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Succession tax planning motivated a tax-free split-up of a single business enterprise into four corporations for the benefit of the four children of the majority shareholder. In Private Letter Ruling 200842003, the distributing corporation had elected to become an “S” corporation less than ten years prior to the split-up.

The distributing corporation had two classes of common stock (Series A and B) that were identical in all respects, except that each share of Series A stock was entitled to X votes and each share of Series B stock was entitled to Y votes. All of the distributing corporation’s stock was owned by members of one family.

      Shareholder 5 was the mother of  Shareholders 1 through 4. She held all of her stock of the distributing corporation in a revocable trust (“Grantor Trust”). Shareholder 5 was the grantor of Grantor Trust and was treated as the owner of Grantor Trust under §674 and §676. Shareholder 5 was the sole surviving trustee of Grantor Trust.

      At the time of Shareholder 5’s death, the Grantor Trust will terminate and the successor trust will become an irrevocable trust.

      Upon the death of Shareholder 5, the trustee will distribute the assets in the Grantor Trust to anyone, including Shareholder 5’s estate, either outright or in trust, as  designated in Shareholder 5’s final will and/or trust. In default of the exercise of Shareholder 5’s power of appointment, the assets in Grantor Trust must be distributed equally among Shareholders 1 through 4.

      For valid business reasons, the distributing corporation consummated the split-up through the use of “D” reorganizations, along with the tax-free split-up rules for corporate separations, as follows:

1)   Distributing corporation created Controlled 1, Controlled 2, Controlled 3, and Controlled 4 (collectively, the “controlled corporations”).

2)   Distributing corporation  transferred all of its assets to the controlled corporations in exchange for all of the stock of each of the controlled corporations and the assumption by each of the controlled corporations of the liabilities associated with the assets transferred.

3)   Distributing corporation distributed pro-rata all of its stock in each of the controlled corporations to Shareholders 1 through 5 in exchange for all of the stock of the distributing corporation held by Shareholders 1 through 5. Each of the controlled corporations elected to become “S” corporations on the first available date after the distributions.

4)   Lastly, the distributing corporation was liquidated.

      Shareholder 5’s estate plan provided that her ownership interests in each of the controlled corporations be separated so that her children will inherit the stock in their respective trust. Therefore, the split-up distributions of the stock of each of the controlled corporations transpired for the following objectives:

First, to implement the business succession planning; and

Second, to avoid a shareholder deadlock after implementation of the plan by allowing each shareholder in the post-transition structure to independently manage their portion of the distributing corporation’s business.

      Shareholder 5 established four grantor trusts for the future benefit of her four children; Trust 1, Trust 2, Trust 3, and Trust 4.  Shareholder 5 was the grantor of each of the Trusts and was treated as the owner of each Trust’s assets under §671.

      Each of the four children became the  sole beneficiary of their respective trust.

      As gifts to her children, Shareholder 5 caused the Grantor Trust to transfer part of its stock in each of the four controlled corporations to trusts for the future benefit of the children.

      Concurrently, Shareholder 5 caused Grantor Trust to sell some of its stock in each of the four controlled corporations for promissory notes from each trust.

      Both the gift transactions and the sale transactions were disregarded for federal income tax purposes, because Shareholder 5 was the grantor of each of the Trusts and was treated as the owner of each Trust’s assets under §671.

            After the tax-free split-up distributions to the shareholders, each of the controlled corporations were, nonetheless, subject to the built-in gains tax in §1374 with respect to any asset transferred from the distributing corporation. However, the ten year recognition period had been reduced by the portion of the recognition period that had expired prior to the distributing corporation’s  transfer of assets in “D” reorganizations to each controlled corporation.

Shareholders in “S” corporations are not normally aware of the unique outcome that may occur on the repayment of the indebtedness due to a shareholder. Two of the landmark cases in this area of the tax law evolved in Cornelius v. Commissioner, 74-1  USTC ¶9446, (CA-5), aff’g 53 TC 417 and Brooks v. Commissioner, TCM  2005-204.

      In Brooks v. Commissioner, TCM  2005-204, the issue before the Tax Court was whether the advances of “open account” debt by shareholders to their closely-held “S” corporation provided the shareholders with basis to offset repayments of “open account” debt made by the company prior to each respective advance.

      Each of two shareholders, who owned 51% and 49%, respectively. of the “S” corporation stock, had a zero basis in their stock in the company. On three occasions, the shareholders had advanced money to the company on open account.

      Both shareholders contended that the basis of a shareholder’s “open account” debt was properly determined at the close of the “S” corporation’s tax year by first netting advances and repayments of “open account” debt during the tax year and then making any necessary debt basis adjustments.

      In Cornelius v. Commissioner, 74-1  USTC ¶9446, (CA-5), aff’g 53 TC 417, the Fifth Circuit Court of Appeals affirmed the finding of the Tax Court that advances by the taxpayers to their “S” corporation and the repayments of those advances constituted separate and complete transactions, as opposed to “open account” debt. The Court of Appeals stated:

        The real question to be decided is whether each advance to the corporation by the shareholders and  its corresponding repayment constituted a separate and complete transaction or whether the indebtedness should be considered as an open account whose fluctuations are to be measured for tax purposes at the end of each taxable year. * * * The Tax Court properly determined that “the 1966 loans and the [1967] repayments thereof constituted a completed transaction, and the loans occurring later in 1967 were separate and apart from such transaction.” * * * [Italics supplied.]

      Based on the Tax Court’s finding in Cornelius that the loans were separate transactions and not “open account” indebtedness, the taxpayers were required to recognize as taxable income the amount of the repayment in excess of the taxpayers’ basis in the advance at the time of repayment, without regard to the basis of a subsequent advance in the year of repayment.

      Upholding the shareholders in Brooks and rejecting the Revenue Service’s application of the Cornelius decision, the Tax Court decided that shareholder’s “open account” debt had been properly determined at the close of the “S” corporation’s tax year by first netting advances and repayments of “open account” debt during the tax year and then making any necessary debt basis adjustments.

      Important findings by the Tax Court in Cornelius were that the loans were separate transactions and were not open account indebtedness. Consequently, the taxpayer was required to recognize as taxable income the amount of the repayment in excess of the taxpayer’s basis in the advance at the time of repayment, without regard to the basis of a subsequent advance in the year of repayment.

      Based on the parties’ stipulations that the advances were open account debt and Commissioner’s failure to contend that any advance and repayment composed a separate transaction, the Tax Court decided that the basis of the open account indebtedness had been properly computed by netting at the close of the year advances of open account debt during the year and repayments of open account debt during the year. In essence, the advances in earlier tax years shielded the taxpayer from the realization of gain upon the repayments during those years.

      As a result, the decision of the Tax Court allowed the taxpayer in Brooks to defer indefinitely the recognition of income on any repayment of his open account debt over the several years during which the taxpayer and the “S” corporation had made advances and repayments, respectively.

      In the aftermath of the Brooks decision, proposed regulations were published in 2007 relating to the treatment of open account debt between “S” corporations and their shareholders.

      Final regulations were promulgated in TD 9428 to provide rules regarding the application of open account debt and the adjustments in basis of any indebtedness of an “S” corporation to a shareholder under  §1367(b)(2). With an effective date of October 20, 2008, the final rules for shareholder advances and repayments on advances in an open account debt were enunciated.

      As expressly stated in the Preamble to  TD 9428, the final regulations must be applied to any and all shareholder advances made on and after the effective date. Also, the final regulations must be applied to repayments on such advances.

      Nonetheless, if a shareholder had an open account debt (net of prior repayments in the taxable year) outstanding prior to the effective date of the final regulations, the rules under the prior final regulations must be applied to any repayments on such pre-effective date open account debt.

      An “S” shareholder may not make additional advances with respect to the pre-effective date open account debt (because all shareholder advances made on or after the effective date of the final regulations constituted a new open account debt subject to the final regulations).

      For instance, assume that the effective date of the final regulations fell within the taxable year of shareholder A’s “S” corporation. Also assume that, at the beginning of the “S” corporation’s taxable year, A had existing open account debt with an outstanding principal balance of $12,000. Assume further that A had made an additional advance of $3,000 to the corporation and had received a $2,000 repayment from the “S” corporation prior to the effective date. Thus, as of the effective ate, A had existing open account debt with an outstanding principal balance of $13,000. Thus, A must net the pre-effective date advance and repayment for the taxable year and combine that net advance of $1,000 with the $12,000 outstanding aggregate principal balance of the then existing open account debt.

      As a consequence, the $13,000 pre-effective date open account debt would not be subject to the final regulations and, thus, would not be subject to any aggregate principal threshold dollar amount and would be repaid under the rules of the prior final regulations.

      Further assume, that on or after the effective date of the final regulations, A had made both an advance of $5,000 to the “S” corporation and had received a $1,000 repayment on that advance, the advance and repayment would constitute a separate new open account debt subject to the rules under the final regulations.

      A reduction in the basis of indebtedness  due to a shareholder must be made if:

1)   Losses,

2)   Deductions,

3)   Noncapital expenditures,

4)   Nondeductible expenses, and

5)   Certain oil and gas depletion deductions

exceeded the basis of a shareholder’s stock in the corporation. Then, the excess amount must be applied to reduce (but not below zero) the basis of any indebtedness of the “S” corporation to the shareholder held by the shareholder at the close of the corporation’s taxable year. Regs. §1.1367-2(b).

      If for any taxable year there had been a reduction of a shareholder’s basis in an “S” corporation’s indebtedness, any net increase for any subsequent taxable year must be used to restore the basis of the debt before any net increase may be used to increase the basis of the shareholder’s stock. §1367(b)(2)(B).

      With respect to a shareholder, net increase means the amount by which the sum of the shareholder’s items of income and excess deductions for depletion exceeds the sum of the items of loss, deduction, noncapital nondeductible expenses, distributions, and certain oil and gas depletion deductions. Regs. §1.1367-2(c)(1).

      “Open account debt” means shareholder advances to the corporation not evidenced by separate written instruments and repayments on the advances. Regs. §1.1367-2(a)(2)(i).

      As a threshold limitation established by the Treasury Department, the aggregate outstanding principal of open account debt  must not exceed $25,000 of indebtedness of an “S” corporation to a shareholder at the close of an “S” corporation’s taxable year. Regs. §1.1367-2(a)(2)(i).

      For instance, if an “S” corporation had ten shareholders, the limitation on the open account debt must be limited to $250,000 as long as no single shareholder had advanced more than $25,000. Preamble to Regs. §1.1367-2(a)(2).

      Where a shareholder had made advances — not evidenced by a separate written instrument, net of repayments, — that exceeded an aggregate outstanding principal amount of $25,000 at the close of the “S” corporation’s taxable year, for any subsequent taxable year the aggregate principal amount of that indebtedness must be treated in the same manner as indebtedness evidenced by a separate written instrument. For any subsequent taxable year, that indebtedness must not be viewed as an “open account debt” and must be subject to all basis adjustment rules applicable to basis of indebtedness of an “S” corporation to a shareholder.

      Particularly important, both advances and repayments on open account debt must be treated as a single indebtedness.

      Basis restoration rules must be applied to “S” corporation debt held by a shareholder on the first day of the taxable year in which the net increase arose. Regs. §1.1367-2(c)(1).

      For example, suppose A and B had been the sole shareholders in Corporation X since 2000. As of the end of the 2008 taxable year, the bases of A’s and B’s stock were both zero. On June 1, 2009, A advanced X $16,000, which was not evidenced by a written instrument. On August 1, 2009, B advanced X $22,000, which was not evidenced by a written instrument. Both the $16,000 advance and the $22,000 advance were open account debt and remained outstanding at those amounts during 2009. There was no “net increase” year 2009.

      At the close of the 2009 taxable year, A’s open account debt did not exceed $25,000. A therefore carried forward to the beginning of the 2010 taxable year the $16,000 as open account debt.

      B’s open account debt did not exceed $25,000 at the close of the 2009 taxable year. B therefore carried forward to the beginning of the 2010 taxable year the $22,000 as open account debt. Regs. §1.1367-2(e), Exp. 6.

      As a continuation of Example 6, further assume that on December 31, 2009, A’s basis in the open account debt was reduced to $8,000, due to losses in excess of A’s basis in the stock of X. On April 1, 2010, X repaid A $4,000 of the open account indebtedness. On September 1, 2010, A advanced X an additional $1,000, which was not evidenced by a written instrument.

      In year 2010, there was, in fact, no net increase in the open account indebtedness.

      The $4,000 April repayment X made to A and A’s $1,000 September advance were netted to result in a net repayment of $3,000

for the taxable year on A’s $16,000 open account debt carried forward from 2009. Because there had been no net increase in 2010, no basis of indebtedness was restored for the 2010 taxable year.

      As a consequence, A realized $1,500 [$8,000/$16,000 x $3,000] of income on the $3,000 net repayment at the close of the 2010 taxable year.

      At close of the 2010 taxable year, A’s open account debt did not exceed $25,000. The net repayment of $3,000 for the taxable year on A’s $16,000 open account debt carried forward from 2009. Thus, A had an open account debt of $13,000 [$16,000 - $3,000] to carry forward as open account debt to the beginning of the 2011 taxable year. Regs. §1.1367-2(e), Exp. 7.

Administrative dissolution under state law did not terminate a corporation’s status as an “S” corporation in Private Letter Ruling 200835002. After its registration to conduct business under state law, the “S” corporation was administratively dissolved in the next year.

As expressly stated by the Revenue Service, the core test of corporate existence for purposes of Federal income taxation must be a matter of Federal law. Whether an organization must be taxed as a corporation under the Code must be determined by Federal, not state law. If the conduct of the affairs of a corporation continued after the expiration of its charter, or the termination of its existence, it became an association. Ochs v. United States, 158 Ct. Cl. 115, 305 F.2d 844, (1962).

A corporation must be subject to Federal corporate income tax liability as long as it continued to do business in a corporate manner, despite the fact that its recognized legal status under state law had been terminated. Messer v. Commissioner, 438 F.2d 774, (CA-3, 1971).

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Succession tax planning motivated a tax-free split-up of a single business enterprise into four corporations for the benefit of the four children of the majority shareholder. In Private Letter Ruling 200842003, the distributing corporation had elected to become an “S” corporation less than ten years prior to the split-up.

The distributing corporation had two classes of common stock (Series A and B) that were identical in all respects, except that each share of Series A stock was entitled to X votes and each share of Series B stock was entitled to Y votes. All of the distributing corporation’s stock was owned by members of one family.

      Shareholder 5 was the mother of  Shareholders 1 through 4. She held all of her stock of the distributing corporation in a revocable trust (“Grantor Trust”). Shareholder 5 was the grantor of Grantor Trust and was treated as the owner of Grantor Trust under §674 and §676. Shareholder 5 was the sole surviving trustee of Grantor Trust.

      At the time of Shareholder 5’s death, the Grantor Trust will terminate and the successor trust will become an irrevocable trust.

      Upon the death of Shareholder 5, the trustee will distribute the assets in the Grantor Trust to anyone, including Shareholder 5’s estate, either outright or in trust, as  designated in Shareholder 5’s final will and/or trust. In default of the exercise of Shareholder 5’s power of appointment, the assets in Grantor Trust must be distributed equally among Shareholders 1 through 4.

      For valid business reasons, the distributing corporation consummated the split-up through the use of “D” reorganizations, along with the tax-free split-up rules for corporate separations, as follows:

1)   Distributing corporation created Controlled 1, Controlled 2, Controlled 3, and Controlled 4 (collectively, the “controlled corporations”).

2)   Distributing corporation  transferred all of its assets to the controlled corporations in exchange for all of the stock of each of the controlled corporations and the assumption by each of the controlled corporations of the liabilities associated with the assets transferred.

3)   Distributing corporation distributed pro-rata all of its stock in each of the controlled corporations to Shareholders 1 through 5 in exchange for all of the stock of the distributing corporation held by Shareholders 1 through 5. Each of the controlled corporations elected to become “S” corporations on the first available date after the distributions.

4)   Lastly, the distributing corporation was liquidated.

      Shareholder 5’s estate plan provided that her ownership interests in each of the controlled corporations be separated so that her children will inherit the stock in their respective trust. Therefore, the split-up distributions of the stock of each of the controlled corporations transpired for the following objectives:

First, to implement the business succession planning; and

Second, to avoid a shareholder deadlock after implementation of the plan by allowing each shareholder in the post-transition structure to independently manage their portion of the distributing corporation’s business.

      Shareholder 5 established four grantor trusts for the future benefit of her four children; Trust 1, Trust 2, Trust 3, and Trust 4.  Shareholder 5 was the grantor of each of the Trusts and was treated as the owner of each Trust’s assets under §671.

      Each of the four children became the  sole beneficiary of their respective trust.

      As gifts to her children, Shareholder 5 caused the Grantor Trust to transfer part of its stock in each of the four controlled corporations to trusts for the future benefit of the children.

      Concurrently, Shareholder 5 caused Grantor Trust to sell some of its stock in each of the four controlled corporations for promissory notes from each trust.

      Both the gift transactions and the sale transactions were disregarded for federal income tax purposes, because Shareholder 5 was the grantor of each of the Trusts and was treated as the owner of each Trust’s assets under §671.

            After the tax-free split-up distributions to the shareholders, each of the controlled corporations were, nonetheless, subject to the built-in gains tax in §1374 with respect to any asset transferred from the distributing corporation. However, the ten year recognition period had been reduced by the portion of the recognition period that had expired prior to the distributing corporation’s  transfer of assets in “D” reorganizations to each controlled corporation.

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      To treat “nonrecently disposed stock” as having been sold on the disposition date, a gain recognition election must be made. This election will enable the purchaser of target stock to enhance its cost basis in the stock of the target corporation by the computed amount of basis in the nonrecently disposed stock.

      Particularly important, the computed amount of the  basis in the nonrecently disposed stock must be ascertained by a formula in the Treasury Department’s regulations.

      “Nonrecently disposed stock” denotes stock in a target corporation, which was held on the disposition date, by a purchaser or a person related to a purchaser who owned under the constructive ownership rules in §318(a), other than §318(a)(4), on the disposition date at least ten percent of the total voting power or value of the stock of the target corporation. Prop. Regs. §1.336-1(b)(17).

      Any holder of nonrecently disposed stock of a target corporation may make a gain recognition election. Once made, the gain recognition election may not be revoked. Prop. Regs. §1.336-4(c).

      Each owner of nonrecently disposed stock must determine its basis amount, and accordingly, the amount of gain recognized pursuant to the gain recognition election.

      If a §336(e) election had been made for a target corporation, any eighty percent purchaser and all persons related to the eighty percent purchaser must automatically be deemed to have made a gain recognition election for its nonrecently disposed target stock.

      A gain recognition election must be made by a non-eighty percent purchaser by providing to the seller, and seller including with the §336(e) election statement, a gain recognition election statement.

      Where a non-eighty percent purchaser made a gain recognition election, all related persons to the non-eighty percent purchaser must also be deemed to have made a gain recognition election. Otherwise, the gain recognition election for the non-eighty percent purchaser will have no effect.

      To illustrate a gain recognition election, assume that on January 1 of Year 1, Seller owned 85 shares of Target stock, A owned 8 shares, B owned 4 shares, and C owned the remaining 3 shares. Each of A’s 8 shares, B’s 4 shares, and C’s 3 shares had a $5 basis. Also, assume that Target had no liabilities.

      First, Seller sold 70 shares of Target stock to A for $10 per share on July 1 of Year 2.

      Next, Seller sold 5 shares of Target stock to B and 5 shares of Target stock to C for $14 per share on September 1 of Year 2.

      Due to the fact that eighty percent [70 + 5 + 5] of the stock of Target had been sold on September 1 of Year 2 that became the date of disposition.

A had incurred $25 of acquisition costs, and B and C had each incurred $10 of acquisition costs in connection with their respective Year 2 purchases. These costs were capitalized in the basis of the Target stock.

      Because A had owned at least ten percent of the Target stock on September 1, the disposition date, and A’s original 8 shares of Target stock owned on January 1 of Year 1 were not disposed of in the qualified stock disposition, A’s original 8 shares of Target stock were “nonrecently disposed stock.”

      To obtain a greater basis in Target’s stock, A made a gain recognition election. Pursuant to the gain recognition election, A must be treated “as if” it had sold on September 1 of Year 2, the disposition date, its 8 shares of nonrecently disposed Target stock for the basis amount. As a result, A’s basis in nonrecently disposed Target stock immediately after the deemed sale became the basis amount.

      A’s basis amount equaled the cost of the recently disposed Target stock without regard to acquisition costs, $700 [70 shares x $10], multiplied by a fraction, the numerator of which was 100 minus 8, the percentage of the Target stock, by value, determined on the disposition date, which was A’s nonrecently disposed of Target stock, and the denominator of which was 70, the percentage of the Target stock, by value, determined on the disposition date, disposed of to A in the qualified stock disposition. This amount must be multiplied by a fraction, the numerator of which was 8, the percentage of Target stock, by value, determined on the disposition date, attributable to A’s nonrecently disposed of Target stock and the denominator of which was 100 minus the numerator amount.

      Simply stated, A’s basis amount became $80 [$700 x 92/70 x 8/92]. Therefore, A recognized gain of $40 under the gain recognition election [$80 basis amount minus A’s $40 [8 shares x $5] basis in the nonrecently disposed of stock prior to the gain recognition election.

      Finally, New Target’s adjusted grossed-up basis [AGUB] became $1,091, the sum of $1,011, the grossed-up basis of all recently disposed of Target stock plus $80, A’s basis in the nonrecently disposed of Target stock pursuant to the gain recognition election. Prop. Regs. §1.336-4(d), Exp. 2.

HOW TO MAKE ELECTION

      An election to apply §336(e) must be made by seller. Seller must attach a statement to its timely filed Federal income tax return for the taxable year that included the disposition date. Prop. Regs. §1.336-2(h).

      If the seller were a member of an affiliated group that filed a consolidated return, the statement must be filed with the affiliated group’s consolidated return.

      In addition, a common parent of a seller’s affiliated group may unilaterally make the §336(e) election. It would be impractical to require each distributee, who generally will hold relatively small percentages of the target stock, to join in the election. Further, the distributees’ interests should generally be protected because of the distributing corporation’s fiduciary responsibilities to its shareholders.

      Information required on a §336(e) election statement is similar to that required on Form 8023, Elections Under §338 for Corporations Making Qualified Stock Purchases.

      In the case of a gain recognition election, a §336(e) election statement must include information pertaining to the gain recognition election.

      When finalized, the regulations will permit taxpayers to make a protective §336(e) election if they are unsure of whether a transaction constituted a qualified stock disposition. If such an election had been made, it must not have any effect if the transaction did not constitute a qualified stock disposition. Otherwise, a protective election  must be binding and irrevocable. Prop. Regs. §1.336-2(j).

      As noted in Part 1 of 2, a §336(e) election is available for sales, exchanges, or distributions (or a combination thereof) of target stock to both corporate and non-corporate purchasers, provided that the target stock was not sold, exchanged, or distributed to a related person. Morever, computations of basis must be calculated and recognition of gain elections will enhance the amount of basis.

ADJUSTED GROSSED-UP BASIS AND AGGREGATE DEEMED ASSET DISPOSITION PRICE

      While the rules retain the term adjusted grossed-up basis (AGUB) as used in §338,  a new term, “aggregate deemed asset disposition price” (ADADP) was created to deal with computing the deemed selling price in §336(e) transactions.

      An old target corporation must recognize all of the gain realized on the deemed transfer of its assets in exchange for the ADADP and allocate the ADADP among the assets held as of the disposition date. Prop. Regs. §1.336-2(b)(1)(I).

      To compute ADADP, the grossed-up amount realized on the sale, exchange, or distribution of recently disposed target corporation stock and must be added to the liabilities of the old target corporation. Prop. Regs. §1.336-3(b)(1).

      Since there is no “actual” amount realized in a distribution of stock, the grossed-up amount realized on the sale, exchange, or distribution must include the fair market value of recently disposed target stock distributed in the qualified stock disposition. Prop. Regs. §1.336-3(c)(1)(i)(B).

      As an example of how to ascertain the adjusted grossed-up basis, suppose that on January 1 of Year 1, Seller owned 85 shares of Target stock, A owned 8 shares, B owned 4 shares, and C owned the remaining 3 shares. Each of A’s 8 shares, B’s 4 shares, and C’s 3 shares had a $5 basis. Also, assume that Target had no liabilities.

       On July 1 of Year 2, Seller sold 70 shares of Target stock to A for $10 per share.

      On September 1 of Year 2, Seller sold 5 shares of Target stock to B and 5 shares of Target stock to C for $14 per share.

      Due to the fact that eighty percent [70 + 5 + 5] of the stock of Target had been sold on September 1 of Year 2 that became the date of disposition.

      A had incurred $25 of acquisition costs, and B and C had each incurred $10 of acquisition costs in connection with their respective Year 2 purchases. These costs were capitalized in the basis of the Target stock.

      Because A owned at least ten percent of the Target stock on September 1, the disposition date, and A’s original 8 shares of Target stock owned on January 1 of Year 1 were not disposed of in the qualified stock disposition, A’s original 8 shares of Target stock were “nonrecently” disposed stock.

      Although B’s original 4 shares and C’s original 3 shares were not disposed of in the qualified stock disposition, because neither B nor C owned with the application of the constructive ownership rules in §318(a), other than §318(a)(4), at least ten percent of the total voting power or value of Target stock on the disposition date, their original shares were not “nonrecently” disposed stock.

      Grossed-up basis of recently disposed Target stock totaled $1,011, determined as follows: The purchasers’ (A, B, and C) aggregate basis in the recently disposed target stock, determined without regard to acquisition costs, was $840 [(70 shares x $10) + (5 shares x $14) + (5 shares x $14)]. Next, this amount was multiplied by a fraction, the numerator of which was 100 minus 8, the percentage of the Target stock which was nonrecently disposed stock, and the denominator of which was 80, the percentage of Target stock disposed of in the qualified stock disposition [$840 x 92/80 = $966]. As a result, the $966 amount was increased by the $45 of acquisition costs incurred by A, B, and C to arrive at the $1,011 [$966 + $45] grossed-up basis of recently disposed of Target stock.

     New Target’s AGUB amounted to $1,051, the sum of $1,011, the grossed-up basis of recently disposed Target stock plus $40 [8 x $5], A’s basis in the nonrecently disposed of Target stock. Prop. Regs. §1.336-4(d), Exp. 1.

Many of the limitations on benefits and contributions have been changed for 2009. For most of the limitations, the increase in the cost-of-living index met the statutory thresholds that have triggered an adjustment to enlarge the amount of the limitation.

Statutory Adjustments

 Several of the limitations established in 2008 must, therefore, be increased at the commencement of 2009. In any event, administrators of either defined benefit or defined contributions plans, who have received favorable determination letters, should not request new determinations letters solely because of yearly amendments to adjust maximum limitations in the plans.

For 2009, the exclusion for elective deferrals described in §402(g)(3) increased from $15,500 to $16,500. This limitation affects elective deferrals to §401(k) plans and to the Federal Government’s Thrift Savings Plan, among other plans.

Limitation on deferrals under §457(e)(15) concerning deferred compensation plans of state and local governments and tax-exempt organizations increased from $15,500 to $16,500 for 2009.

By the same token, the SIMPLE retirement account limitation under §408(p)(2)(E) increased from $10,500 to $11,500.

Dollar limitation under §414(v)(2)(B)(i) for catch-up contributions to an applicable employer plan, other than a plan described in §401(k)(11) or §408(p) for individuals aged fifty or over increased from $5,000 $5,500.

However, the dollar limitation under §414(v)(2)(B)(ii) for catch-up contributions to an applicable employer plan described in §401(k)(11) or §408(p) for individuals aged fifty or over remained unchanged at $2,500.

Defined Benefit Plans

 For 2009, the basic limitation provides that the maximum “annual benefit” to a participant must be the lesser of:

 a) $195,000 [an increase of $10,000], or

 b) 100% of the participant’s average compensation for the high three years. §415(b).

 For participants who separated from service before January 1, 2009, the limitation for defined benefit plans must be computed by multiplying the participant’s compensation limitation, as adjusted through 2008, by 1.0530.

As a general rule, the term “annual benefit” means a benefit payable in the form of a straight life annuity with no ancillary benefits from a noncontributory defined benefit plan. §415(b)(2)(A).

The phrase “high three years” denotes the period of consecutive calendar years during which the participant was an active participant in the plan and had the greatest aggregate compensation from the employer. §415(b)(3).

 Defined Contribution Plans

In the case of a defined contribution plan, the overall limitation must be expressed in terms of the amount of “annual additions” to the account of an employee. For tax years that started after December 31, 2008, the “annual additions” to an employee’s account may not exceed the lesser of:

r $49,000, or

r 25% of the employee’s compensation from the employer. 

Therefore, the limitation for defined contribution plans in 2009 was increased by $3,000 from $46,000 to $49,000.

The term “annual addition” means the sum of:

 1) Employer’s contributions to the plan;

 2) Employee contributions; and

 3) Forfeitures added to the employee’s account during the year. §415(c)(2).

Hence, annual additions must include employer contributions, employee contributions, and forfeitures for a participant under all defined contribution plans of the same employer. Rather than a portion of employee contributions, all employee contributions must be included in determining the $49,000 limit on annual additions. §415(c)(2)(B).

Not to be included in “annual additions” are earnings and gains from the trust funds of the defined contribution plan.

If forfeitures for a particular year could cause the plan not to meet the limitation test for a particular employee, the forfeitures must be reallocated to other participants in the plan. Forfeitures must not be held in a suspense account.

 Highly Compensated Employee

Congress did not reset with the enactment of the Economic Growth and Tax Relief Act of 2001 the definition of a “highly compensated employee.” Instead, the Secretary of the Treasury is authorized to annually adjust the compensatory amount for cost-of-living increases.

First, the term “non-highly compensated employee” means an employee, who is not a highly compensated employee.

For 2009, the limitation used in the definition of highly compensated employee was increased from $105,000 to $110,000.

Compensation taken into account must not exceed $245,000 throughout 2009. §401(a)(17). Thus, the amount of compensation was increased by $15,000 from $230,000 to $245,000.

 Key Employee In Top-Heavy Plan

Under §416(i)(1)(A)(i), the dollar limitation concerning the definition of key employee in a top-heavy plan increased from $150,000 to $160,000 for 2009.

 Governmental Plans

 Annual compensation limitation under §401(a)(17) for eligible participants in certain governmental plans increased by $10,000 from $345,000 to $360,000 in 2009.

 ESOP

For determining the maximum account balance in an employee stock ownership plan subject to a five-year distribution period, the amount was increased in 2009 from $935,000 to $985,000, while the dollar amount used to determine the lengthening of the five-year distribution period was increased from $185,000 to $195,000.

For more information about the Tax Service for Employee Retirement Plans please visit: www.mastaxpub.com 

      An IRA denotes a trust created or organized in the United States for the exclusive benefit of an individual or  beneficiaries of the individual, but only if the written governing instrument creating the trust satisfied certain specified requirements.

      A trust for an IRA will not constitute a qualified trust unless the plan provided that the entire interest of each employee (I) will be distributed to such employee not later than the required beginning date, or (ii) will be distributed, beginning not later than the required beginning date, in accordance with regulations, over the life of such employee or over the lives of such employee and a designated beneficiary (or over a period not extending beyond the life expectancy of such employee or the life expectancy of such employee and a designated beneficiary).  401(a)(9).

      An IRA is subject to the required minimum distribution rules of §401(a)(9) and must satisfy all the requirements in the same manner as a qualified plan.

      While an IRA owner is substituted for an employee, the term “required beginning date” means April 1 of the calendar year following the calendar year in which the IRA owner attains age 70½.

      A designated beneficiary is an individual who is designated as a beneficiary either by the terms of the plan or by an affirmative election by the employee (or the employee’s surviving spouse) specifying the beneficiary. A beneficiary designated as such under the plan is an individual who is entitled to a portion of an employee’s benefit, contingent on the employee’s death or another specified event.

      An employee’s designated beneficiary normally will be determined based on the beneficiaries designated as of the employee’s date of death who remain beneficiaries as of September 30th of the calendar year following the calendar year of the employee’s death.

      Any person who was a beneficiary as of the employee’s date of death, but was not a beneficiary as of that September 30th (e.g., because the person received the entire benefit to which the person was entitled before that September 30th), must not be taken into account in determining the employee’s designated beneficiary for purposes of determining the distribution period for required minimum distributions after the employee’s death. Accordingly, if a person disclaimed entitlement to the employee’s benefit by a disclaimer that satisfied §2518 by that September 30th thereby allowing other beneficiaries to receive the disclaimed  benefit instead, the disclaimant must not be taken into account in determining the employee’s designated beneficiary.

      Under §2518(a), if a person  made a qualified disclaimer with respect to any interest in property, then for estate, gift, and generation-skipping transfer tax purposes, the disclaimed interest in the property will be treated “as if” the interest had never been  transferred to the disclaimant. Instead, the interest must be considered as having passed directly from the decedent to the person entitled to receive the property as a result of the disclaimer.

      As previously observed, the term “qualified disclaimer” means an irrevocable and unqualified refusal by a person to accept an interest in property, but only if: (1) the refusal was in writing; (2) the writing was received by  the transferor of the interest, his or her legal representative, or the holder of the legal title to the property to which the interest related, not later than the date that was nine months after the later of — (A) the date on which the transfer creating the interest in the person was made, or (B) the day on which the person attained the age of twenty-one; (3) the person had not accepted the interest or any of its benefits; and (4) as a result of the refusal, the interest passed without any direction on the part of the person who executed the disclaimer and passed either — (A) to the spouse of the decedent, or (B)  to a person other than the person who had made the disclaimer.  2518(b).

      A qualified disclaimer cannot be made with respect to an interest in property if the disclaimant had accepted the interest or any of its benefits, expressly or impliedly, prior to making the disclaimer.

      Acceptance of benefits must be manifested by an affirmative act that was consistent with ownership of  the interest in the property.

      Acts indicative of acceptance of benefits include: 1) using the property or the interest in the property; 2) accepting dividends, interest, or rents from the property; and 3) directing others to act with respect to the property or interest in the property. Nevertheless, a disclaimant must not be considered to have accepted the property merely because, under applicable local law, title to the property vested immediately on the decedent’s death in the disclaimant.

      There are rules in Regs.  25.2518-3  regarding the circumstances under which an individual  may make a qualified disclaimer of less than  the individual’s entire interest in property and may accept the balance of the property.

      A disclaimer of an undivided portion of a separate interest in property that satisfied the other requirements of a qualified disclaimer under  2518(b) and the corresponding regulations was a qualified disclaimer. Under Regs.  25.2518-3(b), each interest in property that was separately created by the transferor must be treated as a separate interest in property. An undivided portion of a disclaimant’s separate interest in property must consist of either a:

      fraction, or

      percentage

of each and every substantial interest or right owned by the disclaimant in the property and must extend  over the entire term of the disclaimant’s interest in the property and in other property into which the property may be  converted.

      Disclaimer of a specific pecuniary amount out of a pecuniary or nonpecuniary bequest or gift can be a qualified disclaimer provided that no income or other benefit of the disclaimed amount inured to the benefit of the disclaimant either prior to or subsequent to the disclaimer. Regs.   25.2518-3(c).

      Following a disclaimer, the amount disclaimed and any income attributable to that amount must be segregated based on the fair market value of the assets on the date of the disclaimer or on a basis that was fairly representative of the changes in value that may have occurred between the date of transfer and the date of the disclaimer.

      In addition, a pecuniary amount that must be distributed to a disclaimant from the bequest prior to the disclaimer must be treated as a distribution of corpus from the bequest that did not preclude a disclaimer with respect to the balance of the bequest.

            Acceptance of a distribution from the bequest must be considered an acceptance of a proportionate amount of the income earned by the bequest. The income earned by the bequest must be segregated from the disclaimed amount and cannot be disclaimed.

For more information about the Tax Service for Employee Retirement Plans please visit: www.mastaxpub.com 

For more information about the Tax Service for Employee Retirement Plans please visit: www.mastaxpub.com 

      Disclaimer rules were enacted into the law by Congress to allow a potential  recipient of an interest in property to disclaim that interest. By virtue of §2518, the rules were drafted so that the interest in the property disclaimed must be treated as having never been transferred to the disclaimant for gift or estate tax purposes.

      From a broad perspective, the purpose of the disclaimer statute was designed by the legislative body to avoid a second level of tax where a disclaimant was willing and financially able to step back and permit the transfer of the property the disclaimant could have received to be transferred instead to the next person in line.

      In effect, a qualified disclaimer permits the property to pass to the next person in line “as if” the disclaimant never had any interest in it and without the disclaimant having to pay transfer taxes on that transaction. §2046 and §2518(a).

      A person, who made a qualified disclaimer, must not be treated as having made a gift. By the same token, the value of a decedent’s gross estates for purposes of the Federal estate tax must not include the value of property with respect to which the decedent had made a qualified disclaimer. Regs. §25.2518-1(b).

      Prior to the enactment of §2518 by Congress in the Tax Reform Act of 1976, P.L. 94-455, the federal tax consequences of disclaimers depended on local law. To provide definitive rules concerning disclaimers and achieve national uniformity, §2518 was enacted. General Explanation of the Tax Reform Act of 1976, Joint Committee on Taxation, p. 590.

      A qualified disclaimer is an irrevocable and unqualified refusal by a person to accept an interest in the property.

      Where a qualified disclaimer has been made, the gift tax law must be applied as if the gift or bequest of the disclaimed property by the disclaimant had never taken place. As a result, the disclaimant must not be considered to have made a taxable gift, despite the fact that the disclaimant had shifted property to another person.

      To obtain the benefits of §2518, a disclaimant must make a timely “qualified disclaimer.” A qualified disclaimer means an irrevocable and unqualified refusal by a person to accept an interest in property, provided —

      Refusal was in writing,

      Disclaimer was received by the transferor of the interest, his legal representative, or the holder of legal title to the property within nine months from the later of the date of the transfer or the date on which the person refusing the interest attained age 21,

      Person refusing the interest had not accepted the interest or any of its benefits, and

      Due to the refusal, the interest passed without any direction by the person making the disclaimer and passed either to the spouse of the decedent or to a person other than the person making the disclaimer.

      Disclaimers should be drafted to comply with the requirements of the relevant local law. Often, disclaimers are filed with the probate court, where the decedent was domiciled. This filing is important to show, if subsequently required, that the document was timely executed by the disclaimant, since there is no requirement that the document be filed with the Federal Government.

      In the case of a disclaimer made by a surviving spouse, the interest in property passing as a result of the disclaimer may pass to either the surviving spouse or to another person. However, if the surviving spouse retained the power to direct the beneficial enjoyment of the property in a transfer that would not have been subject to the estate or gift tax, then the spouse must be treated as directing the beneficial enjoyment of the property unless the power to direct enjoyment was subject to an ascertainable standard.

      Further, a spouse’s disclaimer must not be disqualified, where the property disclaimed may be paid to the spouse pursuant to the exercise of a trustee’s power to distribute property to the spouse. Regs. §25.2518-2(e)(5), Examples (4) and (6).

      Common uses of disclaimers in tax planning are as follows:

      Transfer property not wanted by one heir to another heir, who wanted the property,

      Shift income tax burden among members of a family on retirement plan benefits,

      Correct errors made in estate tax planning during lifetime,

      Equalize estates of spouses in simultaneous deaths,

      Redirect estate assets to reduce estate or inheritance tax liability,

      Enlarge marital deduction of property passing to a surviving spouse,

      Avoid terminating an “S” corporation election by changing ownership of stock to an eligible shareholder, as opposed to transferring stock to an ineligible shareholder,

      Transfer property to contingent charitable foundation,

      Change ultimate beneficiaries of qualified retirement plans,

      Transfer property to needy heirs of decedent,

      Decrease administrative costs in the case of back-to-back deaths of spouses,

      Utilize maximum unified estate and gift tax exemption amount for both spouses,

      Remedy defective marital deduction bequest,

      Skip a generation of taxes by transferring property to a younger generation,

      Downsize an excessive marital deduction,

      Obtain the benefit of generation-skipping transfer tax exemption, and

      Charitable deduction to decedent’s estate as a result of disclaimer by decedent’s only living descendant.

      A technique for using the unified credit in the estate of the first spouse to die is to have the surviving spouse disclaim all or part of their interest in the estate of the first to die. Using this technique will ensure that the unified credit will be fully used in the estates of both spouses. By bequeathing the residuary estate to the surviving spouse and providing for the disposition of any property disclaimed, the wills enable the surviving spouse, with the benefit of current asset valuations, to evaluate the survivor’s financial needs and decide whether to disclaim, and if so, how much to disclaim, so as to use the unified credit to the extent consistent with an evaluation of the survivor’s needs.

      At the age of 67, Decedent died a resident of State C in Private Letter Ruling 9551015. Decedent was survived by his Spouse, who had not attained the age of 70½. At the time of his death, the Decedent maintained five individual retirement arrangements (IRAs) with Bank including IRAs D, E, F, and G. Spouse was the primary beneficiary of each of the five IRAs, and Trust was the contingent beneficiary of the five IRAs. Trust was irrevocable as of the date of Decedent’s death.

      Decedent was the Grantor of Trust and Spouse was the Trustee. Trust provided that if the Decedent predeceased his Spouse and the required beginning date had not occurred at the Decedent’s death, the Trustee must elect to receive distributions from an IRA in equal quarterly installments over the period measured by the life expectancy of the Decedent’s Spouse. If any quarterly installment amounted to less than the IRA income for the quarter, the Trustee must demand an additional distribution from the IRA so that the total distribution equaled at least the income earned by the IRA for the period.

      Since the Grantor predeceased the Grantor’s Spouse, the Trustee was required to distribute all income to the Grantor’s Spouse. At the death of the Grantor’s Spouse, any undistributed income must be paid to the estate of Grantor’s Spouse.

      During the lifetime of the Grantor’s Spouse, the Trustee must pay to the Grantor’s Spouse so much of the retained Trust principal as necessary for the maintenance and comfort of the Grantor’s Spouse.

      Upon the death of Grantor’s Spouse, the Trustee was required to distribute, per stirpes, the retained principal in the Trust to the Decedent’s issue living at time of the death of the Decedent’s Spouse. Trustee could elect to have the remaining IRA paid to the Trust.

      As a consequence of the Grantor’s Spouse surviving the Grantor, the Grantor’s Spouse was identified as the “designated beneficiary” with respect to IRA benefits.

      Spouse disclaimed her interests in IRAs D, E, F, and G. The disclaimers were valid under the laws of State C. As a result of the disclaimers, the four IRAs passed to the Trust, as the contingent beneficiary.

      In State C, a person, who was a grantee, could disclaim the right of transfer to any property or interest in the property by delivering or filing a written disclaimer. The disclaimed property or interest devolved as if the disclaimant had died before the effective date of the instrument or contract. For all purposes, the disclaimer related-back to that date.

      In Private Letter Ruling 9551015, the first requirement of §2518(b) was satisfied because the disclaimers of IRAs D, E, F, and G were in writing.

      Assuming the disclaimers were delivered, in a timely manner, to the fiduciary who held legal title to the property to which the interest disclaimed was related, the second requirement in §2518(b) was satisfied.

      The third requirement of §2518(b) was satisfied if the disclaimant did not accept any of the interests and benefits with respect to the IRA interest disclaimed prior to the disclaimer.

            Because Spouse did not retain any powers to direct the beneficial enjoyment of the property subject to the disclaimer to persons other than herself, the fourth requirement in §2518(b) was met.

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      An election to apply §336(e) must be made by seller. Seller must attach a statement to its timely filed Federal income tax return for the taxable year that included the disposition date. Prop. Regs. §1.336-2(h).

      If the seller were a member of an affiliated group that filed a consolidated return, the statement must be filed with the affiliated group’s consolidated return.

      In addition, a common parent of a seller’s affiliated group may unilaterally make the §336(e) election. It would be impractical to require each distributee, who generally will hold relatively small percentages of the target stock, to join in the election. Further, the distributees’ interests should generally be protected because of the distributing corporation’s fiduciary responsibilities to its shareholders.

      Information required on a §336(e) election statement is similar to that required on Form 8023, Elections Under §338 for Corporations Making Qualified Stock Purchases.

      In the case of a gain recognition election, a §336(e) election statement must include information pertaining to the gain recognition election.

       When finalized, the regulations will permit taxpayers to make a protective §336(e) election if they are unsure of whether a transaction constituted a qualified stock disposition. If such an election had been made, it must not have any effect if the transaction did not constitute a qualified stock disposition. Otherwise, a protective election  must be binding and irrevocable. Prop. Regs. §1.336-2(j).       

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