parent provides at least $600 of the child's support, he is entitled to the exemption.

The requirements of the first exception may not be met for many reasons. The actual custodial parent may refuse to sign the written declaration because of violations (alleged or otherwise) of other provisions of the divorce instrument by the noncustodial parent, violation by the custodial parent (e.g., failing to execute the form) or other reasons. Due to ignorance of the requirements or a lack of concern, the noncustodial parent may fail to request the written declaration from the custodial parent. Any and all of these scenarios have arisen in court cases.

McCarthy, TC Memo 1995-557, addresses a typical dispute of this type. McCarthy and his former spouse entered into a voluntary divorce agreement that provided joint legal custody of their three children; physical custody of the children was given to his ex-wife. The agreement also contained a provision stating that for all years that McCarthy made all of his child support payments, his ex-wife would make the required written declaration to allow him to claim the dependency exemptions for their children. During 1991, it was determined that McCarthy was in arrears in child support payments. Consequently, his ex-wife did not sign the written declaration for that year and claimed the children as dependents on her tax return. McCarthy argued at trial that the exemptions taken in prior years were not disallowed (implying that the exemptions taken in 1991 should not be disallowed), and that his ex-wife wrongly refused to provide the written declaration in violation of the divorce agreement. The Tax Court ruled against McCarthy; it found that none of the exceptions to the general rule applied. The Tax Court was not concerned with the status of the divorce agreement in some other court proceeding.

In Paulson, TC Memo 1996-560, the divorce instrument provided that the ex-wife had sole legal and physical custody of the minor child. It gave Paulson the right to claim the exemption for any year in which he was current on child support payments throughout the year and current at the time of filing his tax returns. The instrument further stipulated that the custodial parent "shall execute IRS Form 8332 in accordance with present and future Internal Revenue Code provisions and corollary state income tax forms, so that the foregoing Order is fully implemented."

Paulson claimed the exemption for his minor child on his tax return without attaching the required written declaration. At trial, the Service agreed that he was current on all of his child support payments for the years at issue. The facts did not indicate whether the custodial parent refused to sign the declaration or was never asked, but the Tax Court did not indicate that this would be relevant. Instead, the court explained that, if Paulson's "former wife refused to comply with the requirements of the divorce decree, his recourse was to seek relief against her in the State court that issued the decree." The Tax Court, which had jurisdiction over the Federal income tax laws, was not: the appropriate court in which to seek relief over a violation of a state court instrument. Because the appropriate form had not been fried with the return, the Tax Court simply denied the deduction for the exemption.

The last case addresses a timeliness issue as to the filing of the written declaration. In Presley, TC Memo 1996-553, the noncustodial parent (Presley) also claimed an exemption for his two children without attaching the required written declaration (signed by his former spouse) to his return. (The case did not discuss a divorce instrument.) Presley unsuccessfully attempted to argue that the children resided with him for over six months of the year. He did submit a signed Form 8332 at trial; however, the form was signed almost a year after Presley filed the tax return at issue. The Tax Court ruled that, because the Form 8332 was not timely filed (with the tax return), it did not meet the exception and he was not entitled to the exemption.

These decisions make one point perfectly clear: The rules must be complied with specifically, or the dependency exemption will not be allowed. Neither the IRS nor the Federal courts will try to settle disagreements over state court-issued divorce instruments. Further, the requirement that the written declaration be attached to the taxpayer's return when filed will not be overlooked. This could cause problems for taxpayers truly unaware of the requirement. Unfortunately, there are no provisions to allow a retroactive filing of the Form 8332 to correct the omission.

Practitioners need to be aware of, and to counsel divorced clients wisely as to, these rules. Taxpayers need to be aware that divorce instruments are not binding for Federal income tax purposes on the issue of dependency exemptions, unless the requirements of the Federal tax laws are also met. Costly state court battles over provisions of divorce instruments may be wasteful and do not always resolve the issue for tax purposes.

From Cheryl Metrejean, CPA, Ph.D., University of Mississippi, University, MS (not associated with AFAi)

Expecting a New Credit? Beware the AMT

For some time before the Taxpayer Relief Act of 1997 (TRA '97) was even negotiated, the Administration had lobbied hard for a $500-per-child tax credit. Not only did the final bill contain such a provision, but other education credits appeared as well, including the Hope Scholarship Credit and Lifetime Learning Credit. Tax professionals quickly minimized the importance of these credits, noting that most of their clients would exceed the income limits.

Clearly, these new credits are targeted to the "middle-income" taxpayer, earning less than $100,000 beginning in 1998. It is probably a fair assumption that the majority of these taxpayers either prepare their own tax returns or use a basic preparation service, and are unprepared for alternative minimum tax (AMT) consequences. While it is true that clients in this income range do not generally owe AMT, the new credits will raise AMT concerns. (Note: The Onmibus Budget Bill recently passed by Congress provides that these credits will be allowed against AMT only for 1998 returns.)

First, the initial AMT tax rates are significantly higher than the 15% base rate for regular tax. This rate differential is usually more than offset by the $45,000 AMT exemption for married taxpayers ($33,750 for single individuals). Second, these taxpayers usually realize substantial tax savings from the personal exemptions and standard deduction, not allowed in the calculation of AMT income. Finally, while the new credits can significantly reduce their regular tax bill, the credits cannot reduce the AMT.

Consider the following basic 1998 examples:

Example 1: Husband H and wife W file jointly and claim four children as dependents. Two are minors, and two are in the first two years of college, with H and W spending more than $2,000 in qualifying educational expenses on each. H's and W's total income is one $75,000 salary. After claiming $800 in charitable deductions, $8,000 in mortgage interest and $5,000 in state taxes, H and W report taxable income of $45,000. Before the credits, regular tax is $7,095, while AMT would be $5,512. On the surface, H and W qualify for two $400 child credits, and two $1,500 Hope credits, totaling $3,800. However, because the credits cannot be applied to AMT, the maximum total credit to be received is $1,583--the difference between regular tax and AMT. Over $2,000 in expected credits fail to materialize.

Example 2. The facts are the same as in Example 1, except that the family cannot itemize deductions. After the $7,100 standard deduction, taxable income is $51,700. The tax due before credits is $8,971 ($7,800 in AMT).

Again, H and W would seem to qualify for $3,800 in new credits, but their regular tax bill can be reduced only to the $7,800 in AMT. This returns $1,171 in net credits; over $2,500 in gross credits were lost.

To plan for these issues, tax professionals must begin to consider AMT consequences for middle-class taxpayers. In the first example, if the taxpayers could have deferred some or all of the state tax payments until the following year, the net Federal tax bill would be unchanged; the increase in regular tax would be offset by available credits. (For a client who faces AMT every year, the timing usually just defers the AMT problem until another year.) In the case of these lost credits, the Hope Credit is only available for two years per student, and the taxpayers will lose the child tax credit when the child reaches age 17. Perhaps the tinting of AMT preference and adjustment items will not penalize the taxpayer in a later year.

It is quite tempting for an experienced preparer to answer "off-the-cuff" and tell the client (using examples) that he will receive $3,800 in credits. The temptation to answer quickly is even greater for the more simple tax situations, when the tax professional feels quite comfortable. However, these examples show that tax professionals cannot underestimate the effect of AMT when planning for the new credits.

From R. Milton Howell, III, CPA, Davenport, Marvin, Joyce & Co., LLP, Greensboro, NC

TRA '97 Makes Education More Affordable

The Taxpayer Relief Act of 1997 (TRA '97) contained a number of incentives aimed at making higher education financially attainable for more Americans. The incentives reduce the cost of education while providing additional opportunities to save and pay for education.

Education Tax Credits

The Hope Credit is available for students who have not completed their first two years of post-secondary education. The credit is available for tuition paid after 1997; books, room, board and other expenses do not qualify. The credit is 100% of the first $1,000 of eligible expenses, plus 50% of the second $1,000 (for a maximum credit of $1,500). The Hope Credit is per student; a taxpayer may take the credit for himself, his spouse and any eligible dependent. To qualify, the student must be enrolled on at least a half-time basis in a degree, certificate or other program for at least one academic period beginning during the tax year.

The Lifetime Learning Credit is available for qualified expenses paid after June 30, 1998 for eligible students. Qualified expenses include tuition and academic fees for undergraduate, graduate and professional degree courses for students, regardless of the course load. Any courses that improve or develop job skills also qualify. Only one credit per return is allowed, regardless of the number of qualified students. The credit is 20% of up to $5,000 of qualified tuition and related expenses ($10,000 in 2002).

The Hope and Lifetime Learning Credits are calculated on Form 8863. The credits begin to phase out when adjusted gross income (AGI) reaches $40,000 and are completely phased out when AGI reaches $50,000 for single taxpayers ($80,000 and $100,000 for joint filers). Taxpayers may not take both credits in any year for the same student, and neither credit is refundable. Even though the credits have relatively low phaseout limits, they may subject taxpayers to alternative minimum tax.

Beginning in 1998, qualified student loan interest is deductible as an above-the-line deduction for the first 60 months in which interest payments are made. Therefore, the deduction is available whether or not the taxpayer itemizes. The deduction may be taken only by the person primarily liable on the loan. Only the first $1,000 of interest paid in 1998 is deductible. The phaseout for single taxpayers is AGI between $40,000 and $50,000 ($60,000 and $70,000 for joint filers).

Education IRAs

Education IRAs allow taxpayers to invest $500 per year for each family member under the age of 18. These contributions are not tax deductible, but grow tax-free. Withdrawals are tax-free if they are used to pay qualified higher education expenses. Distributions not used for education expenses and those made in the same year that either the Hope or Lifetime Learning Credit is claimed are taxable. Therefore, careful planning is needed to maximize the benefits of the education credits and education IRAs. Contributions can only be made by single taxpayers with modified AGI between $95,000 and $110,000 ($150,000 and $160,000 for joint filers).

Early withdrawals from IRAs used to pay for the qualified higher education expenses of a taxpayer, his spouse or any child or grandchild are exempt from the 10% penalty on early withdrawals. Qualified higher education expenses include tuition, books and fees required for enrollment or attendance at a post-secondary educational institution, including graduate-level courses. The exemption to the penalty is effective for distributions made after 1997 and used to pay for academic periods beginning after that date.

The TRA '97 is very beneficial to taxpayers taking postsecondary classes, saving for their children's education or paying off existing loans. To take full advantage of these education incentives, planning should begin well before college applications are filed.

From Paul Brannelly, Gray, Gray & Gray, Boston, MA

PARTNERS & PARTNERSHIPS

Partnership Year-End Closing When a Partner Dies

Sec. 706(c)(1) delineates the general rule that the tax year of a partnership or a limited liability company taxed as a partnership shall not close as the result of a partner's death, the entry of a new partner, the liquidation of a partner's interest in the partnership or the sale or exchange of a partner's interest in the partnership. Exceptions to this general rule are provided for a termination of a partnership (enacted as part of the Taxpayer Relief Act of 1997 (TRA '97)) or for a disposition of a partnership interest (as provided under Sec. 706(c)(2)).

Old Law

Prior to the TRA '97, Sec. 706(c)(2) identified exceptions to this general rule. These exceptions provided that the tax year of a partnership shall close with respect to a partner who sells or exchanges his entire interest in a partnership or whose interest is liquidated. However, the tax year of a partnership with respect to a partner who dies shall not close prior to the end of the partnership's tax year. This had the effect of including all income in the year of a partner's death on the partner's estate income tax return. This is due to the fact that income from a partnership is included in the tax year of a partner in which the end of the partnership year falls (Sec. 706(a)). This reporting of income on the partner's estate return could be detrimental (due to the accelerated tax brackets on the fiduciary return).

If an agreement exists at the date of death of a partner, the terms of which cause a sale or exchange of the decedent partner's interest in the partnership as of the date of death, the tax year of a decedent partner shall close on the death of such partner (Regs. Sec. 1.706-1(c)(3)(iv)). Accordingly, a partner who wished to end his tax year, in regards to an interest in a partnership, would have to take the time to document such an agreement prior to his death.

The House Report for the TRA '97 states in part:

The rule leaving open the partnership taxable year with respect to a deceased partner was adopted in 1954 to prevent the bunching of income that could occur with respect to a partnership reporting on a fiscal year other than the calendar year. Without this rule, as many as 23 months of income might have been reported on the partner's final return. Legislative changes occurring since 1954 have required most partnerships to adopt a calendar year, reducing the possibility of bunching. Consequently, income and deductions are better matched if the partnership taxable year closes upon a partner's death and partnership items are reported on the decedent's last return.

New Law

The TRA '97 revised Sec. 706(c)(2). The new law provides that the taxable year of a partnership will close with respect to a partner whose entire interest in the partnership terminates (whether by reason of death, liquidation or otherwise). This change limits the partnership flowthrough income to the decedent, in the year of death, to partnership earnings prior to the date of death. In addition, partnership earnings after the date of death can be reported to the decedent's estate on a separate Form K-1.

Conclusion

Two fundamental benefits result from the change to the closing of the partnership's tax year for a deceased partner. First, a better matching of income results from the bifurcation of the tax year as of the date of death. Second, the need for written agreements to end a partnership's tax year for a partner's death is eliminated. Income in respect of a decedent and payments to retired partners should be reviewed for special tax treatment under Secs. 691, 736(a) and 753.

From Thomas Dominic Cervino, CPA, Toback CPAs, P.C., Phoenix, AZ

Release of Limited Partners' Investor Notes Considered Deemed Cash Distribution

In a recent decision (Dakotah Hills Offices Limited Partnership, TC Menlo 1998-134), an agreement releasing limited partners from the payment of their own investor notes was successfully treated by the IRS as a deemed cash distribution under Sec. 752(b).

Limited pampers in various real estate limited partnerships gave security interests in their own investor notes to be used to capitalize the partnerships. The partnerships then obtained guaranty bonds on the notes, assigned the notes to financial institutions (as required for loan collateral) and used the loans in their real estate enterprises. When the partnerships went bankrupt in 1989, the financial institutions first looked to the limited partners for loan repayment, based on the investor notes, and when that was not successful, to the issuer of the guaranty bonds. Once the bond company paid the financial institutions, it became, by agreement, a creditor of the partnerships and the owner of the limited partners' investor notes. After pursuing collection in court, the bond company entered into an agreement with the limited partners releasing them from their obligations on the notes, by allowing them to either "abandon" or "convey" their interests in the partnerships to the bankruptcy trustee.

For a deemed distribution of cash under Sec. 752(b), there must be a decrease in a partner's share of partnership liabilities in the partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities. The limited partners in this case intended the extinguishment of their investor notes to be classified as a "purchase price reduction" within the meaning of Sec. 108(e)(5). This section allows a "solvent" debtor to exclude income from the forgiveness of debt in certain circumstances. The limited partners considered their investor notes to be partnership assets and, therefore, a "debt of a purchaser of property to the seller of such property which arose out of the purchase of such property ..." This would presumably meet the requirements of Sec. 108(e)(5).

If the return of the investor notes to the limited partners in exchange for their partnership interests were all that occurred, the limited partners might have prevailed; the Tax Court stated that "[a] partner's contribution of a promissory note to a partnership will not, in and of itself, establish basis since the note is not deemed to be cash, and is not property in which the partner possesses a basis." Thus, the converse (i.e., the return of a limited partner's own note) would not result in a deemed distribution under Sec. 752(b). However, the opinion goes on to point out that, if a limited partner's share of the liabilities of the partnership itself is increased on the contribution of a promissory note, such an increase will be treated as a contribution of money and will increase the partner's basis under Sec. 752(a).

In the opinion of the Tax Court, the complicated financing arrangements (which were apparently required by the financial institutions) made each limited partner liable for the partnership recourse liabilities, up to and including the amount of that limited partner's own note in the event of default by the partnership: "The sum and substance of the foregoing transactions reflect that the limited partners did not unilaterally possess rights of reimbursement from the partnerships or the general partners for amounts owed by the limited partners to the lenders with respect to the investor notes." Therefore, pledging these notes as collateral for loans to the partnerships increased the basis in their partnership interests, and the settlement agreement with the bond company regarding these notes decreased their share of partnership liabilities and was therefore a deemed distribution of cash under Sec. 752(b).

Could the limited partners have protected themselves from this result? The limited partners might have prevailed in their contention that they only were receiving a "return" of their original investment, if they had a right of reimbursement from either the partnerships or the general partner. Instead, the limited partners were aware from the beginning of the partnership that their own investor notes would be applied as collateral for loans, and that the loan guarantor would have a right to collect from them if the partnership defaulted.

From Eileen W. Belkin, CPA, Gray, Gray & Gra, Boston, MA

S CORPORATIONS

Planning Ahead for S Elections

A common corporate election is changing from C to S status. This transition is easy for a calendar-year corporation; the process could be as simple as filing Form 2553, Election by a Small Business Corporation (Under section 1362 of the Internal Revenue Code), in either the year before or by March 15 of the year in which the change is to take effect. However, this process is not as easy for fiscal-year C corporations that elect to become S corporations and are required to change their year-ends. These corporations go through more obstacles, which need to be addressed throughout the election-making planning process.

A fiscal-year corporation has tinting difficulties electing S status; the IRS does not allow a C corporation to become an S corporation immediately following the corporation's short period. When a fiscal-year corporation decides to elect S status, the effective date of the election is an important factor. The process of electing to become an S corporation is a decision that requires careful planning. For example, if a corporation with a Sept. 30, 1998 year-end elected S status and chose to change its tax year to a calendar year-end, it would not be eligible to become an S corporation until Jan. 1, 2000. In addition, a corporation is not allowed to change its tax year if it has done so within the past 10 years. There was one year, however, when the Service made it easy for a fiscal-year corporation to elect S status; this was allowed under Notice 97-20 and was effective only for the 1997 tax year.

Notice 97-20 waived the limitations that restricted certain corporations from electing S status in a timely fashion. Under Notice 97-20, a fiscal-year C corporation could elect S status in the period immediately following the short period. The notice also waived the 10-year rule in which a corporation could not change its tax year (i.e., from a fiscal year-end to a calendar year-end), if it had done so within the past 10 years. If a corporation chose to elect S status under Notice 97-20, it could have a fiscal year-end during 1996, becoming an S corporation effective Jan. 1, 1997. To file under this notice, the taxpayer was required to file Form 2553 and Form 1128, Application to Adopt, Change, or Retain a Tax Year. On the top of both forms, the taxpayer had to write "Filed under Notice 97-20" The due date to be considered for this procedure was Feb. 15, 1997.

Unfortunately, the benefits received under Notice 97-20 were for only one year. Currently, if a fiscal-year corporation wants to elect S status, it could wait up to two years before the S election takes effect. In addition, if a fiscal-year corporation has changed its year-end within the past 10 years, it will not be eligible for the election. These factors are important when planning to choose an election. For example, assume a corporation with an Aug. 31, 1998 year-end wishes to elect to become an S corporation effective Jan. 1, 2000 and change its year-end to December. The corporation would file a short-period return for the period Sept. 1, 1998 through Dec. 31, 1998. The corporation would file its 1999 tax return as a C corporation for the calendar year, making it eligible to file as an S corporation for 2000. To achieve this, the corporation is required to file Forms 2553 and 1128 with the proper IRS office.

The corporation's due date for the Form 2553 is generally in the year prior to or by March 15 of the year in which the election is to take place; therefore, the Form 2553 will be due by March 15, 2000. Form 1128 is generally due two months and 15 days after the short period; therefore, the Form 1128 will be due by Feb. 15, 1999. If the taxpayer misses these deadlines, there is a provision that enables late applications to be considered timely filed. This occurs when a corporation qualifies under Temp. Regs. Sec. 301.9100-1T. Under this regulation, the Form 1128 will be considered timely filed if it is filed within 90 days of the original due date and if the corporation can confirm that it "has acted reasonably and in good faith" and that "granting relief will not prejudice the interests of the government." If these exemptions can be proven, the Form 1128 will be considered timely filed. For example, assume the above corporation misses the deadline to file the Form 1128. The original due date for the Form 1128 was determined to be Feb. 15, 1999. If the corporation qualifies under Temp. Regs. Sec. 301.9100-1T, it will have until May 16, 1999 to file the Form 1128 (90 days after Feb. 15,1999, the original due date).

Determining if and when a fiscal-year C corporation should become an S corporation involves many decisions. The major decisions are when it wants to become an S corporation and which year-end it will choose. Generally speaking, S corporations have a calendar year-end; however, the corporation can elect to have a fiscal year-end of September, October or November. In any case, when a fiscal year-end corporation is required to change its year-end, advance planning is suggested.

From Tricia Makrianis, CPA, Gray, Gray & Gray, Boston, MA

Reasonable Compensation

On Aug. 8, 1998, the IRS issued Prop. Regs. Sec. 1.1366-3. Before it can be issued in final form, however, hearings must be held so that interested parties may comment. Once the hearings have been completed, any changes will be made to the proposed regulation and it will be issued in final form and become law.

Under Prop. Regs. Sec. 1.1366-3, if a family member (as defined under Sec. 704(e)(3)) of one or more shareholders of an S corporation or a passthrough entity, whose interest is held by such family member, "renders services for, or furnishes capital to, the corporation without receiving reasonable compensation," the Service can make adjustments to the compensation based on amounts that would have been paid to outside parties for the same services. The IRS is proposing to make certain that related-party services are rendered for fair market value, even if this means reducing the previously reported taxable income of an S corporation and increasing the income reportable to the individual or partnership performing the service.

The proposed regulation can be illustrated by the following examples:

Example 1: Father F and son S own equally 100% of the stock in an S corporation. S provides services to the company valued at $50,000, for which he is compensated $25,000; F provides no services to the company. The company has taxable income of $100,000. Based on the facts and circumstances, the Service can allocate $25,000 of the company's taxable income to S so that taxable income of the company now becomes $75,000 and S's compensation becomes $50,000.

Example 2: F and S own equally 100% of the stock in an S corporation. The company paid compensation to a partnership for services performed. A partner in the partnership was S's wife. If the IRS determines that the partnership has not received reasonable compensation for its services under the proposed regulation, it may now adjust the compensation and therefore change the taxable income of not only the S corporation but also of the partnership and all shareholders and partners.

What the Service does not explain in the proposed regulation is how the compensation adjustment should be made on the company's and related entity's books. For instance, in Example 1, it is unclear whether the $25,000 adjustment to taxable income is a distribution on the company's books and, if so, whether the S election is now in jeopardy because of disproportionate distributions. Further, it is vague as to whether the adjustment is considered a gift or additional basis to the shareholder. These underlying issues lie at the heart of this proposed regulation, but the IRS has not as yet addressed them. The treatment of these adjustments is critical. Unrelated parties (such as S's wife in Example 2) could have their income affected. Since there is little guidance available, it is important to recognize the possible severity of the consequences of this proposed regulation.

From James A. Deleo, CPA, Gray, Gray & Gray, Boston, MA

S Corporation Election Waivers

The Small Business Job Protection Act of 1996 (SBJPA) granted the IRS authority to waive an invalid late S election. Thus, the Service could treat a late-filed election as timely, if it was determined a reasonable cause existed for the failure to make a timely election.

Previously, by law, the IRS could accept late-filed elections as effective only for the next calendar or fiscal period. This had significant consequences for start-up companies incurring losses; C corporation losses would be confined to the regular corporation and could not be used unless the S election was revoked within the time frame allowed for the net operating loss carryforward period. If the first-year C corporation generated profits and appreciation of assets, the corporation could be subjected to a 10-year holding period to avoid the Sec. 1374 built-in gains tax. The C corporation and individual shareholders would be required to prepare and file amended tax returns for the open tax years if the Service notified the corporation that a valid Form 2553, Election by a Small Business Corporation (Under section 1362 of the Internal Revenue Code), was not on file. A certified mail receipt was virtually the only method of providing evidence that a Form 2553 was timely filed.

The SBJPA provided the basis for the IRS to issue Rev. Procs. 97-40 and 97-48 on how to obtain automatic relief for late-filed S elections. A corporation is eligible for relief under Rev. Proc. 97-40 if:

1. The sole reason to fail to qualify as an S corporation is the result of Form 2553 being filed late (as defined by Sec. 1362(b)(1)); and

2. The due date for the tax return (excluding extensions) for the first intended S year has not passed.

The disclosure requirements (to be filed with the applicable IRS Service Center) to obtain relief are:

1. Within six months of the original due date of the S election, the corporation must file a completed Form 2553 signed by an authorized (to sign) officer of the corporation and all shareholders who were shareholders at any time from the first day of the tax year through the date the election was filed.

2. The phrase "Filed Pursuant to Rev. Proc. 97-40" must appear at the top of the completed Form 2553.

3. A statement must be attached, explaining the facts and circumstances for the failure to file a timely Form 2553.

Comment: A critical consideration in Rev. Proc. 97-40 lies in what constitutes reasonable cause for a late-filed election. The SBJPA committee reports instruct the Service to be reasonable in exercising: its authority in determining whether reasonable cause exists to grant relief. The Service should apply standards similar to those applied under present law (e.g., Rev. Proc. 94-23, for qualified subchapter S trusts (QSSTs) and other letter ruling requests). The subjectiveness of a reasonable cause interpretation makes it imperative to review the facts and circumstances surrounding the late filing, so the tax adviser may completely represent the unintended nature of the late filing. Balancing a poor communication pattern between client and adviser is crucial to avoiding a possible malpractice suit and to fulfilling the reasonable cause requirement.

Rev. Proc. 97-48 will grant the S corporation and shareholders automatic relief from a late election in only two situations.

First required fact pattern. The corporation's only reason for not qualifying as an S corporation was due solely to a late-filed Form 2553. The corporation and shareholders had reported their income consistent with S status for the initial year of the election and for all, if any, subsequent tax years. At least six months had elapsed since the filing of the first intended S year, and neither the corporation nor any shareholder had been notified of problems regarding S status during the six months following the first timely filed Form 1120S.

The filing disclosures for automatic relief required the corporation to file, with the applicable service center or district director, if under examination:

1. A completed Form 2553, signed by an authorized (to sign) officer of the corporation and all persons who were shareholders at any time during the period the corporation intended to be an S corporation;

2. Insert "Filed Pursuant to Rev. Proc. 97-48" at the top of the completed Form 2553;

3. Attach to the Form 2553 a dated declaration signed by an authorized (to sign) officer of the corporation and all persons who were shareholders at any time during the intended period of the S corporation, attesting that the corporation and shareholders reported their income, on all affected returns, for the initial and every subsequent year, consistent with the S status and "under penalties of perjury, to the best of my knowledge and belief, the facts presented in support of this election are true, correct and complete."

Second required fact pattern. The corporation's only reason for not qualifying as an S corporation was solely due to a late-filed Form 2553 for a tax year that began before 1997. The IRS notified the corporation that, for the first intended tax year, the election would be treated effective for the following tax year and a C return would be required for the first intended S year.

The corporation and all its shareholders reported their income properly, treating the corporation as an S corporation for the first intended S tax year, and reported their income consistent with S status for all subsequent years. The statute of limitations for assessment had not lapsed for any of the tax years of the corporation or shareholders, beginning on or after the first day the corporation intended to be taxed as an S corporation.

The filing disclosures for a required fact pattern require the corporation to file with the applicable service center (or district director, if under examination):

1. A completed Form 2553, signed by an authorized (to sign) officer of the corporation and all persons who were shareholders at any time during the period the corporation intended to be an S corporation;

2. Insert "Filed Pursuant to Rev. Proc. 97-48" at the top of the completed Form 2553;

3. Attach to the Form 2553 a dated declaration signed by an authorized (to sign) officer of the corporation and all persons who were shareholders at any time during the intended period of the S corporation, attesting that the corporation and shareholders reported their income (on all affected returns) consistent with the requirements for automatic relief, the corporation and shareholders agree to amend their tax returns for the first year and any other affected returns to reflect S status and "under penalties of perjury, to the best of my knowledge and belief, the facts presented in support of this election are true, correct and complete."

Corporations satisfying both situations are deemed to have a reasonable cause for a failure to file a timely S election and are granted automatic relief for S status commencing on the first date the corporation intended to be an S corporation. The IRS has been instructed to notify the corporation of the acceptance or denial of the untimely S election application.

These revenue procedures do not provide relief for late shareholder elections, including QSSTs, which are covered by Rev. Proc. 94-23, or for small business trust elections. Letter ruling requests are available for late elections not covered by Rev. Proc. 94-23, 97-40 or 97-48.

From Tim Kenyon, CPA, Cummings, Keegan & Co., P.L.L.P., Minneapolis, MN

RELATED ARTICLE: IN THIS DEPARTMENT

Employee Benefits & Pensions

* Long-term care planning; p. 810.

* Nondiscrimination safe harbors for Sec. 401 (k) plans; p. 811.

* Roth IRAs in estate planning; p. 812.

Estates, Trusts & Gifts

* Checks for noncharitable gifts paid after decedent's death; p. 814.

* Family tax planning after TRA '97: p. 815.

* Planning strategies for Roth IRAs using life insurance; p. 818.

* Recognition of built-in capital gains tax for valuation purposes; p. 818,

* Roth IRAs and estate planning; p. 820.

Expenses

* Qualified long-term care services; p. 820.

Gains & Losses

* Sales of C stock: p. 822.

Individuals

* Divorce, custody and dependency exemptions; p. 823.

* Educational credits and AMT; p. 826.

* Education planning after TRA '97; p. 826.

Partners & Partnerships

* Partnership year-end when partner dies; p. 827.

* Release of limited partners' investor notes; p. 828.

S Corporations

* Planning for S elections; p. 828.

* Reasonable compensation; p. 830.

* Waiver of elections; p. 832.

Unless otherwise indicated, contributors' firms are associated with AFAi.

Michael D. Koppel, CPA Partner Gray, Gray & Gray Accounting Firms Associated, inc. (AFAi) Boston, MA