Senator Bill Nelson (D-FL) spoke during a March 20 hearing of the Senate Finance Subcommittee on Fiscal Responsibility and Economic Growth. The focus of the hearing was on identity theft (ID) and the strategy of many thieves who request fraudulent tax refunds.

Florida has been prominent in the ID tax fraud cases. Sen. Nelson stated, "Instead of stealing cars or selling illegal drugs, more and more criminals are looking with envy at the ease with which tax fraud can be committed anonymously. All the fraudster has to do is file a false return electronically and then have the tax refund loaded onto a prepaid debit card."

IRS Deputy Commissioner for Services and Enforcements Steven Miller indicated that the IRS discovered approximately $14 billion in 2011 fraudulent refund requests. At least $1.4 billion of this amount involved identity thieves. During the past four years, over 460,000 taxpayers have been impacted by identity theft.

The Federal Trade Commission (FTC) also has reported increasing numbers of identity theft cases. During the past five years, identity theft has become a greater problem than credit card fraud. By 2011, there were 39,000 cases of credit card fraud but 67,200 cases of identity theft.

Tampa, Florida Police Department Detective Sal Augeri testified at the hearing. He stated, "Criminals are stealing hundreds of millions of dollars from hard-working Tampa taxpayers and I'm only aware of what's going on here in Tampa."

Augeri explained that tax fraud is a nationwide issue. He also observed that the IRS was "of little assistance in these investigations" because it is not permitted to transfer information to local police.

The hearing was conducted to discuss a bill sponsored by Sen. Nelson. The Identity Theft and Tax Fraud Prevention Act is designed to "give the IRS and identity theft victims the means to better detect and prevent this disastrous offense."

The bill would increase penalties for identity theft, allow the IRS to share information with state and local authorities, secure the Social Security numbers of deceased Americans, allow identity theft victims personal identification numbers or permit them to opt out of electronic filing of tax returns.

National Taxpayer Advocate Nina Olson spoke at the hearing and urged caution. She stated that we also need to protect taxpayer privacy. Olson pointed to the ability of a taxpayer to consent to disclosure of returns by the IRS so that information can be transferred to state or local law enforcement authorities. She stated, "Under this exception, the IRS may develop procedures that would facilitate sharing of identity theft information with state and local law enforcement agencies."

Farm Land Special Use Value Regulation Invalidated

Regulation 20.2032A-8(a)(2) states that Sec. 2032A special use valuation is permitted only if the election applies to 25% or more of the estate. In Carolyn Finfrock v. United States; No. 3:11-cv-03052 (20 Mar 2012), a U.S. District Court ruled that this regulation failed the Chevron test and invalidated the regulation.

Decedent Doris Finfrock-Ware was a resident of Illinois. She owned 61.05% of Finfrock Farms. The four parcels of farmland were managed by her son. When she passed away, the four farmland parcels passed indirectly to heirs.

When she passed away on January 2, 2008, the parcels were 68% of her estate. The estate elected the Sec. 2032A Special Use Valuation on parcel four. Executor Carolyn Finfrock planned to operate a farm on parcel four and therefore elected the special use valuation.

The IRS stated that both the qualified and elected property must be 25% of the estate. Because parcel four did not constitute 25% of the estate, the IRS adjusted Form 706 valuation from $227,233 to $402,930.

Section 2032A exists "to encourage the continued operation of family farms and other small family businesses by permitting real property used for the farm or business to be valued upon its present use, rather than upon its highest and best use." Under Reg. 20.2032A-8(a)(2), the special use election must meet the appropriate standards. The property eligible for the election must be valued at 25% or more of the adjusted gross estate. However, the regulation also requires that the elected property must also be at least 25% of the estate.

The estate argued that the statue creates the 25% requirement for qualified property as a percentage of the estate, but that it does not create a specific requirement for the special use election. The IRS responded that the statue is silent and therefore creates an ambiguity that the Secretary of the Treasury has clarified by stating the requirement to elect special use valuation for at least 25% of the estate.

The Court reviewed the specific terms of the statue. It noted that there is no statutory requirement for an election of special use valuation for 25% or more of the estate value. In the view of the Court, there is no "ambiguity in the statute, because the statute contains no ambiguity, nor fills any gap, as there is no gap to fill." Therefore, the Court determined that Reg.20.2032-8(a)(2) is invalid.

FLP Creation A Bona Fide Sale

In Estate of Beatrice Kelly et al. v. Commissioner; T.C. Memo. 2012-73; No. 24783-08 (19 Mar 2012), the Tax Court determined that a bona fide sale exception applied to a family limited partnership. Therefore, the assets were not includable in the decedent's estate at date of death value.

Decedent Beatrice Kelly and her husband operated a quarry in Rabun Gap, Georgia. Following his death on January 25, 1990, decedent inherited two quarries, real property, promissory notes and stock. On March 29, 1991, she executed a last will and testament with provisions for specific bequests and a division of the residue equally among three of her children. Her fourth child, Roy, had Down Syndrome and lived with her. Her son Bill was appointed Roy's guardian. Roy passed away in 2002.

On October 21, 2001, the three children signed a settlement agreement among themselves mandating equal distribution of the estate. On January 29, 2002, decedent was suffering from Alzheimer's disease and the Probate Court appointed the three children as co-guardians for decedent. She was transferred to a nursing home and never regained testamentary capacity.

On August 8, 2002, the children signed an updated settlement agreement again mandating an equal division of the assets. Because there was concern about a potential contest for the estate by distant relatives and also an ongoing risk of liability due to operations at the quarry, the children contacted attorney Woodrow Stewart. Following his recommendation, they created four family limited partnerships and KWC Management, Inc. (KWC). This entity held 1% of the four partnership interests and served as general partner. The partnerships effectively created an equal division of the estate among the children. KWC was owned by decedent Beatrice Kelly and she received a management fee of 0.7% in 2004 and 1.0% in 2005. This fee was lower than a normal management fee for similar organizations.

On March 17, 2005, Beatrice Kelly passed away. The estate filed IRS Form 706 and included only the KWC shares and retained minority interests in the family limited partnerships. The IRS audited the estate, claimed that the family limited partnership discounts should not be recognized and the assets in all four FLPs should have been included at the date of death value. The IRS assessed a deficiency of $2,205,392.

The Court reviewed the creation of KWC and the four family limited partnerships. It determined that decedent had legitimate and significant non-tax reasons for creating the business entities and therefore the bona fide sale exception applies.

After a petition by the children, the county probate court entered a declaration of non-capacity for Beatrice Kelly. Subsequently, the children created four FLPs and KWC to equalize distribution of the estate and to avoid litigation and potential liability.

The IRS also alleged that there was an implied agreement that the decedent would enjoy all of the income and benefits from the family limited partnerships. However, the family members treated the partnerships and KWC as separate legal entities. In addition, decedent retained $1.1 million in liquid assets. These assets were sufficient for her care and were used to pay her personal bills. While there was a management fee from KWC paid to decedent, she did not require those funds for payment of personal bills. Therefore, the bona fide sale exception applied.

Finally, the IRS noted that the management fee constituted a retained income from FLP assets and claimed that this caused estate inclusion of all assets under Sec. 2036(a). However, the court noted that the fee was reasonable and below the standard industry amount. It was not required for the support and maintenance of the decedent. Because the management fee was an appropriate fiduciary payment by KWC to decedent, it did not cause asset inclusion under Sec. 2036. Therefore, the discounts and ownership interests involved with the four family limited partnerships were permitted.

Insurance Included but Deductible

In Estate of David A. Kahanic et al. v. Commissioner; T.C. Memo. 2012-81; No. 23800-09 (21 Mar 2012), the Tax Court determined that insurance proceeds were included in the estate. However, because the payment of the policy proceeds was a valid debt, it also qualified as an estate deduction.

Dr. David Kahanic was the owner of Aesthetic Eye Plastic Surgery (AEPS). He married Susan Kahanic on October 22, 1988 and they divorced in 2004.

Dr. Kahanic obtained several life insurance policies prior to a diagnosis of high blood pressure and an enlarged heart. The policies were from Security-Connecticut with a death benefit of $495,000. Security-Connecticut with a death benefit of $2 million, AIG with a death benefit of $3 million and Reliastar with a death benefit of $2.495 million.

In the 2004 order for disolution of the marriage, Susan Kahanic received child support and a promise to maintain an insurance policy for $1.2 million to cover that obligation. She also received 96 monthly spousal maintenance payments and David was required to maintain a $500,000 insurance policy to protect that interest.

At a hearing on August 16, 2004, the court reviewed alleged non-compliance by Dr. Kahanic and issued an order requiring him to maintain the entire Reliastar policy for the benefit of Mrs. Kahanic.

When Dr. Kahanic passed away, Mrs. Kahanic was the beneficiary of that Reliastar policy and received the $2.495 million death benefit. At that time, the policy had a cumulative value of $31,165 and a surrender charge of $43,573. Policy premiums were paid through September 1, 2005. The policy also contained a no-lapse provision.

The decedent's will allocated Federal and Illinois death taxes to the residuary and waved contribution from third-party transferees. Because the estate did not have sufficient liquid assets to pay an estimated $970,000 in federal and estate taxes, Mrs. Kahanic lent the estate $700,000 from her insurance proceeds. The estate timely filed IRS Form 706. It included the $2.495 million Reliastar insurance policy, but then deducted the full amount as a debt of the estate. The IRS rejected the position of the estate and issued a deficiency.

The court noted that the principal issues were the inclusion of the estate and then the qualification as a debt. Estate inclusion of the death benefit is appropriate under Sec. 2042(2) if the decedent possesses any incidents of ownership, exercisable either alone or in conjunction with any other person. Because the order of the court precluded any right for Dr. Kahanic to cancel or change the policy, the estate claimed that there were no incidents of ownership. Alternatively, the estate observed that the net cash value of the policy was zero and therefore it had no value in the estate.

The court observed that there was a cumulative value and the policy was in force at date of death. In addition, the policy had a no-lapse provision. Under the method of calculating minimum monthly payments in the policy, it would remain in effect for at least two years after decedent passed away. Therefore, the policy had significant value. As a result, it is includable in the estate under Sec. 2042(2).

The estate then maintained that the obligation existed under the property settlement provisions to pay the full $2.495 million amount to Susan Kahanic. Under Sec. 2516, a payment under a marital and property rights judgment is deemed to be made for full and adequate consideration. Because this settlement agreement was the determination of the marital and property rights of Susan Kahanic, it is deemed full and adequate consideration and therefore satisfies the consideration requirement of Sec. 2053(c)(1)(A).

Finally, while the estate had declined in value by the trial date, when the loan of $207,000 was created in May of 2006, it appeared that the estate had sufficient assets to pay the taxes and have over $150,000 left to pay interest on the loan. Therefore, based upon a reasonable expectation of repayment by Mrs. Kahanic, there was a valid loan. In addition, because the estate was illiquid and it was difficult to sell AEPS for its fair market value, the loan was "actually and necessarily incurred" under Reg.20.2053-3(a). Therefore, the interest payable on the loan also qualified for a deduction.

Applicable Federal Rate of 1.4% for April -- Rev. Rul. 2012-11; 2012-14 IRB 1 (16 Mar 2012)

The IRS has announced the Applicable Federal Rate (AFR) for April of 2012. The AFR under Section 7520 for the month of April will be 1.4%. The rates for March of 1.4% or February of 1.4% 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.