On February 17, the House and Senate both passed the Middle Class Tax Relief and Job Creation Act of 2012 (H.R. 3630).  The 2% payroll tax cut was extended for the full year and compromises were made by both parties.

The Republican negotiators on the committee had been seeking offsetting budget cuts for the $100 billion cost.  Democratic members had sought to increase income taxes on upper-income taxpayers.  Both groups dropped their negotiating positions in the final compromise.

The bill includes three major provisions that affect payroll taxes, unemployment insurance and Medicare.

1. Payroll Tax Cuts – There is a 2% reduction from 6.2% to 4.2% in the payroll tax for employees.  For most taxpayers, this is a savings of $1,000 for 2012.  While the Social Security fund will lose $100 billion in revenue, this amount will be transferred through increasing the debt on the general fund.
2. Unemployment Insurance – For most states, the unemployment insurance may be extended to a maximum of 63 weeks.  However, states with unemployment rates over 9% may be able to extend unemployment benefits for up to 73 weeks.
3. Medicare – The increased reimbursement rate for physicians known as the "Doc Fix" is enacted.  For the past decade, physician reimbursement rates have been increased to reflect inflation.

The payroll tax compromise involves additional funding to pay for the unemployment benefit extension and the "Doc Fix."  There will be broadband spectrum sales to media companies, increased pension contributions by new federal employees and reductions in payments to some Medicare hospitals and certain specialists' fees.  The Medicare hospital and specialists' fees changes are designed so they will not affect patient care.

The net result is a compromise between both Republican and Democratic negotiators.  Both parties appear pleased that the issue has been resolved for 2012.  President Obama is expected to sign the bill promptly.  He has strongly supported the payroll tax reduction for this year.

Editor's Note: Members of Congress expect this to be the last major tax bill until the November election.  Democratic negotiators proposed including the "tax extenders" in the bill but they were not in the final version.  As a result, it is still likely that tax extenders such as the Charitable IRA Rollover will be passed but the expected bill will not clear Congress until the end of November.  While tax extenders have been passed with dates retroactive to January 1, donors who hope to use the Charitable IRA Rollover for 2012 may delay taking required minimum distributions (RMDs) until the end of November.

Marital Portability Election Extension

In Notice 2012-21; 2012-10 IRB 1 (16 Feb 2012), the IRS created a special category with a six month additional period to file IRS Form 706 and elect marital portability.

In the tax bill signed December 17, 2010, Sec. 2010(c)(5)(A) created a new option called marital portability.  If an executor files IRS Form 706 for a person who passes away during 2011 or 2012, the deceased spouse's unused exclusion amount (DSUEA) may be transferred to a surviving spouse.  The transfer may permit a surviving spouse to have an applicable exclusion that would be double the basic amount, or over $10 million (plus indexed increases).

For some 2011 estates, IRS Form 706 may not have been filed because the estate was under $5 million and the IRS had not yet given guidance on how to qualify for marital portability.  In Notice 2011-82 published on October 17, 2011, Treasury explained the applicable requirements for filing IRS Form 706 and qualifying a surviving spouse's estate to claim the DSUEA.

Executors for many 2011 decedents with estates under $5 million did not file IRS Form 706 within the required nine month period and did not file Form 4768, "Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-skipping Transfer) Taxes."  In order to give fair opportunity for all executors to make the marital portability election, Notice 2012-21 grants a period of up to 15 months to file Form 4768.  In essence, there is an automatic six month election that will be permitted for 2011 decedents.

Editor's Note: The Treasury position shows welcome flexibility.  Decedents with estates under $5 million who passed away in January or February of 2011 may still file Form 4768.  There still is a requirement to file Form 706 within 15 months of the date of death.  The April deadline for the executors of January decedents will approach rapidly, but this still permits the preservation of DSUEA.  Most commentators expect that marital portability will be extended after 2012.

Estate May Deduct Actual State Tax Payment

In Marshall Naify Revocable Trust v. United States; No. 10-17358 (14 Feb 2012), the Ninth Circuit considered a request for a refund of a deficiency.  The refund request was based on a claim that the estate should be permitted to deduct the estimated rather than the actual state income tax payment.  The Ninth Circuit denied the trust request.

Decedent Naify was a California resident who held a substantial position in Telecommunications, Inc. (TCI) notes.  In 1999, TCI merged into AT&T and the notes were converted into AT&T stock, thereby creating a substantial capital gain.

To avoid potential payment of California tax on this $660 million capital gain, Naify created a Delaware corporation, Mimosa, Inc., and transferred his TCI notes to this new entity.  Following his death in April of 2000, Naify's executor filed his 1999 income tax return and did not report the gain on the California return.  At the time of the filing of IRS Form 706 in July of 2001, the estate noted that there was a potential $62 million California claim for income taxes on the capital gain and claimed that amount as a deduction.  The IRS audited the estate tax return and denied the deduction.  Subsequently, the California FTB audited the income tax return and issued a deficiency for $58 million plus interest and penalties.  In 2004, the estate settled with the California FTB.  It paid tax of $19 million plus $7 million in interest, for a total of $26 million.

The IRS permitted the estate to deduct the $26 million and assessed a deficiency of $11 million, which was paid by the Naify trust.

In March of 2006, the trust filed a claim for refund with the IRS for the $11 million deficiency.  It was denied.  In April of 2009, the trust filed an action against Treasury in District Court and sought refund of the $11 million deficiency amount.  The District Court ruled against the estate and it appealed.

The Court of Appeals noted that a deduction for a claim under Reg. 20.2053-1(b)(3) is permitted only if it is "ascertainable with reasonable certainty."  The trust claimed that there was a 67% probability that the California FTB would be successful in its claim.  Therefore, at the District Court level, it reduced the $62 million deduction to $47 million.

The Court of Appeals stated that a claim supported by an estimate based on a probability is "not a factual allegation.  Rather it is a legal conclusion."  Because the amount was inherently uncertain, it was not deductible.

The FTB case was dependent upon several contingencies.  The FTB needed to assert a 1999 claim, determine that Mimoso was not a valid Delaware corporation and issue a deficiency notice.

The District Court noted that the estate expert claimed a 67% probability that California would succeed.  However, as the Court stated, an estimate of probability does not make the claim reasonably certain.

Finally, Reg. 20.2053-1(b)(3) states that a post-death settlement is considered dispositive of claims.  In this case, the settlement with the California FTB was a fixed amount and therefore dispositive of the claim.  The request for refund of the deficiency was denied.

Applicable Federal Rate of 1.4% for February – Rev. Rul. 2012-7; 2012-6 IRB 1 (19 Jan. 2012)

The IRS has announced the Applicable Federal Rate (AFR) for February of 2012.  The AFR under Sec. 7520 for the month of February will be 1.4%.  The rates for January of 1.4% or December of 1.6% also may be used.  The highest AFR is beneficial for charitable deductions of remainder interests.  The lowest AFR is best for lead trusts and life estate reserved agreements.  With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable.  During 2012, pooled income funds in existence less than three tax years must use a 1.8% deemed rate of return. Federal rates are available by clicking here.

IRS Commissioner Doug Shulman was pleased to announce a substantially enhanced application for iPhone and Android phones.  The IRS2GO application was first announced in 2011 and had 350,000 downloads.  Commissioner Shulman expects the new application to be widely used.

He stated, "The new smartphone app provides an easy way for people to get helpful information about their taxes.  IRS2GO reflects a wider commitment at the IRS to find innovative ways to serve taxpayers in a rapidly changing world."

The new version has five major sections:

1. YouTube – The smartphone app includes links to many short YouTube videos.  The videos have titles such as "Tax Tips: Taxable and Non-Taxable Income," "Tax Tips: When Will I Get My Refund," "Healthcare: Small Business Healthcare Tax Credit," and "Free Help Preparing Your Tax Return."

2. News – The IRS periodically produces news releases.  These news items may be viewed on your iPhone or Android phone.

3. Get My Tax Record – By entering your Social Security Number and other identifying information, you may have access to your personal tax records.

4. Get My Refund Status – By entering your Social Security Number and other information, it is possible to obtain your refund status.

5. Follow Us – If you so desire, you may follow the IRS on Twitter.

Editor's Note: The IRS has developed a good smartphone application.  It is easy to use and includes very helpful content.  This updated IRS application will be very popular with taxpayers.  Finally, it is not very often that your editor uses the words "IRS" and "popular" in the same sentence.

House Charitable Deduction Up in Flames

In Theodore Rolfs et al. v. Commissioner; No. 11-2078 (8 Feb 2012), the 7th Circuit affirmed a Tax Court decision.  Taxpayers had given a home to the Village of Chenequa Fire Department and it was burned down as part of normal firefighter training.  The Tax Court denied a deduction.

Theodore Rolfs and wife Julia Gallagher purchased a three acre lakefront property in the Village of Chenequa, Wisconsin.  The value of the land was $599,000 and the value of the home was $76,000.  They planned to tear down the home and build a new residence.

Rather than incur the $10,000 cost of demolition, the Rolfs transferred the home to the Village of Chenequa with the condition that the fire department burn down the house as part of their normal training activities.  The taxpayers claimed a charitable deduction for the $76,000 value of the home.  The IRS denied the deduction and the Tax Court determined that there would be no charitable deduction.

The Circuit Court noted that deductions are permitted under Sec. 170(a)(1) for gifts to public entities such as the Village of Chenequa.  Taxpayers did comply with the contemporaneous written acknowledgement and Form 8283 Appraisal Requirements.  Therefore, there was a potential charitable contribution.

There have been numerous cases where individuals donated property to fire departments for training purposes.  The key question is the benefit to the donor versus benefit to the public.   The Court also noted that "The fair market value of donated property must take into account conditions on the donation that affect the fair market value."

The Tax Court determined that the requirement for the Fire Department to burn down the property was a condition of the gift.  The 7th Circuit held that the claimed $76,000 deduction did not reflect the requirement that the fire department must burn down the home.  Therefore, "the valuation must incorporate any reduction in value resulting from a restriction on the gift."

The appraisal of $76,000 by the taxpayer applied to a gift of a fee interest.  The taxpayer argued that the conservation easement test of "before and after" should be applied.   However, the Court noted this was not a conservation easement.

Because moving the home to a new lot would cost $100,000, there was no value to the property if it had been sold apart from the land.  In addition, there also was no value to the property after it had been burned down by the Fire Department, a condition of the gift.  Therefore, the gift value with the property subject to the condition was zero and the charitable deduction was denied.

Gravel Easement Value Does Not Hold Water

In Esgar Corp. et al. v. Commissioner; T.C. Memo. 2012-35; Nos. 23676-08, 23688-08, 23689-08 (6 Feb 2012), the Tax Court greatly reduced three claimed conservation easement deductions.

A Colorado C corporation with the name Esgar Corp. and couples Delmar and Patricia Holmes and George and Georgetta Tempel jointly owned ranch land approximately 200 miles southeast of Denver, Colorado.  On December 17, 2004, they transferred conservation easements to the Greenlands Reserve and claimed a total deduction value of approximately $1.9 million.  The IRS audited their returns, denied the deductions and accessed deficiencies, interest and penalties.

The Court noted that there were two questions at issue.  First, what is the actual fair market value of the conservation easements?  Second, if the valuation claimed is not correct, should the Sec. 6662(a) accuracy penalties apply?

The three taxpayers and a fourth party initially each owned one-fourth of approximately 2,200 acres of real property near Holly, Colorado.  Following the sale of 661.75 acres, they owned approximately 1,479 acres that were titled the "Midwestern Farms."  A portion of the Midwestern Farms was an alluvial gravel pit that was leased to E. Colorado Aggregates.  The royalties received by the partners from Gravel Extraction increased to approximately $390,000 by the year 2004.  There were four gravel pits in the county, but Midwestern was the largest of the group.

After extensive discussion with CPA Brian Wurst, on Dec. 17, 2004, Esgar, the Temples and the Holmeses  deeded conservation easements on 163 acres to the Greenlands Reserve.  Based on valuations by the Bill Milenski Appraisal Service, Inc. the charitable conservation easement deductions were $570,500 for Esgar, $867,500 for Holmes and $836,500 for Tempel.  In the opinion of CPA Wurst, Milenski "took a reasonable approach to determine the value."

The Court noted that a charitable deduction for a conservation easement requires a perpetual restriction on the property that is granted to a qualified charity.  The valuation of a conservation easement under Reg. 1.170A-14(h)(3)(i) involves one of two preferred methods.  If there is a "substantial record of sales of easements comparable to the donated easement," then this is the preferred method.  If the comparables are not substantial, then a "before and after" method is necessary to determine the value.

Because there was no good record of comparable sales and the parties stipulated that the after value was $24,000 for the Esgar and Tempel properties and $27,000 for the Holmes property, the remaining question was the fair market value of the properties prior to the easements.

Both parties offered expert opinions.  Taxpayer's expert, Jean Cruikshank, was unable to provide any comparables for "gravel-motivated sales."  A second expert, Robert B. Frahme, discussed the possibility of mining the gravel and using coal trains to "backhaul" gravel on the return runs after hauling coal to market.  However, he was not able to provide any specific data on the process.

A third expert, Gerald K. Ebanks, determined that there were 7.6 million tons of gravel on the properties, and estimated the potential royalties if this gravel were extracted.  A fourth expert, John R. Emmerling, concluded that gravel mining was the highest and best use of the property and that 7.6 million tons of gravel could be extracted.  He also estimated the potential revenue from royalties, but did not explain when demand would be sufficient to actually extract the gravel.

IRS Appraiser Kevin McCarty determined that the highest and best use of the property was for agriculture.  He noted that there was a 35 year estimated supply of gravel in the county within the existing Midwestern's gravel pit.  He stated, "The dominance by the two major gravel operators leaves little room available either for expansion by these operators or the entrance of a new operator."

Using the agricultural property assumption, McCarty reviewed 22 sales and suggested that three of the 22 were good comparables for the property.  Based on his analysis, he determined that the Holmes property was valued at $36,000 and the Esgar and Tempel properties were valued at $33,000.

The valuation issue faced by the court was a claim by the taxpayer that the conservation easements' total value was $1,991,588 versus the IRS appraiser claim that the value was $9,000.

The Court noted that there had been some increased gravel demand in the area, but that none of the taxpayer experts had provided a basis for determining that this new demand would lead to potential extraction of gravel.  In addition, there was no unloading facility for gravel, no willing coal company and the coal trains were not normally used to haul gravel.  Therefore, the backhauling option was not supported by any data.  As a result, the "highest and best use of the subject properties was agriculture."

Based upon a comparable sale of G.P. Ranches at $411 per acre for the land plus gravel or a sale by City Farm at $160 per acre, the Court adjusted the numbers for the acreage and determined that the comparable value for agriculture purposes on the before valuation was $1,100 per acre for the Esgar and Tempel property and $1,150 per acre for the Holmes property.  Therefore, the net value of the conservation easements for Tempel and Esgar was $49,774 and for Holmes, $49,502.50.  Finally, the Court considered the Sec. 6662(a) accuracy penalties.  The IRS claimed that there was a substantial valuation misstatement that would trigger the 20% penalty.  However, Sec. 6664(c) enables avoidance of the penalty if there is reasonable cause and the taxpayer acted in good faith.

Because the taxpayers relied on CPA Wurst, who was a competent professional, and because the taxpayers provided Wurst all relevant information, the taxpayers could rely upon his advice in good faith. Therefore, they met the standard for the reasonable cause exception to the accuracy-related penalty.

Editor's Note: This was a rather dramatic example of the battle of the appraisers on the gravel conservation easement interest.  The taxpayers started at $1.9 million and the IRS at $9,000.  Both the Tax Court and the 7th Circuit Court analyzed the respective positions and determined that the taxpayers did not have any reasonable basis for their claim.  The resulting permitted charitable deduction was just under $150,000.  Taxpayers chose to use very aggressive assumptions for their claimed deductions.  If a taxpayer chooses to use aggressive assumptions, there is a significant risk that the Tax Court will completely disregard those assumptions.

Applicable Federal Rate of 1.4% for February – Rev. Rul. 2012-7; 2012-6 IRB 1 (19 Jan. 2012)

The IRS has announced the Applicable Federal Rate (AFR) for February of 2012.  The AFR under Sec. 7520 for the month of February will be 1.4%.  The rates for January of 1.4% or December of 1.6% also may be used.  The highest AFR is beneficial for charitable deductions of remainder interests.  The lowest AFR is best for lead trusts and life estate reserved agreements.  With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable.  During 2012, pooled income funds in existence less than three tax years must use a 1.8% deemed rate of return. Federal rates are available by clicking here.