



Help with State Income Tax Audits

Just as the IRS conducts tax audits, so do the states. If you become involved in a state tax audit, keep in mind that Internal Revenue Code Section 6103 authorizes the IRS to share tax information with state governments for tax administration purposes. Among the information exchanged between the IRS and state taxation authorities is individual and business return information. One of the procedures that state taxing authorities use in selecting returns for audit is comparing the information (or the lack thereof) reported on an individual's federal income tax return with what is reported on their state income tax return.

With this in mind, one of the first steps in dealing with a state income tax audit is to gather all information on your account with the IRS. Basic information is readily available on a taxpayer's tax return transcript, a copy of which can be easily obtained through the IRS's Get Transcript webpage. Keep in mind that it will take around 10 days to receive your transcript. As mentioned below, this could potentially be different than the information on your tax return.

Once you have a copy of your IRS transcript, compare income and expense items with the corresponding items under review by your state tax commission. Many states use federal AGI as a key figure in the calculation of state income tax liability, so a difference in federal AGI reported by the IRS and federal AGI reported on your state income tax return could have triggered the audit.

If there are discrepancies, consider why that might be the case. Did you file your federal return but forget to file your state return (or vice versa)? Did the IRS make changes to your tax return? I've even seen a case of a false IRS return filed by a third party engaging in federal refund fraud that triggered a state income tax audit. Of course, you should always talk with a tax professional at the very earliest sign of an audit. With the right information and good advice, you can make any necessary changes to your returns and arrive at a fair resolution of your state income tax audit.

Comparison of DAPT Statutes

The law has long allowed individuals to establish spendthrift trusts for the benefit of third-party beneficiaries and thereby remove the trust assets from the reach of creditors. However, until relatively recently, the law did not allow individuals to establish spendthrift trusts for their own benefit and successfully remove trust assets from the reach of their own creditors.

Alaska became the first domestic jurisdiction to allow this type of planning by passing an asset protection trust enabling statute in 1997. A Domestic Asset Protection Trust (DAPT) allows an individual to transfer assets to a trust, remain a beneficiary of the trust while removing the assets from the reach of creditors, and also achieve numerous tax planning objectives.

DAPTs offer significant protection for individuals residing in states that have adopted DAPT legislation. Whether a trustor residing in a jurisdiction that has not adopted DAPT legislation can form a trust pursuant to the laws of a foreign DAPT jurisdiction and successfully protect their assets from creditors has not been adequately settled by the courts.

A number of factors must be weighed in determining which jurisdiction a trustor should select as the situs for their DAPT. An excellent resource for comparing the provisions of the various DAPT statutes is David G. Shaftel's Comparison of the Domestic Asset Protection Trust Statutes. Sixteen states have passed DAPT enabling laws, the latest being Mississippi in 2014, and Mr. Shaftel's chart compares and contrasts the applicable laws in each of these jurisdictions.

Powers of Attorney and Third Parties

A Durable Power of Attorney is an important estate planning tool that allows whomever you name in the document to act on your behalf and manage your affairs, even if you are incapacitated. A power of attorney can be effective immediately upon signing or can "spring" into effectiveness upon your disability.

Financial institutions have become sensitive to potential liability for power of attorney abuse, whereby a power of attorney is secured under suspicious circumstances by the agent and/or used for the agent's own personal benefit. Agents and their attorneys or advisers should consider the following questions about a power of attorney document:

Is the agent specifically authorized to take the desired actions? A financial institution may be "within its rights not to permit the attorney-in-fact to take a requested action unless the specific authority to take such action is included in the power of attorney." Accordingly, some shorter-form powers of attorney may be insufficient.

Will the agent's authority be restricted? For example, some financial institutions, as a matter of policy, do not allow agents online access to the principal's accounts even if the principal did their banking online. Financial institutions will, quite reasonably, be extremely reluctant to add an agent as an account owner or change pay-on-death designations.

Is the power of attorney still in effect? Financial institutions may be wary of old power of attorney documents, or those signed in other states, and may require the agent to sign an affidavit of some kind warranting that the document is in effect, such as this form from Fidelity.

Was the power of attorney validly executed? The financial institution will probably want the document to be notarized, even if not required by law, to give it some assurance that the principal was competent when signing. An agent purporting to act for an incapacitated principal may be questioned if the document was signed very recently. Thus, the document should not be too old or too new. Finally, many financial institutions will require an original document, rather than a copy. Keeping the foregoing questions in mind will help ensure that a power of attorney is honored by third parties.

Nonprofits Reference Chart

Section 501(c)(3) of the Internal Revenue Code is only one of nearly three dozen Code sections that provide for tax-exempt status for certain organizations. The IRS has an good chart, located at this link, summarizing those other sections and organizations. At the same time, there are numerous sub-categories of 501(c)(3) organizations. The purpose of this post is to supplement the IRS's chart with a list of distinct tax-exempt entities that fall under 501(c)(3). The organizations described below apply for tax-exempt status with IRS Form 1023 and can receive contributions which are tax-deductible to the donor:

 Code Sections   Description 
 509(a)   All 501(c)(3) organizations are private nonoperating foundations unless described in another line on this chart 
 509(a)(1) and
 A church or a convention or association of churches 
 509(a)(1) and
 A school, meaning an educational organization with regular faculty, curriculum, and enrolled body students in attendance 
 509(a)(1) and
 A hospital providing medical or hospital care, medical education or medical research 
 509(a)(1) and
 An organization operated for the benefit of a college or university that is owned or operated by a governmental unit 
 509(a)(1) and
 Certain governmental units 
 509(a)(1) and
 An organization that receives a substantial part of its financial support in the form of contributions from publicly supported organizations, from a governmental unit, or from the general public 
 509(a)(2)   An organization that normally receives not more than one-third of its financial support from gross investment income and receives more than one-third of its financial support from contributions, membership fees, and gross receipts from activities related to its exempt functions
 509(a)(3)(B)(i)   Type I supporting organization, which must be operated, supervised, or controlled by one or more 509(a)(1) or (2) organizations 
 509(a)(3)(B)(ii)   Type II supporting organization, which must be supervised or controlled in connection with one or more 509(a)(1) or (2) organizations 
 509(a)(3)(B)(iii)   Type III supporting organization, which must be operated in connection with one or more 509(a)(1) or (2) organizations 
 509(a)(4)   An organization which is organized and operated exclusively for testing for public safety 
 A private operating foundation 
 A private nonoperating conduit foundation 
 A common fund foundation 

IRS Notice 784 - Trust Fund Recovery Penalty

As mentioned in a previous post, the IRS pays out tax refunds (often constituting amounts an employer has withheld from an employee's paycheck in excess of that employee's income tax liability) before verifying if the employer has actually withheld those amounts or paid them to the IRS. This is a flawed method and helps explain why the IRS is extremely concerned that employers remit these withheld taxes, as well as social security and Medicaid taxes, to the IRS.

One enforcement mechanism is the Trust Fund Recovery Penalty (TFRP), which is described IRS Notice 784, which is referenced in the IRS's website and current Internal Revenue Manual. Since Notice 784 effectively explains the TFRP but does not appear to be generally available on the web, I quote it here:
Could You be Personally Liable for Certain Unpaid Federal Taxes?

If you are an employer, you must withhold federal income, social security (or railroad retirement), and Medicare taxes from your employee’s wages or salaries. If you provide communication or air transportation services, you also may have to collect certain excise taxes from people who paid you for the services. (Get Pub. 510 for more information on excise taxes.) These taxes are called trust fund taxes and must be paid to the Internal Revenue Service through tax deposits or as payments made with the applicable returns.

The trust fund recovery penalty. – If trust fund taxes willfully aren’t collected, not truthfully accounted for and paid, or are evaded or defeated in any way, we may charge a trust fund recovery penalty. This penalty is equal to the amount of the trust fund taxes evaded, not collected, not accounted for, or not paid to IRS. We also charge interest on the penalty.

Who has to pay the penalty? – The trust fund recovery penalty may apply to a person or persons IRS decides is responsible for collecting, accounting for and paying the trust fund taxes and who acted willfully in not doing so. If IRS can’t immediately collect the taxes from the employer or business, we will decide who the responsible person or persons are and who acted willfully.

“Willfully” means voluntarily, consciously, and intentionally. A responsible persons acts “willfully” if this person knows that the required actions are not taking place for any reason. Paying other business expenses instead of trust fund taxes is considered willful behavior.

Any person who had responsibility for certain aspects of the business and financial affairs of the employer (or business) may be a responsible person. A responsible person may be an officer or employee of a corporation, or a partner or employee of a partnership. This category may include accountants, trustees in bankruptcy, members of a board, banks, insurance companies, or sureties. The responsible person can even be another corporation, a volunteer director/trustee, or employee of a sole proprietorship. Responsible persons may include those who direct or have authority to direct the spending of business funds.

If we charge you this penalty, we may take your assets (except exempt assets) to collect the amount owed.

Avoid the penalty. – You can avoid the trust fund recovery penalty by making sure that all taxes are collected, accounted for, and paid to IRS when required. Make your tax deposits and payments on time. IRS employees are available to assist you if you need information on tax deposits and payments. You may telephone the IRS tax information number in your area for help. Pub. 937, Employment Taxes and Information Returns, Pub. 15, Employer’s Tax Guide, and Form 941, Employer’s Quarterly Federal Tax Return, are also helpful and available from IRS.
Source: Bloomberg BNA, Tax and Accounting Center, links added by me.

Irrevocable Trust Planning

Individuals with substantial assets can utilize a number of techniques to minimize gift and estate taxes. These techniques include making lifetime transfers of assets using irrevocable trusts. This post will describe some of the irrevocable trust planning techniques for income-producing assets. Such trusts will name an "income beneficiary," who will be entitled to the income generated by the asset and a "remainder beneficiary," who will be entitled to the asset itself after a defined period of time.

One way to classify such trusts is by how the income of the income beneficiary is calculated: In general, income is calculated as either a fixed amount (an annuity) or as a fixed percentage of the net fair market value of the trust assets (a unitrust amount). Another way to classify these trusts is whether they involve a charitable beneficiary. Finally, with respect to charitable trusts, the charitable beneficiary can be either the income or the remainder beneficiary. These different trusts can be described using the following chart:

 Annuity Income   Unitrust Income 
 Charitable Lead Trusts (CLTs)   Charitable Lead Annuity Trust (CLAT)   Charitable Lead Unitrust (CLUT) 
 Charitable Remainder Trusts (CRTs)   Charitable Remainder Annuity Trust (CRAT)   Charitable Remainder Unitrust (CRUT) 
 Grantor Retained Trusts (GRTs)   Grantor Retained Annuity Trust (GRAT)   Grantor Retained Unitrust (GRUT) 

In summary, a CLAT and a CLUT both provide a charity with income for a period of time, in the form of an annuity or unitrust amount respectively, with non-charitable beneficiaries receiving the remainder interest when the income period ends. A CRAT and a CRUT are similar, except that the charitable beneficiary receives the remainder interest at the end of the income period, during which either an annuity or unitrust amount is paid to non-charitable beneficiaries. Finally, a GRAT and a GRUT provide for both an income interest and a remainder interest to non-charitable beneficiaries. Future posts will discuss the situations in which each of these trusts are typically used.

Social Security Planning

Normally, in planning when to apply for social security benefits, it makes sense (assuming you expect to live a long time) to delay applying. However, for some married couples, the "file and suspend" strategy results in greater benefits, even though it runs somewhat counter to the normal strategy. According to the Social Security Administration,
If you and your current spouse are full retirement age, one of you can apply for retirement benefits now and have the payments suspended, while the other applies only for spouse's benefits. This strategy allows both of you to delay receiving retirement benefits on your own records so you can get delayed retirement credits.
The practical effect of this technique is explained by the AARP in the following example:
John and Mary, a married couple... are 66, which is their full retirement age. Mary is retired; John plans to keep working until he is 70.

At 66, John, who had a bigger income than Mary over the course of his career, files for his full retirement benefits of $2,000 a month, but immediately suspends payment. By doing that, he will begin accruing delayed retirement credits: For each year that he keeps his payments in suspension, they'll be 8 percent higher when he does take them. The credits top out at age 70. Since John's basic retirement benefit at age 66 was $2,000, his new payment if he waits until 70 to collect will be about $2,640, plus any cost-of-living increases.

When John filed for his benefits, he automatically activated Mary's ability to apply for a spousal benefit... equal to up to one-half of the other spouse's retirement benefit. So Mary can collect $1,000 a month [without even] taking her own retirement benefit...
This means that the couple in this example receives $12,000 per year without receiving any retirement benefits on their own record, which they will start doing at a later date. This is an example of how the wrong strategy for collecting social security benefits can mean the receiving tens of thousands of dollars less than would otherwise be possible. Just as an attorney should be consulted for estate planning or other legal questions, a financial planner with social security expertise should be consulted when planning for retirement.

Pass Wealth Tax Free by Marrying a Descendant?

As I discussed in a previous post, some states ban close relatives from marrying with gender-based consanguinity statutes on the premise that same-sex unions are unlawful. For example, Mississippi law states:
The son shall not marry his grandmother, his mother, or his stepmother; the brother his sister; the father his daughter, or his legally adopted daughter, or his grand-daughter;... and the like prohibition shall extend to females in the same degrees. All marriages prohibited by this subsection are incestuous and void. Miss. Code Ann. § 93-1-1(1).
This statute does not prohibit a son from marrying his father; but this possibility was foreclosed by Miss. Code Ann. § 93-1-1(2), which prohibited marriage between persons of the same gender. The state of Massachusetts has a similarly-worded statute, but in Goodridge v. Department of Public Health, the court legalized same-sex marriage but addressed the statutory language. The court stated in a footnote that "the statutory provisions concerning consanguinity or polygamous marriages shall be construed in a gender neutral manner."

Today's Supreme Court decision of Obergfell v. Hodges holds that the Constitution requires states to license a marriage between two people of the same gender. It does not mention consanguinity or contain any limiting language like Goodridge, yet it applies to all states, including Mississippi and a handful of others with gender-based consanguinity statutes.

Accordingly, in these states, there is no law preventing an individual from marrying a close relative, as long as they are the same gender. Furthermore, it is unclear what rationale a state would have in removing the right of same-sex relatives to marry. The ability for wealthy individuals to pass their estate to an heir by marrying the heir and benefiting from the unlimited marital deduction is a compelling tax planning opportunity.

Donor-Advised Funds

For the charitably-motivated individual, the easiest way to support a nonprofit and qualify for a tax deduction is to simply make a donation to an eligible charity (the IRS maintains an on-line list of most such organizations at their EO Select Check page). However some individuals wish to retain some degree of control over exactly how their funds are utilized to support charitable endeavors. The strategies for doing this are innumerable, but one popular alternative that is almost as easy as an outright contribution is a contribution to a donor-advised fund.

A donor-advised fund is a separately-identified fund or account owned and controlled by a public charity over which a donor retains nonbinding advisory privileges. Any public charity can establish a donor-advised fund, and can even do so inadvertently if the charity operates one of its accounts "as if contributions of a donor... are separately identified" and the donor expects to have an advisory role over how the contribution is used.

Donor-advised funds have been around for decades, but were not mentioned in the Internal Revenue Code until the Pension Protection Act of 2006. Congress's objective in addressing the issue was to curtail perceived abuses whereby such funds were established "for the purpose of generating questionable charitable deductions, and providing impermissible economic benefits to donors and their families..." The response was an excise tax on any consideration paid by a donor-advised fund to a disqualified person, without regard to any consideration received in exchange, which is how standard excise taxes under Code Section 4958 function.

Fortunately, these rules are easy to follow because a public charity owns the donor-advised fund and will vet an individual's recommended distributions. The donor receives an immediate tax deduction, subject to the least restrictive AGI limitations, for contributions made to their donor-advised fund, and the donor can make additional contributions and recommendations indefinitely. Donor-advised funds are free to set up, cheap to maintain, and the fund investments are professionally managed. A donor-advised fund is a simple yet meaningful approach to charitable giving.

Tax Refund Fraud

To continue the theme of my last post, this post discusses a specific type of identity theft: tax refund fraud. According to NBC News (and which I can verify from my own experience), all it takes to be able to electronically file a fraudulent tax return in someone else's name is a matching name, birth date, and social security number. With that information, all a thief needs to do is fabricate some wages and an employer, report a bogus tax withholding amount, and the difference between those two numbers will be refunded however the thief directs. This works because, to quote NBC:
By law, the tax-refund system as it is currently constituted amounts to a "pay first, ask questions later" system... In other words, an imaginative crook in possession of the three basic items of a person's identity could... get the money within 30 days—the amount of time the law says that the agency must refund tax filers.
Actually, by entering their own direct deposit information on the fraudulent return, the thief could get the refund in a couple days and not have to worry about trying to cash a refund check in the victim's name. Alternatively, a patient thief could paper file a fraudulent return and not even need the victim's birth date since that is not requested on the tax form itself.

The only obstacle to success in this crime is a voluntary program whereby some financial institutions can refuse to deposit a tax refund into an account on which there is a different name from the taxpayer. But not all institutions perform this cross check. Here is some Q&A from the Bureau of the Fiscal Service, a division of the Treasury that operates the federal government's deposit systems:
Can an RDFI [Receiving Depository Financial Institution] rely strictly on the account number in the ACH Entry Detail Record when posting a tax refund payment to a customer's account?

Yes, an RDFI may post IRS tax refunds received through the Automated Clearing House (ACH) network using the account number only....

Is an RDFI liable for an IRS tax refund sent to an account that does not belong to the named or intended recipient?

No. An RDFI is not liable for an IRS tax refund sent through the ACH network to an erroneous or fraudulent account since the IRS provided incorrect account information.
In other words, the IRS is required by law to authorize a refund before verifying if it is legitimate, and the Bureau of the Fiscal Service will authorize the deposit into any account reported to them by the IRS. The bank has no obligation to verify that the name on the refund destination account matches the name of the taxpayer. The real taxpayer will be left to clean up the mess when they discover they can't file their own return. Of course, the thieves will likely be caught after the fact, but the moral of the story is to avoid the mess by protecting your personal identification information and filing your tax return early.

What to do About Identity Theft

Identity thieves can wreak havoc on your credit report and your life, and the Federal Trade Commission has a very useful informational packet designed to help victims get their lives back in order. Some highlights from that packet describing what victims of identity theft should do immediately after realizing they've been victimized are as follows:

1. Have a credit reporting company place an Initial Fraud Alert on your report. This is easy to do, it lasts for 30 days, and it will make it harder for an identity thief to open accounts in your name. This can be initiated online at each of the credit reporting companies websites, Equifax, Experian, and TransUnion.

2. Although not emphasized in the FTC's packet, identity theft victims should immediately change PIN numbers and online passwords to all financial accounts. The password to the email addresses used to reset online financial account passwords should itself be updated.

3. Order copies of your credit reports, review the reports for unauthorized charges or accounts, and contact any businesses related to the problem accounts. Placing the Initial Fraud Alert entitles you to a free credit report immediately. The FTC packet has sample letters that can be sent to businesses alerting them of the identity theft.

4. Contact appropriate government agencies. Income tax fraud is popular at this time of year; the IRS's Form 14039 can used to report identity theft to the IRS. The U.S. Postal Inspection Service, the "leading federal law enforcement agency in the investigation of identity takeovers," has a complaint form located here. Contact your state's attorney general office as well.

5. Create an Identity Theft Report. This consists of two separate documents; first is an Identity Theft Affidavit that can be generated online with the FTC's Complaint Assistant. The Identity Theft Affidavit should be taken to your local police station, along with documentation of the theft, photo ID, and proof of address. Use this information to file a police report; the police report and the FTC Identity Theft Affidavit together constitute an Identity Theft Report. Keep track of your police report number and Identity Theft Affidavit number.

After these steps have been taken, next comes the long process of clearing up your credit report, closing fraudulent accounts, ensuring that businesses remove fraudulent charges, and taking legal action where necessary. The FTC is a good resource for these steps as well.

Utah DAPT Update

Two recent developments in Utah Domestic Asset Protection Trust law are worth mentioning. First, the Utah Supreme Court issued a ruling in the case of Dahl v. Dahl, dealing with a DAPT in the context of a divorce. Ms. Dahl appealed a lower court's decision, arguing that it erred in holding that she had no enforceable interest in the assets of a DAPT established by Mr. Dahl, and the Utah Supreme Court agreed.

Although the trust agreement specified Nevada law as the law governing the trust, the Utah Supreme Court applied Utah law for public policy reasons. Whereas under Nevada law the trust would have been irrevocable, under Utah law the Court found that the trust was revocable. Even though the trust agreement stated that it was irrevocable, another provision said that Mr. Dahl could amend the trust with the consent of the beneficiaries, and the trust did not include any express restrictions on this power.

This case is not a "traditional asset protection planning case," according to Jay Atkisson writing for Forbes. However, it reminds planners and clients alike that in order for a DAPT to be effective, it should, at a minimum, be formed pursuant to the law in which the settlor is domiciled and not be used to try and "cheat another spouse."

In another development, a bill has been proposed in the Utah legislature, H.B. 318 - Domestic Asset Protection Trust Amendments, which would repeal and replace Section 25-6-14, the current Utah asset protection trust statute. The "new type of asset protection trust" the bill creates would, among other things, require asset protection trusts to be registered with the Utah Division of Corporations and reduce the value of a settlor's assets that would be protected from creditors. Specifically, a DAPT could assert only the following exemptions:
The Median Exemption is an amount equal to the sum of the median value of a Utah owner occupied housing unit and the median Utah household income as determined in the most recent American Community Survey conducted by the United States Census Bureau.

The 50% Exemption is determined on a claim by claim basis and is an amount equal to the sum of [certain amounts] reduced by the Median Exemption...
For 2013, the Median Exemption would appear to only be $211,400 for median owner-occupied unit value plus $59,770 for median household income. This would represent a significant creditor-friendly change to Utah's DAPT law.

Flight Department Companies

If you or your client is thinking about owning an aircraft in a limited liability company or other entity, think again. While an individual aircraft owner can operate an aircraft for personal use, this is not the case when that same aircraft is owned by an LLC, even one that is disregarded for tax purposes. The Federal Aviation Administration has consistently viewed these entities as "flight department companies," which require commercial registration. The following is from a Legal Interpretation to James W. Dymond from Rebecca MacPherson, Assistant Chief Counsel, Regulations Division, dated March 9, 2007:
A company whose sole purpose is transportation by air and receives compensation (amounts paid by the Client needed to pay the costs of owning and operating the aircraft) must obtain certification under Part 119… Section 91.501(b)(4) is drafted to permit an individual owner, not a company, to operate an airplane for his own personal transportation and guests without charge. Thus section 91.501(b)(4) cannot be used by a flight department company.
Jeff Wieand, an expert in this area, explains as follows:
As this runs somewhat contrary to conventional asset protection wisdom, it is important to be familiar with these and other FAA regulations when dealing with aircraft.