Monday, May 16, 2011

Insurance Policy Holders & Demutualization= IRS Tax Refund

Originally published in the November/December 2008 issue of South Carolina CPA Report, below check out an article discussing the tax implications of insurance company demutualization:

Millions of people and entities own insurance policies in one form or another. And if you owned a policy in the late 1990s or the early 2000s, your ownership may entitle you to a tax refund.

In the not so distant past, many insurance companies were owned by the policy holders who were entitled to receive company dividends and vote. These were called "mutual insurance companies.” USAA, for example, retains this current corporate structure. But many of these mutual insurance companies restructured themselves from policy holder owned to stockholder owned in the late 1990s and the early 2000s.

As part of the restructuring, individuals who owned policies were distributed new stock in the insurance companies when it transformed to a publicly owned company. This transformation from policy holder owned into publicly owned is called "demutualization.”

In the past, the IRS required that taxpayers, who received stock as part of a demutualization, pay capital gains tax on the 100 percent of the value of the stock when it was sold. But a recent court decision shot down the IRS's position and, in fact, said that the taxpayer owed no tax at all. This decision has widespread ramifications for individuals, professional associations and business entities that owned insurance policies.

Some of the largest insurance companies - in America demutualized in the last decade, including MetLife Inc. and Prudential Financial Inc. Between MetLife and Prudential alone, there were approximately 22 million policyholders at the time oftheir demutualization that occurred in 2000 and 2001, respectively. Indeed, when this tax treatment issue was shared with a South Carolina accountant, he advised that the one of the largest malpractice coverage providers in South Carolina for accountants was Prudential. No doubt, millions of individuals and entities received stock in insurance companies as a result of demutualization. More importantly, if the stock was sold, these individuals and entities paid tax on the sale. As it turns out, it appears that no tax was owed.

In August 2008, the Court of Federal Claims issued a decision in Fisher v. United States. The court held that tax is only owed on the sale of the demutualization stock to the extent that the sale proceeds exceed the cost basis in the taxpayer's policy. Because the stock was sold for $31,759 and the taxpayer had paid over $194,000 in premiums, the cost basis in the policy far exceeded the proceeds from the sale of the stock. As such, no taxable event occurred, and no tax was owed.

Let us review certain issues that could, affect a taxpayer's ability to receive the benefits of this decision. The ability to claim refunds by filing amended returns is limited to those claims filed within three years of filing the income tax return for the year in which the sale of the stock occurred, or two years after payment of the tax—whichever is longer.

If a taxpayer timely filed and paid, they are effectively limited to filing claims for refund for the 2005 to 2007 tax years, unless an agreement to extend the statue of limitations was entered into. If enough money is at issue, the taxpayer may consider bringing an action under the Tucker Act that provides for a six year statute of limitations. Please note that South Carolina follows the Federal Law for timely filing claims for refund, and refunds for South Carolina income tax should be available as well. As Certified Public Accountants whether practicing in public or private practice, this ruling has potential for great refunds. No need to make unintended gifts to the IRS.

NOTE: The opinion in Fisher was subsequently affirmed on appeal. See 333 Fed. Appx. 572 (Fed. Cir. Oct 09, 2009).

By Lindsey W. Cooper Jr., Esq. and Robert Baldwin, CPA, PFS, AEP.
Both authors work in Charleston, SC, at the Law Offices of L.W. Cooper Jr., LLC, and Baldwin and Associates LLC, respectively. Robert Baldwin is a former president of SCACPA.

Friday, May 6, 2011

Easy Money for Easements No More

With over 700 registered properties in an area which covers the majority of the peninsula on which it’s located, Charleston is one of several cities in the country protected by city, state, and federal law through its designation as “historic.” Beginning in the 1930’s, the city of Charleston drafted and enacted city ordinances aimed at preserving the architectural importance of these historic neighborhoods.

In furtherance of this aim, Charlestonians wishing to further protect the significance of their homes have begun donating historic easements to organizations such as the Preservation Society of Charleston, which alone holds over 75 exterior easements in the city. While these easements preserve the cultural significance of these buildings, they also offer an attractive tax incentive for home owners: charitable deductions. However, with a recent wave of U.S. Tax Court decisions restricting charitable tax deductions for conservation easements, this added incentive may all but disappear.

Charitable Deductions for Conservation Easements

The Internal Revenue Code provides tax incentives for individual seeking to make charitable donations, which may cover monetary contributions to your local church or dropping off clothing at Goodwill. While subject to limitations, Section 170 allows taxpayers to deduct the amount of charitable contributions they make within the taxable year on their tax returns. Section 170(f)(3)(B)(iii) specifically extends this deduction to donated “qualified conservation contributions,” which is defined as a contribution of a qualified real property interest, to a qualified organization exclusively for conservation purposes. It is this simple definition that is getting taxpayers in hot water.

A “qualified real property interest” is further defined as “a restriction (granted in perpetuity) on the use which may be made of the real property.” The Code clarifies that a contribution shall not be treated as “exclusively for conservation purposes” unless the conservation purpose is protected in perpetuity. Therefore, Congress made it clear that in order to receive the tax benefit of your contribution, the easement must essentially exist and be protected forever. But what about properties which are mortgaged?

While protecting an easement in perpetuity sounds great, technical problems arise when a bank holds a first priority mortgage on the property. The Treasury Regulations attempted to provide a loophole for this situation by providing that banks may subordinate its rights in the property to the rights of the organization to enforce the conservation purposes of the gift in perpetuity. Sounds easy enough, but, here is where it gets tricky.

The Regulations further require that, at the time of the gift, the property owner must agree that the donation of the easement gives rise to a property right, immediately vested in the donee organization, with a fair market value that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift bears to the value of the property as a whole at that time. Simplified, the easement must immediately vest a property right in the organization holding the easement which shall be enforceable against all third parties. This property right and the perpetuity requirement are two essential provisions of the charitable contribution which the IRS recently started to scrutinize.

Kaufman v. Commissioner

Enter Kaufman. In 1999, Lorna Kaufman purchased property located in Boston’s South End historic district with the help of a home loan with Washington Mutual. In 2003, Kaufman granted a façade easement to the National Architectural Trust (NAT) while seeking the benefit of a federal tax deduction. In order to satisfy the requirements relating to mortgaged property, Washington Mutual executed a Lender Agreement whereby it agreed to subordinate its rights to that of NAT for the purpose of carrying out the easement in perpetuity. However, the agreement also provided that the bank would have priority to all insurance proceeds and all proceeds of condemnation until the mortgage is paid in full. An appraisal occurred and the Kaufman’s took over $220,000.00 of deductions on their 2003 and 2004 returns relating to the donation of the façade easement.

The Tax Court disallowed the Kaufman’s deductions in their entirety for failing to meet the provisions of Treas. Reg. §1.170A-14(g)(6)(i) and (ii)—the crucial rule requiring an immediately vesting property right. The bank retained priority to all insurance and condemnation proceeds of the property by virtue of the Lender Agreement, precluding any right of NAT to its proportionate share. Therefore, the façade easement failed as a matter of law to comply with the enforceability-in-perpetuity requirements of Treasury Regulation § 1.170A-14(g)(6).

The implications of this case are staggering. What Kaufman tells us is that if a property is subject to a mortgage, and the property owner wishes to donate an easement and take a tax deduction, the bank must agree to waive its rights to the portion of the property covered by the easement. With banks in trouble and homes under water, these financial institutions will be hard pressed to forego any proceeds it may be entitled to pursuant to a mortgage. Without this subordination, your federal tax deduction will be challenged and disallowed. While some homeowners may be able to satisfy Kaufman’s requirements, or if they own their property outright, there is still a more difficult Tax Court holding to swallow for us Charlestonians.

1982 East, LLC v. Commissioner

The opinion in 1982 East was issued just one week after Kaufman. In 1982 East, an entity purchased property in 2002 in New York City’s Metropolitan Museum Historic District, making it subject to the city’s landmark and zoning laws. As in Kaufman, the property was subject to a mortgage held by Wachovia and the property owners sought to grant a façade easement to NAT. In order to donate the easement seemingly compliant with the Tax Code, Wachovia entered into a Lender Agreement featuring the same language as that in Kaufman. The entity completed an appraisal and took a $6.5M charitable deduction on its 2004 partnership return relating to the donation of the easement.

The Tax Court found that the Kaufman holding prevented the entity from taking the charitable deduction on its return. The façade easement was not protected in perpetuity because the organization did not obtain a vested property right as required by Treas. Reg. §1.170A-14(g)(6).

The Tax Court went further in its holding to determine that the easement also failed to meet the provisions of I.R.C. §170(h)(4). This section provides that the definition of “conservation purpose” for purposes of the façade easement means “the preservation of an historically important land area or a certified historic structure.” The Court stated that the entity’s deduction also depended on whether the transfer of the donated property in fact preserved the subject property, regardless if the provisions of Treas. Reg. §1.170A-14(g)(6) were met.

The Court found that it did not. New York City law made it unlawful for the entity to alter the subject property unless the Landmarks Preservation Commission approved it. Because local law and the rules of the Landmarks Preservation Commission preserved the subject property, not the rights which NAT possessed pursuant to the easement, the easement failed to meet the requirements of I.R.C. §170(h)(4).

Charleston, like many other historically significant towns, created their own ordinances and Board of Architectural Review to govern and manage the proposed alteration of historically significant properties. These properties are protected by these provisions regardless of whether a façade or any other type of conservation easement is given to charity. The Court in 1982 East found that any additional protections provided by the grant of an easement to such an organization are not meaningful enough to meet the requirements of the Tax Code. It does not “preserve a historically important structure” because the laws of the City of Charleston already protect it. People in this city who live under these BAR restrictions may not be able to take a charitable deduction on their federal returns if they choose to grant an easement on their property.

These two Tax Court opinions nearly eliminate any incentive for a homeowner to donate a preservation easement on their property. While the taxpayers in Kaufman and 1982 East were not subject to penalties for their erroneous deductions due to the Court’s first impression of the issue, future taxpayers will not be so lucky. Taking such a deduction may result in not only the disallowance of your deduction, but also accuracy related penalties and penalties for the substantial understatement of income tax, plus interest.

Of course, nothing prevents you from donating an easement out of the goodness of your heart. Just don’t plan on feeling the benefits in your wallet.