The New Jersey Tax Court recently released its opinion in Estate of Ruth Oberg, NJ Tax Court, Docket No 000240 (October 24, 2017), upholding the Division of Taxation’s assessment of additional New Jersey estate tax.  The case provides some important reminders about doing proper estate planning.

The estate in this case had a date of death value of $3.1 million and an alternate valuation date value of $2.1 million.  The estate claimed the alternate valuation date on its New Jersey estate tax return.  Unfortunately for the estate, however, the return was filed almost four years after the decedent’s death.  The judge agreed with the Division of Taxation that the return was filed too late to be able to claim the alternate valuation date.

The decedent also had made an undocumented loan to her daughter.  The estate claimed that the loan was a self-cancelling installment note (“SCIN”) and therefore was cancelled at death.  The court, emphasizing the difficulties of proving that an undocumented loan was actually a SCIN, found that the decedent had an interest in the loan at her death, and it was includible in her estate.  The court also found that the Division of Taxation was not bound by the IRS closing letter issued in the estate where the federal estate tax return was accepted as filed.

This is a classic “failure to plan” case.  If the decedent had properly documented the loan, and if the estate tax return had been filed on time, the additional estate tax assessed in the case could have been avoided.

The IRS has withdrawn the controversial proposed regulations under Code §2704 that would have significantly affected the use of discounts in US estate planning.

Code §2704 provides that certain “applicable restrictions” on ownership interests in family entities – that is, entities where the transferor and family members control the entity – should be disregarded for valuation purposes.  The proposed regulations created new rules relating to a lapse of a liquidation right.  They also created a class of restrictions known as “Disregarded Restrictions” that included many common types of restrictions in business entities and would be ignored for gift and estate tax valuation purposes.  See our prior blog post on this topic.

The effect of the proposed regulations appeared to be that they would eliminate or greatly restrict minority interest and lack of marketability discounts that are commonly applied in gift and estate tax valuations (resulting in higher valuations).  The regulations were very controversial from the moment they were issued.  Among other things, commentators said the regulations were unclear and unrealistic.

Treasury and the IRS have stated that they now believe that the approach of the proposed regulations to valuation discounts is unworkable.  The IRS issued a notice (Notice 2017-38) that it was reviewing the proposed regulations as unduly complex or overly burdensome, and has now withdrawn the proposed regulations.

Experts have started to calculate the inflation adjustments to key estate and gift exemption amounts for 2018.  Note that these are not the official figures to be released by the IRS, but should be used as a guide.  The IRS will officially release the numbers later this year.

For an estate of any decedent dying during calendar year 2017, the applicable exclusion was increased from $5.45 million to $5.49 million.  This change increased not only the applicable exclusion amount available at death, but also a taxpayer’s lifetime gift applicable exclusion amount and generation skipping transfer exclusion amount.  This means a husband and wife with proper planning could transfer $10.98 million estate, gift and GST tax free to their children and grandchildren in 2017.  The projected 2018 adjustment to the applicable exclusion will increase from $5.49 million to $5.6 million which means that a husband and wife with proper planning could potentially transfer $11.2 million estate, gift and GST tax free to their children and grandchildren in 2018.

For 2017, the estate, gift and GST tax rate remains the same at 40% and the gift tax annual exclusion remains at $14,000.  For gifts made in 2018, the projected gift tax annual exclusion will be adjusted to $15,000 (up from $14,000 for gifts made in 2017).

The New Jersey Estate Tax repeal will be effective as of January 1, 2018.  The current $2 million exemption which increased on January 1, 2017 is set to be eliminated as of January 1, 2018.  Keep in mind that the New Jersey Inheritance Tax is still in effect. This is a tax imposed on transfers to beneficiaries who are not spouses, parents, children or grandchildren (i.e., nieces, nephews, siblings, friends, etc.) New Jersey Inheritance Tax rates start at 11% and go as high as 16%.

The New York exclusion amount was changed as of April 1, 2014.  Beginning April 1, 2014, the exclusion has increased as follows:

•           $2.0625 million for decedents dying between April 1, 2014 through March 31, 2015;

•           $3.125 million for decedents dying between April 1, 2015 through March 31, 2016;

•           $4.1875 million for decedents dying between April 1, 2016 through March 31, 2017;

•           $5.25 million for decedents dying between April 1, 2017 through December 31, 2018.  Beginning in 2019, the exclusion would be indexed for inflation, and equal to the Federal exclusion.

In 2017, the gift tax annual exclusion to a non-citizen spouse was increased from $148,000 to $149,000.  This is projected to increase to $152,000 in 2018.  While gifts between spouses are unlimited if the donee spouse is a United States citizen, there are restrictions when the donee spouse is not a United States citizen.

The US Tax Court recently held that a foreign corporation is not subject to US income tax on the sale of a partnership interest where the partnership conducts a US business.  In so holding, the Tax Court rejected a 26 year old Revenue Ruling (Rev Rul 91-32) that reached the opposite conclusion.  For foreign investors in US businesses (that do not own real estate), this is an important decision.

A foreign investor who owns an interest in a partnership that holds US real estate may be subject to US federal income tax on a sale of that partnership interest under the Foreign Investment in Real Property Tax Act (“FIRPTA”).  For real estate, the IRS has indicated that gain derived by a foreign investor from the disposition of an interest in a partnership is subject to US tax only to the extent it is attributable to US real property interests owned by the partnership.  Regs §1.897-7T(a); Notice 88-72.

In Rev Rul 91-32, the IRS set forth its view that taxation on the sale of a partner’s interest in a partnership can go beyond mere real estate investment and apply to a sale of an interest in a partnership if the partnership is engaged in any US trade or business and has effectively connected income (“ECI”).  In this ruling, the IRS applied the “aggregate” theory of partnership taxation to justify looking through the partnership to its underlying assets in determining the source and character of the partner’s gain.

In July, 2017, the Tax Court issued its decision in Grecian Magnesite, Mining, Industrial & Shipping Co, SA v Comm’r, 149 TC 3The court declined to follow the IRS’s long standing position under Rev Rul 91-32, and held that a non-US person’s gain from the sale of its interest in a partnership engaged in a US trade or business is generally not subject to US federal income tax.

Grecian Magnesite Mining was a privately owned corporation organized under the laws of Greece that sells magnesia and magnesite to customers around the world.  From 2001 through 2008, it was a member of a US LLC that was engaged in the business of extracting, producing, and distributing magnesite in the US.  In 2008, Grecian Mining’s interest in the LLC was completely redeemed, resulting in treating the transaction as a sale or exchange of the membership interest.

The IRS asserted that the capital gain was properly treated as ECI since Grecian Mining was engaged in a trade or business as a result of its investment in the LLC.  Grecian Mining’s position was that the assets of the LLC do not control the character of the gain from a disposition of an interest in the LLC.  The gain should not have been treated as US-source gain and generally cannot be taxed in the US as ECI under the proposition that foreign-source income cannot be ECI except in limited instances that arise from the presence of US real estate under FIRPTA, which only applied to a small part of their gain.

Foreign investors should carefully review their US tax exposure on a sale of a partnership interest before they simply pay tax on their realized gain.  Grecian Magnesite calls into question the validity of Rev Rul 91-32 (though an appeal or non-acquiescence is possible).  A foreign investor should be able to rely on this case to avoid paying tax.  Moreover, foreign investors that have already paid income tax based upon Rev Rul 91-32 may wish to file a refund claim based on this decision.

On November 2, 2015, new partnership audit rules, repealing existing TEFRA rules, were enacted in Section 1101 of the Bipartisan Budget Act (“BBA”).  On August 15, 2016, Treasury published temporary regulations (TD 9780, 81 FR 51795).  The BBA will become effective on January 1, 2018, although partnerships can elect into the new rules retroactively to November 2, 2015.

The new rules have created quite the excitement among certain tax professionals because they shift both the audit and the collection of partnership taxes to the partnership.  Since 1982, partnership audits have been governed by the Tax Equity and Fiscal Responsibility Act (“TEFRA”).  Partnerships with 10 or fewer partners (with some exceptions, such as tiered partnerships) were exempt from TEFRA rules, and were governed by the default partner-level audit regime that existed prior to TEFRA.  What that means is, such small partnership audits were of the K-1’s of the partners who owned interest in the partnership in the years under audit, and correspondingly any adjustments were paid by those “review-year” partners.  For all other partnerships, TEFRA now required that the audit be conducted at the partnership level, which means adjustments were to be made to partnership income and deductions, with amended K-1’s then issued to the review-year partners.  The regime was now partnership-level audits with partner-level assessments.  In other words, those partners whose actions caused the additional tax were the ones responsible for paying it.

In addition, under TEFRA, over-100 partner partnerships could elect to have partnership-level assessments, that is, additional tax paid not by review-year partners but by current, “audit-year” partners (under the Electing Large Partnership Audit rules that were also repealed by the BBA).  This would result in a partnership-level audit and partnership-level assessment.

Unfortunately, over the years the IRS found partner-level collection difficult, and Congress has now responded by consolidating not only the audit but also the collection of tax at the partnership level.  In other words, the collection of tax is now made from audit-year partners, or partners having interest in the partnership in the year it is being audited.  This may be fine for small static family partnerships whose partners do not change, but it is not fine for large dynamic partnerships with ever-changing ownership interests.

A partnership representative (PR), rather than TEFRA’s Tax Matters Partner (TMP), now controls the conduct of the audit at the partnership level.  Neither the IRS nor the PR is statutorily obligated to give notice or audit rights to the other partners, a response to the IRS’ desire to streamline the audit without too many administrative hurdles.

An additional change in IRS’ favor is that there is no longer an automatic exemption from the consolidated audit for under-10 partnerships.  Now the burden is on the partnership to make an annual election out of the BBA rules under Section 6221 of the Internal Revenue Code.  The election can only be made by partnerships having fewer than 100 partners and those partners have to be individuals, C corporations, S corporations, tax-exempt entities or estates of partners.  When such an election out of the BBA is made and an audit arises that year, the partnership will essentially have a pre-TEFRA audit at the partner-level (as had been the case for under-10 partnerships under TEFRA).  The catch?  If the partnership has other partnerships or trusts as partners, it cannot elect out of the BBA consolidated rules no matter its size or preference.

If a partnership cannot elect out of the BBA rules because of its size or composition of its partners, it can still elect under Section 6226 to “push-out” payments of the additional tax assessed from the audit-year to the review-year partners.  The push-out election essentially replicates the TEFRA regime of partnership-level audit and partner-level payment.

Note that the rules are not clear on whether multi-tier partnerships can push-out payment to the ultimate partners.  The IRS has indicated the push-out will not automatically reach the ultimate partners unless the partnership can provide sufficient information about the tiers of income and loss allocations.

The new rules upend the status quo, affect countless existing partnership agreements, and create additional liability for purchasers of partnership interests.  At the same time, the new rules potentially create additional leverage for controlling partners.  All these considerations need to be reviewed on a case-by-case basis to amend existing agreements and draft robust new ones for the future under the new regime.