Planning Notes

The United States can hold parties to asset transfers, both transferors and transferees, personally liable for outstanding debts owed to the United States by a debtor. One type of such debt has the potential to affect many: federal tax and tax-related debts owed by decedents' estates. However, the basis and scope of liability associated with transfers from decedents' estates vary significantly depending upon whether the party is a fiduciary or transferee.

Fiduciary Liability

Executors, administrators, personal representatives, and others that control and distribute the assets of a decedent’s estate are called fiduciaries. Such fiduciaries are required to respect the creditors’ priorities set forth in 31 U.S.C. §3713(b) when handling estate matters and if not, they may be held personally liable for the debts of the estate owed to the United States.

The imposition of personal liability is subject to the following three (3) conditions set forth in 31 U.S.C. §3713 and case law as made by courts:

1. The creditor priority set forth in 31 U.S.C. §3713(a) must apply;
2. The fiduciary’s liability cannot exceed the amount of debts paid before those owing to the United States are paid; and
3. The fiduciary must have notice of such debts.

Although the first two conditions are somewhat straightforward, the third condition is more complicated because it does not exist in statutory form but has been consistently added by courts in such cases. “[I]t has long been held that a fiduciary is liable only if it had notice of the Claim of the United States before making the distribution.” Want v. Comm’r, 280 F.2d 777, 783 (2nd Cir. 1960).

What constitutes notice is usually dependent upon the facts and circumstances of a particular case but, in general, the requirement may be “satisfied by either actual knowledge of the liability or notice of such facts as would put a reasonably prudent person on inquiry as to the existence of the unpaid claim of the United States.” Leigh v. Comm’r, 72 T.C. 1105 (U.S.T.C. 1979). Inquiry is not required unless there are circumstances that would suggest to a reasonably prudent person that an inquiry be made. Rev. Rul. 66-43. Further, it is the burden of the IRS to prove that the fiduciary had notice of such debts.

When calculating and imposing personal liability for unfiled tax returns, IRS personnel are advised to take into account the notice that a particular fiduciary had regarding unfiled returns. Specifically, the IRS manual states that an IRS agent should “determine if and when the fiduciary had knowledge of the balance due or unfiled returns.” Internal Revenue Manual 5.5.3.9(3).

As a result of the three (3) aforementioned conditions, the basis and scope of personal liability as they pertain to fiduciaries is much more limited than such basis and scope as they pertain to transferees, discussed below.

Transferee Liability

Transferees of assets from a decedent’s estate owing estate, gift, or income taxes to the United States, whether they are heirs, devisees, or others, may be held personally liable for such debts through a summary procedure set forth in 26 U.S.C. §6901 whereby the IRS can seek to impose personal liability upon transferees depending upon the type of tax obligation if a transfer, or series of transfers, rendered the decedent’s estate insolvent. However, §6901 does not impose personal liability; rather, the legal authority to impose personal liability is different for each type of tax.

A) Federal Estate Tax

Section 6324(a)(2) provides that transferees of property included in the gross estate of a decedent are personally liable for unpaid estate taxes associated with such property. However, the courts are split as to whether the IRS must follow the procedures set forth in §6901 to assess the tax against the transferee if the tax has been assessed against the estate.

In U.S. v. Russell, the Tenth Circuit Court of Appeals held that the collection procedures set forth in §6901 are cumulative and alternative, and therefore the IRS was not required to follow the procedures set forth in §6901. 461 F.2d 605 (10th Cir. 1972). In U.S. v. Schneider, however, a district court held that assessment against the estate provided insufficient notice to the transferee. 92-2 USTC 60, 119 (N.D. 1992).

B) Federal Gift Tax

Unlike federal estate tax obligations, however, the courts agree that federal gift taxes need not be assessed against a transferee before the IRS can collect the tax.

Section 6324(b) imposes a lien “upon all gifts made during the period for which the return was filed, for 10 years from the date the gifts are made.” Section 6324(b) subsequently addresses the liability that will result from non-payment of taxes, in particular: “If the tax is not paid when due, the donee of any gift shall be personally liable for such tax to the extent of the value of such gift.”

C) Federal Income Tax

Determining the authority by which the IRS can impose personal liability for unsatisfied federal income tax obligations is much more complicated than for federal estate or gift tax obligations because there is no basis in the Internal Revenue Code (IRC) to do so; rather, the IRS must look to other legal authority, including: i) state fraudulent transfer statutes, ii) federal fraudulent transfer statutes, or iii) equitable principles.

i) State Fraudulent Transfer Statutes

Although a discussion of each state's fraudulent transfer laws is not within the scope of this post, each state has enacted statutes whereby transfers that are made for less than a fair valuation while a debtor is insolvent can be “avoided” by the courts.  The basis for many of these fraudulent transfer staatutes is the Uniform Fraudulent Transfer Act (UFTA). Although the specific provisions of each state's particular codification of the UFTA may vary, the relevant provisions of the UFTA define “insolvent” as applicable to decedents' estates as follows:

1. A debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets, at a fair valuation.
2. A debtor who is generally not paying his [or her] debts as they become due is presumed to be insolvent.

UFTA §2.

The U.S. Supreme Court has held that the IRS can leverage these state statutes to collect federal income tax obligations from transferees. Comr. v. Stern, 357 U.S. 39 (1958). The effect of these statutes is to return the transferred assets back to the transferor whereafter creditors of the transferor can attach those assets and use them to satisfy claims against the transferor.

Various federal tax courts have held that the IRS need not “assess” the tax in order for it to affect the insolvency of a debtor; rather the “the tax is ascertainable when the tax period ends” and must be factored into insolvency calculations from that point forward. 67 T.C.M. 1968, 1970 (U.S.T.C. 1994). In making such insolvency calculations, courts have further held “that the transferee is liable irrespective of the particular moment at which the transferor lapsed into insolvency, if such results no later than at the end of a series of transfers.” Id. at 1970.

ii) Federal Fraudulent Transfer Statutes

The Federal Debt Collections Procedures Act of 1990 (FDCPA), 28 U.S.C. §§3001-3308, enables the IRS to seek three types of remedies against transferees of insolvent estates for federal income tax obligations if the transfers were for less than “reasonably equivalent value”:

1. avoidance of the transfer or obligation to the extent necessary to satisfy the debt to the United States;
2. a remedy under this chapter against the asset transferred or other property of the transferee; or
3. any other relief the circumstances may require.

28 U.S.C. §3306(a).

The definition of “insolvent” set forth §3302(a) of the FDCPA is very similar to the aforementioned definition in the UFTA. In particular, the FDCPA specifies that “a debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets at a fair valuation.” Section 3302(b) also sets in place a presumption that “[a] debtor who is generally not paying debts as they become due is presumed to be insolvent.”

iii) Equity

Although there remain a number equitable principles, e.g. the trust fund doctrine or the concept of alter ego, through which the IRS can seek to recover an estate's unpaid federal income tax obligations from a transferee, the IRS uses such causes sparingly since the enactment of 26 U.S.C. §6901.

Creditors' Claims Period

Although the various implementations of the Uniform Probate Code as codified by the individual states can generally bar creditors' claims if such claims are not asserted during a specific period of time, often four (4) months, following the proper publication of notice of probate, the collectability of such federal tax debts is generally not affected because the Uniform Probate Code specifically allows creditors' claims based upon fraudulent transfers after that expiration of such period. UPC §1-106.  

This brief overview of some important considerations associated with tax liabilities for estates, fiduciaries, and transferees is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Covenants not to compete are used in various situations in attempts to ensure fairness and protect parties to a contract by limiting competition. Such covenants are sometimes held by courts to be unenforceable because they are overbroad in terms of geographical and time restrictions. However, these restrictive covenants can be written in a way so as to allow a court the discretion to alter such restrictions if a court finds that a covenant contains restrictions that are overbroad.

The "Blue Pencil"

Arizona courts “may ‘blue pencil’ a restrictive covenant by eliminating grammatically severable, unreasonable terms, [but] the court cannot add covenants or rewrite them.” Varsity Gold v. Porzio. 45 P.3d 352 at 355. In other words, Arizona courts are permitted to strike unreasonable restrictions in non-compete covenants so as to make such covenants reasonable; however, such courts are not permitted to rewrite or add to non-compete covenants to make them reasonable.

The "Step-Down"

One method used to write non-compete covenants, known as the “step-down” method, specifically recognizes and accounts for a court's power to “blue pencil” unreasonable restrictions. At least one opinion in Arizona’s Federal District courts has approved of such method. Compass Bank v. Hartley. 430 F. Supp. 2d 973 at 980.

The "step-down" method allows the drafters of non-compete covenants to add a series of terms that progressively become less and less restrictive, so that if a court finds a term unreasonable, it can strike the term while still giving effect to the remaining, less-restrictive alternate convenant. 

For example, a covenant restricting geographical and chronological scope can be written something along the lines of the following:

Employee shall not be permitted to offer services in the “Geographical Area” during the “Time Period”.

Geographical Area means the United State of America. If a court, arbitrator, or other tribunal of competent jurisdiction determines such a restriction is overbroad, Geographical Area means the State of Arizona. If a court, arbitrator, or other tribunal of competent jurisdiction determines such a restriction is overbroad, Geographical Area means Maricopa County. If a court, arbitrator, or other tribunal of competent jurisdiction determines such a restriction is overbroad, Geographical Area means the immediate area in which Employee offered services on behalf of Employer.

A similar “step-down” can also be used for “Time Period” or duration of the covenant.

Although courts may “blue pencil” covenants not to compete, courts are not compelled to do so. Indeed, a court can still find a covenant not to compete unenforceable even if the covenant implements such a “step-down” strategy. So it bears repeating that covenants not to compete should be written carefully and fairly.

This brief overview of some important considerations associated with covenants not to compete in Arizona is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Although the eligibility requirements referenced below may be seem difficult to fulfill, people can often become eligible for ALTCS through the formation of a Qualified Income Trust or Miller Trust.

The Arizona Long-Term Care System (ALTCS) is Arizona's implementation of the Medicaid program. ALTCS imposes federally-defined restrictions on income and resources of ALTCS members. For 2012, the income limit has been increased to $2,094.00 and the community spouse resource deduction has been increased to $113,640.00.

You can learn more about ALTCS eligibility by reading a prior post on the subject.

This brief overview of some important considerations associated with The Arizona Long-Term Care System (ALTCS) is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

In July 2011, Arizona’s Legislature enacted, and Governor Brewer signed, the current version of A.R.S. § 28-2055(B). This statute provides that a person (called a grantor) can designate a beneficiary to whom ownership of a motor vehicle will be transferred upon the death of the grantor via a beneficiary deed.

Unlike a beneficiary deed for real property, which must be recorded by a county recorder’s office, a beneficiary deed for a motor vehicle does not need to be recorded. As such, it is the responsibility of the grantor to ensure that the beneficiary will have access to the beneficiary deed when the time comes to present the deed to the Motor Vehicle Division (MVD).

As with other types of beneficiary deeds and payable on death accounts, a beneficiary deed can be revoked or the beneficiary designation can be changed until the grantor’s death.

You can download a fillable PDF of the MVD's beneficiary deed form at no cost.

This brief overview of some important considerations associated with motor vehicle beneficiary deeds is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Arizona life insurance beneficiaries who are deemed to have “insurable interests” in the lives of another, other than those effecting the insurance or their legal representatives, are “entitled to [life insurance] proceeds against the creditors and representatives of the person effecting the insurance.” A.R.S. § 20-1131(A).

Eligible Beneficiaries

Not everyone is entitled to be a beneficiary of a life insurance policy on the life of another. In fact, only the following parties are permitted to have an “insurable interest” in the life of another:

1. In the case of individuals related closely by blood or by law, a substantial interest engendered by love and affection.

2. In the case of other persons, a lawful and substantial economic interest in having the life, health or bodily safety of the individual insured continue, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the individual insured.

3. An individual party to a contract or option for the purchase or sale of an interest in a business partnership or firm, or of shares of stock of a closed corporation or of an interest in the shares, has an insurable interest in the life of each individual party to the contract and for the purposes of the contract only, in addition to any insurable interest which may otherwise exist as to the life of the individual.

4. A charitable organization as provided in section 43-1201, paragraph 4, which has a policy ownership interest has an insurable interest in the life of each proposed insured who joins with the charitable organization in applying for a life insurance policy naming the charitable organization as owner and irrevocable beneficiary.

A.R.S. § 20-1104.

Cash Surrender Value Beneficiaries

In addition to proceeds that are payable at death, many life insurance policies also have a cash surrender value, however, the class of beneficiaries that may receive such proceeds against the creditors of the insured is significantly smaller than the class that receives proceeds payable at death against the creditors of the insured.

In particular, if a person was continuously insured for a period of two years by an unexpired life insurance policy and that life insurance policy names the insured’s “surviving spouse, child, parent, bother, sister or any other dependent family member” as beneficiary, the cash surrender value of such policy is “exempt from claims and demands of all creditors, other than a creditor to whom the policy has been pledged or assigned, and except that, subject to the statute of limitations, the amount of any premiums which are recoverable or avoidable by a creditor pursuant to title 44, chapter 8, article 1, with interest, shall inure to their benefit from the cash surrender value.” A.R.S. § 20-1131(D).

This brief overview of some important considerations associated with life insurance and protection from creditors under Arizona law is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

A qualified personal residence trust, or QPRT, can reduce the federal estate tax associated with transfers of real property to heirs, reduce the federal gift tax associated with such transfers, and, provide asset protection.

Federal Estate & Gift Tax

A trust settlor (sometimes called a grantor or truster) must transfer his/her ownership of a residence to an irrevocable grantor trust while retaining the right to use the residence for a term of years. The IRS characterizes the transfer of the remainder interest, i.e. the interest in the residence after the term of years has expired, as a completed gift to the trust beneficiaries and the settlor must file a gift tax return for the present value of the remainder. Note that a such a gift is not eligible for the federal gift tax annual exclusion, because it is a future interest.

The key to minimizing the present value of the remainder interest in the residence, is to choose the longest reasonable term of years possible because the longer the term of the trust, the lower the present value of the remainder interest, which results in a smaller gift. Although the calculations involved in determining the value of the remainder interest are complex (IRC § 2701), a trust with a term of twenty (20) years, for example, will allow a much lower valuation of the remainder interest than a trust with a term of one (1) year.

Choosing the longest reasonable term of years is complicated by the fact that if the settlor is not alive at the expiration of the term of years, the value of the residence will be included in the settlor's estate. As such, the settlor must balance his/her desire to reduce the gift tax with the reality of his/her life expectancy in order to reduce the federal estate tax.

Federal Estate Tax Uncertainty

During 2011 & 2012, the effective unified federal estate and lifetime gift tax exemption is $5 million dollars per person or $10 million per legally married couple. This means that people can transfer their assets to heirs, while alive or dead, without being subject to federal estate or gift tax if the value of the decedent's estate and the lifetime gifts not subject to the annual gift tax exemption, does not exceed the effective unified federal estate and gift tax exemption.

This current effective unified federal estate and gift tax exemption, i.e. $5 or $10 million, is likely more than sufficient to cover the entire estate for most Americans. However, in 2013 the exemption is set to drop to $1 million per person or $2 million per married couple if Congress does not act and would result increase the number of people subject to the federal estate and gift taxes.

Federal Capital Gains Tax

Because a residence owned by a QPRT will not be included in the gross estate of the settlor, unless the settlor does not outlive the QPRT term, the beneficiaries of the trust will not receive the step-up in basis, which they would have received if the residence was included in the gross estate of the settlor. Without a step-up in basis, and if the property has appreciated substantially since acquired, the beneficiaries will be liable for capital gains based upon the settlor's cost basis as opposed to the fair market value of the property at the settlor's death, i.e. stepped-up basis. However, if the beneficiaries make the residence their primary residence, the personal residence exclusion may cover all or part of that appreciation if the residence is later sold.

Asset Protection

Because a QPRT is irrevocable, it is not legally owned  by the trust settlor and cannot be used to satisfy creditors' claims unless it was fraudulently transferred to the trust, used to guarantee a debt, or similar action.

This brief overview of some important considerations associated with a qualified personal residence trust (QPRT) is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

The United States Bankruptcy Code ("Code") provides for the discharge of federal income tax obligations in certain, limited situations. While there are numerous restrictions on bankruptcy discharge of such taxes, one is of particluar importance: timing.

Individual Bankruptcy

Individuals are generally permitted to file for discharge through bankruptcy under two chapters of the Code: Chapters 7 & 13. Chapter 7 provides for discharge of debts through liquidation while Chapter 13 provides for discharge pursuant to a repayment plan through which some debts are repaid and the others are discharged.

Federal Income Tax Obligations

Although both Chapters 7 & 13 provide for the discharge of qualifying federal income tax obligations, Chapter 13 requires repayment of such obligations.  However, Chapter 13 does avoid the accrual of future penalties and interest.

Timing Requirements

The Code permits discharge of certain older federal income tax debts while it does not permit the discharge of newer federal income tax debts. Federal income taxes are generally not eligible for discharge through liquidation under Chapter 7 or through repayment under Chapter 13 unless the following timing requirements are met:

1. The debtor's federal income tax return was due, including all extensions, more than three years before the bankruptcy petition filing.
2. The IRS assessed the tax more than 240 days before the bankruptcy petition filing.
3. The debtor's federal income tax return was filed more than two years before the bankruptcy petition filing.

11 USC §§ 507(a)(8) & 523(a)(1)(B).

Prior to Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), Chapter 13 provided for a "super-discharge" of tax debts for which the debtor did not actually file a tax return, however, that exception has been eliminated and timing requirements are now ostensibly the same as under Chapter 7.

This brief overview of some important considerations associated with bankruptcy and taxes is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Arizona law permits the reduction, or elimination, of property tax obligations for qualified real property owners and also permits qualified real property owners to defer payment of property taxes until the real property is sold or the real property owner dies. A.R.S. §§ 42-11111 & 42-17302.

Property Tax Exemption

The State of Arizona calculates real property taxes on owner-occupied residences based upon Assessed Value. The Assessed Value is 10% of the Full Cash Value, not 10% of the fair market value.

If the person meets the requirements set forth in A.R.S. § 42-11111, the amount of the current exemption is then subtracted from the Assessed Value. The property tax is then calculated based upon the modified Assessed Value.

Qualification

The exemption is available to individuals in a number of different cirumstances including qualifying widows, widowers, and disabled persons whose income does not exceed particular amounts and whose house does not exceed a particular Assessed Value, which is set forth in A.R.S. § 42-11111.

Property Tax Calculation

For example, a woman who meets the requirements set forth in A.R.S. § 42-11111 resides in and owns a home with an Assessed Value of $15,0000. In 2011, the exemption amount is $3,488. After substracting the exemption from the Assessed Value, her property tax will be caclulated based upon an Assessed Value of $11,512 ($15,000 - $3,488).

Property Tax Deferral

Arizona law permits a qualified individual to elect to defer the payment of property taxes on that individual's qualifying residence for a particular year.

Qualification

In order to be qualified, the individual must meet the following requirements:

1. The individual shall be at least seventy years of age on the date the deferral claim form is filed.

2. The individual, either individually or with another individual who resides in the residence, shall own the residence or be purchasing the residence under a recorded instrument of sale or shall hold the property under the terms of a real estate trust.

3. The individual must either:

(a) Have lived in the current residence for at least six years immediately preceding the date the deferral claim form is filed.

(b) Have lived in this state for at least ten years immediately preceding the date the deferral claim form is filed.

4. The individual may not own or have any legal, equitable, beneficial or security interest in any other residence or other real property, wherever it may be located, except indirectly through an investment security, such as a mutual fund, that includes real property among its assets.

A.R.S. § 14-17302(B)(1)-(B)(4)

In addition, "the total taxable income of all persons residing in the residence for the taxable year immediately preceding the current year may not exceed ten thousand dollars." A.R.S. § 14-17302(D).

Property tax deferals are also available to married couples who meet the requirements for individuals and who "[c]onsent to the deferral of taxes, regardless of whether both spouses have an ownership interest in the residence." A.R.S. § 42-17302(C).

Payment

The deferred property taxes, plus interest, must be paid upon the occurrence of one of the following events as set forth by statute:

1. The individual who claimed the deferral dies without a surviving spouse who qualifies under section 42-17302.

2. The tax deferred residence is sold or becomes subject to a fully executed, binding contract of sale or title to the residence is otherwise transferred to persons other than the individual or the individual's spouse who qualifies under section 42-17302. A tax deferred residence may not be transferred or conveyed unless the deferred property taxes, interest and costs are paid in full.

3. The residence is no longer the residence of the individual and, in the case of a married individual, the individual's spouse who qualifies under section 42-17302, unless the individual or spouse is required to be absent from the residence due to illness.

4. The residence becomes income producing property.

A.R.S. § 42-17311(A)(1)-(A)(4)

This brief overview of some important considerations associated with Arizona property tax exemption and deferral is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

The Internal Revenue Code (IRC) allows that after the death of the account owner, the proceeds from an Individual Retirement Account (IRA) may be distributed to a single beneficiary, multiple beneficiaries, multiple trusts (each having one beneficiary), and multiple trusts (each having multiple beneficiaries). In the case of a trust with multiple beneficiaries, however, the length of the distribution period may not exceed the life expectancy of a single designated beneficiary.

Required Minimum Distribution Beginning Date

The federal law, IRC §401(a)(9)(A)(i) & (ii), governing IRA distributions requires that distributions to the account owner begin by a certain date.

In the case of a non-spouse designated beneficiary, distributions must begin by the end of the year following the account owner's death. If the designated beneficiary was the decedent's spouse, however, the designated beneficiary may delay such distributions until he/she is 70 1/2.

Distribution Period: Actual Life & Life Expectancy

Section 401(a)(9)(A)(ii) requires that the entire interest of the account owner be distributed over the actual life of the account owner and a designated beneficiary or "over a period not extending beyond the life expectancy of such [account owner] or the life expectancy of such [account owner] and a designated beneficiary."

Whose Life Expectancy? (Multiple Trust Beneficiaries)

In cases of multiple trust beneficiaries, and after the death of the account owner, distributions may not continue beyond the life or the life expectancy of the oldest beneficiary (designated beneficiary).

Section 1.401(a)(9)-8 of the Treasury Regulations sets forth "separate account" rules for separate IRAs that the permit distributions from each account without reference to the lives or life expectancies of any other beneficiaries. However, §1.401(a)(9)-5 states "the separate account rules under A-2 of §1.401(a)(9)-8 are not available to multiple beneficiaries of a trust with respect to the trust's interest in the employee's benefit."

Separate Account Rules & Trusts

Although §1.401(a)(9)-4 requires that only individuals, not trusts, may be designated beneficiaries for purposes of determining the timing of required distributions, neither the IRS nor the Treasury Regulations prohibit the posthumous splitting of an IRA into two accounts. In such cases, however, distributions may not continue longer than the life expectancy of the eldest surviving beneficiary.

This brief overview of some important considerations associated with posthumous IRS distribution timing is by no means comprehensive. Always seek the advice of a competent professional when making important financial and/or legal decisions.