th 28 Annual Tax Conference
Thursday, May 21, 2015 Inn at St. John’s, Plymouth
Conference Schedule
Moderator: James H. Combs Honigman Miller Schwartz and Cohn LLP Detroit
Time Plenary Session 8:00 a.m. – Continental Breakfast, Exhibitor Showcase, and Registration 8:30 a.m. 8:30 a.m. – Welcome and Introductions 8:45 a.m. Marjorie B. Gell Chair, State Bar of Michigan Taxation Section Council Western Michigan University Thomas M. Cooley Law School Grand Rapids
8:45 a.m. – Washington Update: Current Tax Legislative Developments 9:45 a.m. • Future budget outlook • Trends in US taxation • Legislative outlook • Prognosis for tax reform
Tom Crawford C2 GROUP/FTI Consulting Washington, DC
9:45 a.m. – Lobbying the Tax Issue in Michigan 10:30 a.m. • Strategy: How, when, where, and to whom to make your case • Substance: Does it matter? What implications catch attention? • Interests: Who cares (and who matters)?
Kirk A. Profit Governmental Consultant Services Inc. Lansing
Tricia G. Kinley Michigan Chamber of Commerce Lansing 10:30 a.m. – Vendor Visits and Break 10:45 a.m. 10:45 a.m. – Changes in Real Estate, Pass-Through Entities, and Estate Planning 11:30 a.m. • The future for real estate investors under the present Congress • Why the Regulations under 162 and 263 are good news for real estate • The Proposed Regulations under Section 752: better safe than sorry? • Conservation easements -- the divide between Congress and the IRS
Stefan F. Tucker Venable LLP Washington, DC 11:30 a.m. – Round-Up of Select Recent State and Local Tax Cases 12:30 p.m. • Latest developments in sales and use tax cases, including the industrial processing exemption, cloud computing, click-through nexus, and what constitutes a taxable “use” • Recent State tax cases involving corporate officer liability and procedural and jurisdictional issues • Latest developments in property tax cases, including special assessments, real estate transfer tax, and valuation of “big box” properties
Joanne B. Faycurry Schiff Hardin LLP Ann Arbor 12:30 p.m. – Lunch and Awards Presentation 1:30 p.m. James H. Combs Tax Conference Planning Chair Honigman Miller Schwartz and Cohn LLP Detroit
Time Breakout Sessions 1:30 p.m. – State and Local Tax Federal Income Tax Committee – Estates and Trusts 2:30 p.m. Committee/Practice and Procedure Wisdom Committee/Employee Benefits Committee – Grande Ballroom Red Flags when Buying or Selling a Committee – Kings I/II Current Developments in Michigan Business Employee Benefit Litigation Update Tax Litigation, Legislation, and • Analyzing the target’s federal • Recent and pending Supreme Administrative Guidance income tax position Court cases impacting qualified • Caselaw Update: IBM, Detroit • Key state and local tax issues, plans Edison, and other recent including potential successor • Trending qualified plan issues litigation liability in the 6th Circuit and beyond • Legislative Update: Officer • Adding value in structuring liability reform, offer-in- the transaction, including in Liam K. Healy compromise, retroactivity, and cross-border acquisitions Ferguson Widmayer PC audit reform Ann Arbor • Administrative Update: A Aaron Seth Feinberg review of recent administrative General Motors guidance Detroit
Thomas J. Kenny Juliana G. Rolecki Varnum LLP KPMG LLP Novi Detroit
Wayne D. Roberts Nosson C. Stoll Varnum LLP KPMG LLP Grand Rapids Detroit
Nichole Shultz Department of Treasury Lansing 2:30 p.m. – Vendor Visits and Break 2:40 p.m. 2:40 p.m. – Estates and Trusts Committee – Practice and Procedure Committee/ Federal Income Tax Committee – 3:40 p.m. Grande Ballroom Young Lawyers Committee - Wisdom Kings I/II Tax Consequences of Negotiating The Basics of Practice with the Digital Currency: Following the Buy-Sell Agreements IRS: Audits, Appeals, and Tax Tax Consequences • How to make your covenants Litigation • Understanding virtual more enforceable • Overview on practice before currency • The impact of a right of first the IRS • Exploring its role in taxation refusal or a right of first offer • How various cases progress • Anticipating unresolved issues • “Cause” for purposes of with the IRS terminating a key • Common defenses and IRS Joni D. Larson employee/stockholder forms Western Michigan University Thomas • Strategies for working with M. Cooley Law School Stefan F. Tucker the IRS Lansing Venable LLP • Question and answer session Washington DC Eric M. Nemeth Varnum LLP Novi
Eric R. Skinner IRS Office of Chief Counsel Detroit Detroit 3:40 p.m. – Vendor Visits and Break 3:50 p.m. 3:50 p.m. - State and Local Tax Committee/Young Employee Benefits Committee – Federal Income Tax Committee – 4:50 p.m. Lawyers Committee – Grande Wisdom Kings I/II Ballroom
Lobbyist Roundtable Fiduciary Responsibilities for Federal Tax Issues in Taxable Employer Stock Transactions • Lobbyists discuss Michigan legislative issues, including • Employer stock transactions – • Current developments in law state tax issues the GreatBanc settlement • Select tax accounting methods • Get insight into the role of agreement • Hot topics lobbyists in the legislative • Employer stock investment process and how it can relate funds – the Dudenhoeffer case Michael P. Monaghan to your practice and closely-held company Plante & Moran PLLC stock Clinton Township Kirk A. Profit • Fiduciary status of investment Governmental Consultant Services advisors Inc. Lansing Jeffrey A. DeVree Varnum LLP Douglas B. Roberts, Jr. Grand Rapids Consumers Energy Jackson Warren J. Widmayer Ferguson Widmayer PC Ann Arbor 5:00 p.m. - Networking Reception 6:00 p.m.
Tax Conference, 28th Annual Thursday, May 21, 2015 The Inn at St. John's, Plymouth Faculty List
James H. Combs Moderator Honigman Miller Schwartz and Cohn LLP 660 Woodward Ave Ste 2290 Detroit, MI 48226 (313) 465-7588 Fax: (313) 465-7589 [email protected] Tom Crawford Speaker C2 Group/FTI Consulting 325 7th St NW Ste 400 Washington, DC 20004 (202) 567-2900 Fax: (202) 393-7887 [email protected] Jeffrey A. DeVree Speaker Varnum LLP PO Box 352 Grand Rapids, MI 49501-0352 (616) 336-6566 Fax: (616) 336-7000 [email protected] Joanne B. Faycurry Speaker Schiff Hardin LLP 350 S Main St Ste 210 Ann Arbor, MI 48104 (734) 222-1527 Fax: (734) 222-1501 [email protected] Aaron Seth Feinberg Speaker General Motors 300 Renaissance Ctr Detroit, MI 48243 (313) 667-9616 [email protected] Marjorie B. Gell Speaker Western Michigan University Thomas M. Cooley Law School 111 Commerce Ave SW Grand Rapids, MI 49503 (616) 301-4080 Fax: (616) 301-6841 [email protected] Liam K. Healy Speaker Ferguson Widmayer PC 538 N Division St Ann Arbor, MI 48104 (734) 662-0222 Fax: (734) 662-8884 [email protected] Thomas J. Kenny Speaker Varnum LLP 39500 High Pointe Blvd Ste 350 Novi, MI 48375 (248) 567-7400 Fax: (248) 567-7440 [email protected] Tricia G. Kinley Speaker Michigan Chamber of Commerce 600 S. Walnut St. Lansing, MI 48933 (517) 371-7669 [email protected] Joni D. Larson Speaker Western Michigan University Thomas M. Cooley Law School 300 S Capitol Ave Lansing, MI 48933 (517) 371-5140 ext 2706 [email protected] Michael P. Monaghan Speaker Plante & Moran PLLC 19176 Hall Rd Ste 300 Clinton Township, MI 48038 (586) 416-4943 Fax: (586) 416-4901 [email protected] Eric M. Nemeth Speaker Varnum LLP 39500 High Pointe Blvd Ste 350 Novi, MI 48375 (248) 567-7402 Fax: (248) 567-7440 [email protected] Kirk A. Profit Speaker Governmental Consultant Services Inc. 120 N Washington Sq Ste 110 Lansing, MI 48933 (517) 484-6216 Fax: (517) 484-0140 [email protected] Douglas B. Roberts Jr. Speaker Consumers Energy 1 Energy Plaza Jackson, MI 49201 (517) 702-2820 [email protected] Wayne D. Roberts Speaker Varnum LLP 333 Bridge St NW Grand Rapids, MI 49504 (616) 336-6892 Fax: (616) 336-7000 [email protected] Juliana G. Rolecki Speaker KPMG LLP 150 W Jefferson Ave Ste 1900 Detroit, MI 48226 (313) 230-3000 Fax: (313) 230-3001 [email protected] Nichole Shultz Speaker Michigan Department of Treasury
Lansing, MI 48922 (517) 636-5300 [email protected] Eric R. Skinner Speaker IRS Office of Chief Counsel Detroit 500 Woodward Ave Ste 1300 Stop 31 Detroit, MI 48226 (313) 628-3111 Fax: (313) 628-3105 [email protected] Nosson C. Stoll Speaker KPMG LLP 150 W Jefferson Ave Ste 1900 Detroit, MI 48226-3506 (313) 230-3011 Fax: (313) 447-2690 [email protected] Stefan F. Tucker Speaker Venable LLP 575 7th St NW Washington, DC 20004 (202) 344-8570 Fax: (202) 344-8300 [email protected] Warren J. Widmayer Speaker Ferguson Widmayer PC 538 N Division St Ann Arbor, MI 48104 (734) 662-0222 Fax: (734) 662-8884 [email protected] 5/12/2015 Faculty Biographies Tax Conference, 28th Annual
James H. Combs Honigman Miller Schwartz and Cohn LLP Detroit, Michigan A partner in the firm, James H. Combs concentrates his practice on corporate taxation, mergers and acquisitions, tax credit projects, and financial products taxation. He is admitted to practice in Michigan and Texas and serves on the Committee on Financial Transactions of the Taxation Section of the American Bar Association. A graduate of the University of Texas School of Law, Mr. Combs has had several articles published. Tom Crawford C2 Group/FTI Consulting Washington, DC Tom Crawford is a senior managing director in FTI Consulting's Strategic Communications segment, part of the segment's Public Affairs practice, and serves as head of its Government Affairs specialty practice in the Americas. He primarily serves clients in the fields of budget matters, corporate governance, retirement security, and tax policy and regulation. He has worked on every budget reconciliation and tax-measure package considered by Congress in the past two decades. Prior to FTI Consulting, Mr. Crawford was a founding partner of the government affairs and lobbying firm, C2 Group, which was acquired by FTI Consulting in 2013. He also was a legislative director and managing partner at Murray Montgomery and O'Donnell. Before Mr. Crawford came to Capitol Hill, he served as the legislative director in the Michigan Legislature and on the professional campaign staff through four election cycles for both statewide and federal races. Mr. Crawford is a member of the Tax Council and chairs the board of directors at Harvard University's Center on Media and Child Health. He has spoken around the world on advocacy, insurance, and tax policy and has been a lecturer in the Smithsonian series. Jeffrey A. DeVree Varnum LLP Grand Rapids, Michigan Jeffrey A. DeVree practices in the areas of business law and taxation. He works with clients firm-wide on federal, state, local, and international tax matters, including tax controversies as well as tax planning for business transactions. He is a member of the Business Law and Taxation Sections of the State Bar of Michigan and has served on the Taxation Section Council. Mr. DeVree is also a member and a past chairman of the Business and Tax Section of the Grand Rapids Bar Association. He serves on the tax policy committees of the Michigan Chamber of Commerce and the Grand Rapids Area Chamber of Commerce and worked with those committees to review and develop proposals for replacing the single business tax. Mr. DeVree has published articles in "The Michigan Tax Lawyer," "The Grand Rapids Business Journal," and other publications. He is a frequent speaker at seminars and meetings on tax matters, most recently including the Association of General Contractors, the Michigan Association of CPAs West Michigan Tax Symposium, and the State Bar of Michigan's Annual Tax Conference. Joanne B. Faycurry Schiff Hardin LLP Ann Arbor, Michigan Joanne B. Faycurry focuses her practice on state and local taxation matters. Her state tax practice focuses on controversy and litigation work as well as state tax planning with respect to all state-levied taxes, including the now-repealed single business tax, the Michigan Business Tax, sales, use and withholding taxes, and individual income taxes. Ms. Faycurry's local tax practice focuses on real and personal property tax valuation/assessment disputes, exemption claims, and special assessment disputes. Ms. Faycurry is a member of the American Bar Association's Taxation Section, where she serves on the State and Local Taxes Committee and its BAT Task Force Special Committee. A member of the State Bar of Michigan, she is a past chairperson of both the Taxation and Real Property Law Sections’ State and Local Tax Committees. Additionally, she is a fellow in the Litigation Counsel of America and a member of the Detroit Metropolitan Bar Association and the Federal Bar Association. A frequent speaker and writer on state and local tax matters, Ms. Faycurry is the author of the Michigan chapter of the ABA's "Sales and Use Tax Handbook" (2002-present), and author of Michigan Municipal Finance’s "Michigan Property Tax Developments." Aaron Seth Feinberg General Motors Detroit, Michigan Aaron Feinberg is senior tax counsel for General Motors, where he focuses on domestic and international tax planning and various tax related matters. Prior to joining GM, Aaron was a managing director in KPMG’s Detroit office and led the firm’s mergers and acquisitions tax practice in the Mid-Americas region. Aaron also spent six years in the tax group at Skadden, Arps, Slate, Meagher & Flom LLP in Washington, D.C. and was a partner in the corporate and securities department at Honigman Miller Schwartz & Cohn LLP in Detroit. Aaron holds an LLM in taxation from Georgetown University School of Law as well as a JD from Boston University School of Law. Marjorie B. Gell Western Michigan University Thomas M. Cooley Law School Grand Rapids, Michigan Marjorie B. Gell is an associate professor, teaching federal income tax at the JD level and federal tax research in the LLM program. She holds a JD and an LLM in taxation from Wayne State University Law School. Professor Gell is the coeditor of "Guidebook to Michigan Taxes 2012," and coauthor of "Practical Guide to the Michigan Business Tax" (2009). She has written numerous articles in national and state tax journals, and her column "As a Matter of Tax" appears nationally in State Tax Notes. Professor Gell has served since 2005 on the council of the Taxation Section of the State Bar of Michigan and serves as chairperson of the section. She has also served as the section's Legislation Monitor and Public Policy Liaison and has chaired and cochaired annual conferences. From 2005 to 2007, Professor Gell was the editor-in-chief of the section's "Michigan Tax Lawyer," and in 2008 she served as coeditor. She is also an advisory member of the State Bar of Michigan Standing Committee on Libraries, Legal Research, and Legal Publications as well as a member and founder of the Michigan Women's Tax Association. Professor Gell is also a member of the Grand Rapids Chamber of Commerce Tax and Regulatory Policy Committee. Liam K. Healy Ferguson Widmayer PC Ann Arbor, Michigan A partner with the firm, Liam K. Healy practices in the areas of estate planning, taxation, probate, business law, and employee benefits/ERISA. He holds both a JD from the Michigan State University College of Law and an LLM in taxation from Georgetown University Law Center. Mr. Healy is a member of the Washtenaw County Bar Association and the State Bar of Michigan. Thomas J. Kenny Varnum LLP Novi, Michigan Thomas J. Kenny is a partner in the firm's tax team. His practice includes civil and criminal tax litigation. He was employed by the Michigan Department of Attorney General from 1979 to 1987, where he acted as legal counsel to the Department of Treasury in litigation matters before the Michigan Tax Tribunal, Court of Claims, and Court of Appeals. Prior to his employment with the Michigan Attorney General, he was an assistant prosecuting attorney in Detroit and handled criminal litigation and appeals. Mr. Kenny's tax practice focuses on the representation of Fortune 1000 companies in State and Local Tax ("SALT") litigation, which includes sales, use, corporate income, franchise, motor fuel, tobacco, real and personal property and Michigan Business Tax matters. He has represented clients before administrative agencies and courts in Michigan and around the country. The multi-state representation includes tax cases in Indiana, New York, Ohio, Pennsylvania, and Tennessee. Tricia G. Kinley Michigan Chamber of Commerce Lansing, Michigan Tricia G. Kinley advocates key tax policy and regulatory positions for the Michigan Chamber of Commerce. As senior director of tax and regulatory reform, she works extensively with administration officials and legislators and educates the public about state tax policy proposals through the media and other public forums. In addition to her work at the Chamber of Commerce, Ms. Kinley worked for Johnson & Johnson, handling a wide range of key legislative and regulatory issues, and the Detroit Regional Chamber of Commerce as director of public policy, where she developed and advocated taxation and workplace policies. She also served as government affairs coordinator for the American Society of Employers, where she was the lead representative for the organization's governmental activities, lobbying, and legislative inquiries at the state and national level. Joni D. Larson Western Michigan University Thomas M. Cooley Law School Lansing, Michigan Professor Joni D. Larson is the assistant director of the Graduate Tax Program. She also teaches Individual Tax, Business Organizations, Partnership Tax (LL.M.), and Tax Research and Argument (LL.M.). Professor Larson earned her J.D. from the University of Montana School of Law and her LL.M. from the University of Florida College of Law. Before joining the Cooley faculty in 2002, she worked for the Office of Chief Counsel for the Internal Revenue Service, both in the National Office, where she was an attorney with the Passthroughs and Special Industry Branch of the Field Service Division, and in the field, where she litigated on behalf of the IRS. In addition to numerous other publications, Professor Larson has authored the textbook "Partnership Taxation: An Application Approach" (Carolina Press). Michael P. Monaghan Plante & Moran PLLC Clinton Township, Michigan Michael P. Monaghan consults with many closely held and mid-sized companies and specializes in tax planning related to the restructuring of entities, including determining the best strategy to sell or buy a business and tax-free mergers and reorganizations. He frequently consults with clients to structure newly formed businesses and has considerable experience with cross-entity mergers, mergers of partnerships, redemptions, 338(h)(10) elections, spin-offs, and disregarded entities. Mr. Monaghan also consults with individuals and multinational companies to determine the best structure to minimize their worldwide tax burden. He also specializes in the area of the research tax credit and has written many articles on the subject. Mr. Monaghan is a member of the American Bar Association, the State Bar of Michigan, the Macomb County Bar Association, and the St. Clair County Bar Association. Eric M. Nemeth Varnum LLP Novi, Michigan Eric M. Nemeth practices in the areas of civil and criminal tax controversies, litigating matters in the various federal courts. Before joining Varnum, he served as a senior trial attorney for the Office of Chief Counsel of the Internal Revenue Service and as a special assistant U.S. attorney for the U.S. Department of Justice, as well as a judge advocate general for the U.S. Army Reserve. Mr. Nemeth is the former chairperson of the Taxation Sections of both the State Bar of Michigan and the Federal Bar Association. He speaks and writes frequently on matters of tax practice and procedure for the ABA and locally. Mr. Nemeth is an adjunct professor of tax at Michigan State University College of Law and serves on the board of directors of the law college's Tax Clinic. Kirk A. Profit Governmental Consultant Services Inc. Lansing, Michigan Kirk A. Profit had an award-winning 10-year career in the Michigan House of Representatives before joining Governmental Consultant Services Inc. While a member of the Legislature, he chaired the influential House Tax Policy Committee, as well as the House Committee on Higher Education. The former legal advisor and Undersheriff to the Washtenaw County Sheriff’s Department earned a bachelor's degree from Eastern Michigan University, where he also worked as an adjunct professor. He is a member of the State Bar of Michigan, having earned his juris doctorate from the University of Detroit School of Law. Douglas B. Roberts, Jr. Consumers Energy Jackson, Michigan Douglas B. Roberts, Jr. is the Director of State Government Affairs for Consumers Energy. He advocates on behalf of the company at the state capitol in Lansing on issues including environmental policy, tax policy, and energy policy. Mr. Roberts joined Consumers Energy in 2011. Previously, he spent eight years as the Director of Environmental and Energy Policy for the Michigan Chamber of Commerce, where he spearheaded revisions to the state's environmental cleanup laws, passage of the comprehensive 2008 energy law, and passage of the multi-state Great Lakes Compact, among other successful initiatives. He earned his B.A. from Hope College and an M.P.A. from Michigan State University, and is currently working on MBA from Michigan State. Wayne D. Roberts Varnum LLP Grand Rapids, Michigan Wayne D. Roberts is a tax attorney who practices in the areas of federal and state tax litigation, tax planning, civil and criminal tax defense, and tax aspects of mergers and acquisitions. He has represented closely held businesses, Fortune 1000 companies, and individuals in tax disputes with the IRS, Michigan Department of Treasury, revenue departments in Indiana, Ohio, Tennessee, California, Illinois, New Jersey, New York, and numerous other state and local taxing jurisdictions. Mr. Roberts is a registered CPA in Michigan, Ohio, and Illinois. He serves on multiple committees for business groups, including the tax committees of the Michigan Chamber of Commerce and the Grand Rapids Chamber of Commerce. Mr. Roberts is a former chair of the State Bar of Michigan's Taxation Section and also served as chair of the Taxation Section's State and Local Tax Committee. He is a member of the American Bar Association Taxation Section, the Michigan Association of CPAs, and the Grand Rapids Bar Association and serves as vice chairperson of the National Association of State Bar Taxation Sections. Mr. Roberts is a frequent speaker and writer and has written and presented for ICLE on multiple occasions. He also has authored and edited tax treatises for CCH Wolters Kluwer and published articles in a variety of journals, including the "Michigan Bar Journal," the "Journal of Multistate Taxation and Incentives," the "Wayne Law Review," and the State Bar of Michigan's "Michigan Tax Lawyer." Juliana G. Rolecki KPMG LLP Detroit, Michigan Juliana G. Rolecki is a senior associate in KPMG's Mergers and Acquisitions (M&A) practice. She has extensive experience advising strategic and private equity clients in domestic and cross-border transactions, including mergers, acquisitions, tax-free reorganizations, spin transactions, inversions, and debt restructurings. Her current and past clients include market leaders in automotive component manufacturing, finance, health care, and pharmaceutical industries. Prior to joining the KPMG M&A group, Ms. Rolecki worked as a tax attorney at Cleary Gottlieb Steen & Hamilton in New York, where she assisted clients with sovereign debt restructuring transactions, capital markets transactions, corporate mergers and acquisitions, restructurings, and the taxation of financial products. She is a member of KPMG's Network of Women (KNOW) and the New York Bar Association. Nichole Shultz Michigan Department of Treasury Lansing, Michigan Nichole Shultz has been with the Michigan Department of Treasury since 2003. She is the manager of the Office of Collections, Technical Services Area, which is responsible for the collection of delinquent taxes and other state agency debts. Ms. Shultz oversees various functions within the Office of Collections including the newly established Offer in Compromise program. She has a Bachelor of Business Administration degree in Management/Computer Information Management from Northwood University. Eric R. Skinner IRS Office of Chief Counsel Detroit Detroit, Michigan Eric R. Skinner is the managing counsel for the IRS Office of Chief Counsel - Detroit. He has been with the Office of Chief Counsel since 1995. Prior to joining the IRS, Mr. Skinner was a tax attorney with the Detroit office of Deloitte and Touche. A graduate of Michigan State University College of Law, he also serves as an adjunct professor in the Tax LL.M. Program at Thomas M. Cooley Law School and the Tax MST Program at Walsh College. Nosson C. Stoll KPMG LLP Detroit, Michigan Nosson C. Stoll is a manager in KPMG's Mergers & Acquisitions Tax practice. He has significant experience advising clients on U.S. federal tax aspects of business acquisitions and dispositions including tax planning, structuring, diligence, and related compliance matters. Prior to joining the M&A Tax practice, Mr. Stoll worked as a tax attorney in the Corporate Tax department of a large Detroit law firm. As a practicing attorney, he advised clients on a wide variety of U.S. federal and state tax issues. Stefan F. Tucker Venable LLP Washington, DC Stefan F. Tucker represents a wide variety of clients, from the entrepreneur and the professional, on the one hand, to publicly traded enterprises, such as real estate investment trusts, on the other hand. His practice encompasses an entire range of subjects, including mergers and acquisitions; entity planning, structuring, and formation; asset protection and preservation; business transactions; and family business planning and wealth preservation. Mr. Tucker has extensive experience in federal and state income, estate, and gift taxation matters, including tax audits. He is a past chairperson of the American Bar Association's Section of Taxation and was an active member of the Section's Task Force on Tax System Restructuring, with a particular focus on real estate. In addition, Mr. Tucker is a member of the District of Columbia Bar's Division of Taxation, having previously served as a member of its Steering Committee. He is also a member of the American Law Institute, the American College of Real Estate Lawyers, and the American College of Tax Counsel. Mr. Tucker has been a professorial lecturer at law from 1970 to 1990 at Georgetown University Law School and an adjunct professor at law since 1990 at Georgetown University Law Center. He is also a visiting lecturer at the University of Michigan Law School. Mr. Tucker serves on the advisory boards of "Real Estate Taxation" and "Practical Tax Strategies." Warren J. Widmayer Ferguson Widmayer PC Ann Arbor, Michigan Warren J. Widmayer concentrates his practice on employee benefits law, tax, and estate planning. He is a past chairperson of the Taxation Section of the State Bar of Michigan and past chairperson of the Great Lakes Area TE/GE Council (an IRS employee plans liaison group). Mr. Widmayer is also a member of the American Bar Association's Taxation Section and its Employee Benefits Committee; the Washtenaw County Bar Association; the ESOP Association; and the International Foundation of Employee Benefit Plans. He is listed in "The Best Lawyers in America" for Employee Benefits Law and Tax Law; was named Best Lawyers' 2012 Ann Arbor Employee Benefits (ERISA) Law Lawyer of the Year; and has been listed in "Super Lawyers" since 2006. A graduate of the University of Michigan Law School, Mr. Widmayer is a frequent author and speaker on employee benefits issues. Taxation Section Council (810800) As of January 4, 2015
Chair P46974 Marjorie B. Gell Western Michigan University Cooley Law School 111 Commerce Ave SW Grand Rapids MI 49503-4105 Phone: (616) 301-6800 x6823 e-mail: [email protected]
Vice Chair P57175 Michael M. Antovski, Detroit
Treasurer P58898 Alexander G. Domenicucci, Southfield
Council Member Term Ending: 2015 P68781 Jackie J. Cook, Ann Arbor P71691 William Charles Lentine, Bloomfield Hills P48934 Regina M. Staudacher, Royal Oak Term Ending: 2016 P58525 Marla Schwaller Carew, Troy P59750 James H. Combs, Detroit P51464 Frank E. Henke, Clinton Township Term Ending: 2017 P61138 Paul V. McCord, Lansing P52057 Joseph Pia, Rochester Hills P59516 Tammie J. Tischler, Ann Arbor
Commissioner Liaison P20535 Richard J. Siriani, Troy
Ex Officio P60466 Lynnteri Arsht Gandhi, Detroit
Administrator P33443 Brian D. Figot, Beverly Hills
SECTION MEMBERSHIP APPLICATION FOR EXISTING BAR MEMBERS
Please check the section(s) you would like to join and submit with prepayment. The membership year is October 1 to September 30. Membership begins immediately through September 30.
SECTION NO. COST SECTION NO. COST Administrative & Regulatory Law .... 01 .....$20 Labor & Employment Law ...... 14 .....$35 Agricultural Law ...... 37 .....$25 Latin American Bar Activities ...... 15 .....$15 Alternative Dispute Resolution ...... 02 .....$40 Law Practice Management & American Indian Law ...... 31 .....$20 Legal Administrators ...... 16 .....$25 Animal Law ...... 32 .....$25 Litigation ...... 29 .....$25 Antitrust, Franchising & Master Lawyers* ...... 27 .....$25 Trade Regulation ...... 03 .....$30 Master Lawyers* ...... 27 .....FREE Appellate Practice...... 30 .....$25 $25 for those who are 50 years of age or have 20 years of experience; free for active, inactive, and emeritus members who are 60 years of age Arts, Communication, or have 30 years of practice. Entertainment & Sports...... 04 .....$20 Military & Veterans' Law ...... 38 .....$25 Aviation Law ...... 23 .....$25 Negligence Law ...... 17 .....$50 Business Law ...... 05 .....$35 Paralegal/Legal Assistant ...... 25 .....$25 Children’s Law ...... 13 .....$40 Prisons & Corrections ...... 35 .....$30 Consumer Law ...... 33 .....$15 Probate & Estate Planning ...... 18 .....$35 Criminal Law ...... 07 .....$25 Public Corporation Law ...... 19 .....$30 Elder Law and Disability Rights . . . 26 .....$35 Real Property Law ...... 20 .....$45 Environmental Law ...... 08 .....$30 Social Security Lawyers ...... 34 .....$35 Family Law ...... 09 .....$60 Solo and Small Firm ...... 10 .....$20 Health Care Law ...... 28 .....$35 Taxation ...... 21 .....$30 Information Technology Law ...... 06 .....$25 Workers’ Compensation Law ...... 22 .....$30 Insurance & Indemnity Law ...... 36 .....$25 total: $______ Intellectual Property Law ...... 11 .....$35 (add both columns) International Law ...... 12 .....$35
All orders must be accompanied with payment. Check # ______is enclosed, made payable to the State Bar of Michigan. P Number ______Please charge the below debit/credit card: Name VISA: Exp. Date: Address MasterCard: Exp. Date:
Authorized Signature: City
State, Zip Please return to: State Bar of Michigan Finance Department Phone 306 Townsend Street Lansing, MI 48933-2012 Email Fax: (517) 372-5921
Prices are subject to change without notice. Revised 12/14
Tax Conference, 28th Annual
Table of Contents
1. Washington Update: Current Tax Legislative Developments 1-1
Tom Crawford C2 Group/FTI Consulting Washington, DC
Exhibit A PowerPoint Presentation 1-3
2. Lobbying the Tax Issue in Michigan 2-1
Tricia G. Kinley Michigan Chamber of Commerce Lansing
Kirk A. Profit Governmental Consultant Services Inc. Lansing
I. Introduction 2-1
Exhibit A Michigan Chamber of Commerce’s Priority for the State 2-3
3. Changes in Real Estate, Pass-Through Entities, and Estate Planning 3-1
Stefan F. Tucker Venable LLP Washington, DC
I. Legislative Developments 3-1 II. 2014-2015 Priority Guidance Plan (Updated as of December 31, 2014, Released January 29, 2015) 3-3 III. Proposed, Temporary and Final Regulations 3-6 IV. Revenue Procedures and Legal Advice 3-18 V. Private Letter Rulings 3-22 VI. Chief Counsel Advice, Technical Advice Memoranda and Action on Decision 3-26 VII. Cases 3-31 4. Round-Up of Select Recent State and Local Tax Cases 4-1
Joanne B. Faycurry Schiff Hardin LLP Ann Arbor
I. Recent Decisions of Michigan Supreme Court and Court of Appeals on Sales/Use Tax Issues 4-1 II. Recent Decisions of Michigan Supreme Court and Court of Appeals on Apportionment - MTC Election 4-13 III. Recent Decisions of Michigan Court of Appeals on Approach to Valuing Properties of “Big-Box” Retailers for Property Tax Assessment Purposes 4-17
5. Current Developments in Michigan Tax Litigation, Legislation, and Administrative Guidance - State and Local Tax Committee/Practice and Procedure Committee 5-1
Thomas J. Kenny Varnum LLP Novi
Wayne D. Roberts Varnum LLP Grand Rapids
Nichole Shultz Michigan Department of Treasury Lansing
I. Court of Claims Jurisdiction: Payment of Tax, Penalty and Interest 5-1 II. Tax Tribunal Jurisdiction: Payment of “Uncontested Portion of an Assessment, Order, or Decision” 5-2 III. Statute of Limitations: Completion of an Audit 5-2 IV. Property Tax Appeals: Real Party in Interest 5-3 V. Revenue Act: Requirements of a “Notice of Intent to Assess” 5-4 VI. Update on Corporate Officer Liability: SB 64; PA 3 of 2014 - Revised MCL 205.271(5) 5-4 VII. HB 4003 Created an Offer-In-Compromise (“OIC”) Program for the State of Michigan that Would Apply to All Michigan Taxes 5-8 VIII. Industrial vs. Commercial Classification Disputes 5-9 IX. CVS Caremark and Iron Mountain - Standard of Review from STC Decision 5-10 6. Red Flags when Buying or Selling a Business - Federal Income Tax Committee 6-1
Aaron Seth Feinberg General Motors Detroit
Juliana G. Rolecki KPMG LLP Detroit
Nosson C. Stoll KPMG LLP Detroit
Exhibit A PowerPoint Presentation 6-3
7. Employee Benefit Litigation Update - Estates and Trusts Committee/ Employee Benefits Committee 7-1
Liam K. Healy Ferguson Widmayer PC Ann Arbor
I. Introduction 7-1 II. Supreme Court Cases Involving ERISA 7-1 III. Cases of the 6th Circuit 7-10 IV. Other Circuit Court Decisions Involving ERISA 7-14
Exhibit A PowerPoint Presentation 7-25
8. Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee 8-1
Stefan F. Tucker Venable LLP Washington, DC
I. S Corporation/LLC Comparison 8-1 II. Business Use of FLPs and FLLCs 8-9 III. Recent Cases Regarding Estate Inclusion of FLP and FLLC Interests 8-14 IV. Recent Cases Regarding Valuation of FLP and FLLC Interests 8-21 8. Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee (continued)
Exhibit A Buy-Sell Agreements: An Issues Checklist 8-29
9. The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation - Practice and Procedure Committee/Young Lawyers Committee 9-1
Eric M. Nemeth Varnum LLP Novi
Eric R. Skinner IRS Office of Chief Counsel Detroit Detroit
I. Overview of the IRS 9-1 II. The Tax Examination 9-2 III. Criminal Investigation 9-2 IV. IRS Appeals 9-2 V. IRS Chief Counsel 9-2 VI. IRS Collection Division 9-2
Exhibits A Form 2848 Power of Attorney and Declaration of Representative 9-3 B Information Document Request Response Letter 9-5 C Notice of Determination 30 Day Letter 9-7 D Notice of Deficiency 90 Day Letter 9-9 E Correspondence Regarding Prosecuting of Taxpayer 9-13 F Information Re Filing a Case in the United States Tax Court 9-17 G Letter Re Stipulation of Facts 9-23 H US Tax Court Decision 9-25 I Notice of Federal Tax Lien Filing and Your Right to a Hearing Under IRC 6320 9-29 J Form 12153 Request for a Collection Due Process or Equivalent Hearing 9-35 K Form 433-A Collection Information Statement for Wage Earners and Self-Employed Individuals 9-39 L Form 656 Offer in Compromise 9-47 10. Digital Currency: Following the Tax Consequences - Federal Income Tax Committee 10-1
Joni D. Larson Western Michigan University Thomas M. Cooley Law School Lansing
I. Digital Currency - Definitions 10-1 II. Online, Multi-player, Video Gaming Systems 10-1 III. Bitcoin - How It Works 10-2 IV. Tax Treatment of Virtual Currency 10-4 V. The Real Problem with Bitcoin 10-5 VI. Going Forward 10-6
11. Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee 11-1
Douglas B. Roberts, Jr. Consumers Energy Jackson
Kirk A. Profit Governmental Consultant Services Inc. Lansing
Part One: Exhibit A PowerPoint Presentation 11-3
Part Two: I. Introduction 11-9
Exhibit A Key Michigan Legislators and Government Contacts 11-11 12. Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee 12-1
Jeffrey A. DeVree Varnum LLP Grand Rapids
Warren J. Widmayer Ferguson Widmayer PC Ann Arbor
I. Prudence - The Dudenhoeffer Case 12-1 II. Process - The GreatBanc Settlement Agreement 12-5 III. Status - The Proposed Regulation on Investment Advice 12-7
Exhibits A GreatBlanc Settlement Agreement 12-9 B Proposed Fiduciary Regulation: EBSA News Release 12-21 C Proposed Fiduciary Regulation: EBSA Fact Sheet 12-23 D Proposed Fiduciary Regulation: Notice of Proposed Rulemaking 12-29 E Proposed Fiduciary Regulation: Notice of Proposed Class Exemption for Best Interest Contracts 12-91
13. Federal Tax Issues in Taxable Transactions - Federal Income Tax Committee 13-1
Michael P. Monaghan Plante & Moran PLLC Clinton Township Washington Update: Current Tax Legislative Developments
by Tom Crawford C2 Group/FTI Consulting Washington, DC
Washington Update: Current Tax Legislative Developments
Tom Crawford C2 Group/FTI Consulting Washington, DC
Exhibit Exhibit A PowerPoint Presentation ...... 1-3
1-1
Washington Update: Current Tax Legislative Developments
Exhibit A PowerPoint Presentation th FTI CONSULTING: FTI CONSULTING: Reform in the 114 Tax Congress
1-3 Tax Conference, 28th Annual, May 21, 2015 (D-MI) (D-CO) Tax Reform Tax • –Tax Individual Income Grassley (R-IA) and Mike Senators Enzi (R-WY) and Senator Debbie Stabenow • – and Investment Savings Sherrod Brown Mike Crapo (R-ID) and Senator (D-OH) Senator • –Tax International Rob Portman (R-OH) Senator and Senator Chuck Schumer (D-NY) • Development and Infrastructure – Community Dean Senator Heller (R-NV) and Senator Michael Bennet •Tax– Income Business Thune (R-SD) Ben and Senator Cardin (D-MD) Senator John What’s New in 2015 What’s Groups –Finance Committee Working by Report May on Text Options with Legislative the Same What’s • Reform is hard • Tax • Parties are far apart The is in Bad Shape Congress the White House and between Relationship The Chairman Hatch –Theater but a Path to Reform One Priority and not Number Chairman Ryan will have a bill and be engaged middle class tax breaks The White House wants to message Republican Majorities can do Budget Reconciliation (see next slide)
1-4 Washington Update: Current Tax Legislative Developments didn’t cross the finish line – still out there it’s Tax Reform Tax Why this year? •deal at the end of 2014 that agreed to a $500 billion the White House and Congress • Reconciliation • Dynamic Scoring •as a Possibility – Business Only Senator Portman, Congressman Nunes, Secretary Lew • Inversions • OECD Base Erosion and Profit Shifting (BEPS) Project Why not this year? • Uncertainty about the use of reconciliation and rules surrounding it •their seats Republicans defending more than half of Senate Finance with 2016 elections • of the Chairman Camp plan The difficulty •Congress and President Obama Conflict between Republican
1-5 Tax Conference, 28th Annual, May 21, 2015 Budget Reconciliation The Budget Fifty votes are Year. to set spending priorities for the Fiscal in the Congress process time-limited A to needed to pass the budget after long series of referred as Vote-a-Rama. votes, The Budget can contain reconciliation instructions –or to committees achieve savings missives Reconciliation: Some of the items that have used levels by making new policy. spending •• Package Welfare Clinton Cuts • Tax Bush Pieces of the Affordable Care Act federal spending, which would tax reform Budget reconciliation can only be used for policies that affect do. to but is Reconciliation. open order the regular Chairman Hatch has said he would prefer to go through Senate Budget Chairman Mike Enzi has said the Leadership will wait until March to decide whether to use the process. Reform and a politically risky Tax Reconciliation would give Republicans a 50-vote threshold for Cuts. ownership of the issue. It would also likely limit Tax the reform to 10 years, just like the Bush
1-6 Washington Update: Current Tax Legislative Developments Sept. 30 expires WIC expire Authorization expires • CHIP funding •& Child Nutrition • FAA Ex-Im reauthorization expires June 1 June 30 Three Provisions of USA Patriot Act expire Surface Transportation Law Expires May 31 May March 31 March Medicare Doc Fix Expires March 15 March Debt Ceiling Suspension lifted predicts that (Treasury be could borrowing extended to Sept. or Oct.) DHS Funding Expires Feb. 27 Timeline for Action for Timeline Jan. 1 Tax Extenders Expired
1-7
Lobbying the Tax Issue in Michigan
by Tricia G. Kinley Michigan Chamber of Commerce Lansing Kirk A. Profit Governmental Consultant Services Inc. Lansing
Lobbying the Tax Issue in Michigan
Tricia G. Kinley Michigan Chamber of Commerce Lansing
I. Introduction...... 2-1 Exhibit Exhibit A Michigan Chamber of Commerce’s Priority for the State ...... 2-3 I. Introduction When it comes to lobbying tax issues in Michigan, policy priorities must be set in order to have an effective strategy. It is helpful to review the priorities of experienced organizations like the Michigan Chamber of Commerce (included as an exhibit).
2-1
Lobbying the Tax Issue in Michigan
Exhibit A Michigan Chamber of Commerce’s Priority for the State
Make Michigan One of the 10 Best Tax Climates in the U.S.
Making Michigan one of the 10 best tax climates in the U.S. is a high-priority issue for the Michigan Chamber. Michigan is making significant improvement in our business tax climate; personal property tax reform and a competitive, flat rate Corporate Income Tax are greatly contributing to Michigan’s improved tax rankings among states.
Improved tax laws that bring Michigan into the mainstream are important to how businesses perceive the environment for expansion and job growth, but more needs to be done in this area.
Michigan continues to carry a reputation for administering taxes by way of litigation. This is inefficient for the state and unfair to taxpayers. State and local tax policy should be clear and transparent, and taxpayers should feel confident that if they must pursue litigation, the courts will have the final say.
Lastly, Chamber members are troubled by the state’s continued use of third-party contingency fee paid auditors for tax and unclaimed property administration. Michigan could send a great message to the business community by banning this practice outright.
During the 2015-2016 legislative session, the Michigan Chamber will advocate:
• Supporting measures to dramatically improve the administration of taxes and seek measures to hold the state accountable for failing to adhere to its own rules and court decisions. • Strongly opposing expansion of sales and use taxes to services. • Strongly opposing increasing sales, use, excise or other transactional taxes. (Does not apply to the May 5, 2015 ballot proposal, which will be evaluated separately.) • Strongly opposing efforts to impose a graduated income tax on Michigan families, entrepreneurs and business taxpayers. • Seeking improvements to state tax appeals processes, including elimination of Michigan’s “pay-to-play” requirement for the Court of Claims. • Ensuring proper implementation of Michigan’s voter-approved personal property tax reform and support expansion of personal property tax relief to all job providers. • Supporting further reform to Unclaimed Property laws to simplify compliance and protect holder’s rights.
Chamber Staff Contact: Tricia Kinley Senior Director of Tax & Regulatory Reform (517) 371-7669
2-3
Changes in Real Estate, Pass-Through Entities, and Estate Planning
by Stefan F. Tucker Venable LLP Washington, DC
Changes in Real Estate, Pass-Through Entities, and Estate Planning
Stefan F. Tucker Venable LLP Washington, DC Tammara F. Langlieb Venable LLP Washington, DC
TABLE OF CONTENTS
I. LEGISLATIVE DEVELOPMENTS ...... 3-1 A. Achieving a Better Life Experience Act of 2014 ...... 3-1 1. Qualified ABLE Program ...... 3-1 2. Tax-Advantaged ABLE Accounts ...... 3-1 3. Amounts in an Individual’s ABLE Account ...... 3-1 4. Qualified Disability Expenses ...... 3-2 B. Tax Increase Prevention Act of 2014 ...... 3-2 1. Election to Claim Itemized Deductions for State and Local Sales Taxes ...... 3-2 2. Mortgage Forgiveness Exclusion ...... 3-2 3. Mortgage Premium Insurance Deduction ...... 3-2 4. Extension of New Energy Efficient Home Credit for Contractors ...... 3-2 5. Extension of Bonus Depreciation ...... 3-2 6. Increase in Section 179 Expensing for 2014...... 3-2 7. Additional Extension of Time to Elect the Acceleration of AMT and R&D Credits...... 3-3 8. Extension of Fifteen-Year Straight-Line Cost Recovery for Certain Real Property ...... 3-3 9. Qualified Small Business Stock ...... 3-3
II. 2014-2015 PRIORITY GUIDANCE PLAN (UPDATED AS OF DECEMBER 31, 2014, RELEASED JANUARY 29, 2015) ...... 3-3 A. Financial Institutions and Products ...... 3-3 B. General Tax Issues ...... 3-4 C. Gifts, Estates, and Trusts ...... 3-5 D. Partnerships ...... 3-5
3-i Tax Conference, 28th Annual, May 21, 2015
E. Tax Accounting ...... 3-5 F. Tax Administration ...... 3-5
III. PROPOSED, TEMPORARY AND FINAL REGULATIONS ...... 3-6 A. Sections 162(a) and 263(a) (Deduction and Capitalization of Expenditures Related to Tangible Property) ...... 3-6 1. Overview ...... 3-6 2. Materials and Supplies ...... 3-6 3. Amounts Paid to Acquire or Produce Tangible Property ...... 3-6 4. Amounts Paid to Improve Tangible Property ...... 3-7 5. Adaptation to a New or Different Use ...... 3-9 6. Election to Capitalize Repair and Maintenance Costs ...... 3-10 7. Effective Date ...... 3-10 B. Sections 195, 708 and 709 (Deduction of Start-Up Expenditures and Organizational Expenses Following a Technical Termination of a Partnership) ...... 3-10 1. Overview ...... 3-10 2. Basic Rule ...... 3-10 3. Effective Date ...... 3-10 C. Section 453B (Gain or Loss on Disposition of Installment Obligations) ...... 3-10 1. Overview ...... 3-10 2. Exception to the General Rule ...... 3-11 3. Exception to the Exception to the General Rule ...... 3-11 4. Effective Date ...... 3-11 D. Sections 707 and 752 (Disguised Sales and Partnership Liabilities) ...... 3-11 1. Overview ...... 3-11 2. Debt Financed Distributions ...... 3-11 3. Preformation Capital Expenditures ...... 3-11 4. Anticipated Reduction ...... 3-12 5. Partner’s Share of Partnership Recourse Liabilities ...... 3-12 6. Partner’s Share of Partnership Nonrecourse Liabilities ...... 3-12 7. Effective Date ...... 3-12 E. Section 752 (Partner’s Share of Recourse Partnership Liabilities) ...... 3-13 1. Overview ...... 3-13 2. Overlapping Risk of Loss ...... 3-13 3. Tiered Partnerships ...... 3-13 4. Related Persons ...... 3-14 5. Effective Date ...... 3-14 F. Section 856 (Definition of Real Estate Investment Trust Property) ...... 3-14 1. Overview ...... 3-14 2. Land ...... 3-15 3. Inherently Permanent Structures ...... 3-15 4. Structural Components...... 3-15 5. Intangible Assets That Are Real Property ...... 3-16
3-ii Changes in Real Estate, Pass-Through Entities, and Estate Planning
6. Distinct Asset ...... 3-17 7. Effective Date ...... 3-17 G. Section 1366 (Debt Basis for S Corporation Shareholder) ...... 3-17 1. Overview ...... 3-17 2. Debt Basis ...... 3-17 3. Shareholder Guarantee ...... 3-18 4. Examples ...... 3-18 5. Effective Date ...... 3-18
IV. REVENUE PROCEDURES AND LEGAL ADVICE ...... 3-18 A. Rev. Proc. 2014-12, 2014-3 I.R.B. 415 ...... 3-18 B. Rev. Proc. 2014-20, 2014-9 I.R.B. 614 ...... 3-19 C. Rev. Proc. 2014-51, 2014-37 I.R.B. 543 ...... 3-20 D. Rev. Proc. 2015-20, 2015-9 I.R.B. 694 ...... 3-21 E. Legal Advice Issued by Associate Chief Counsel AM 2014-003 (POSTN- 122768-13) ...... 3-21
V. PRIVATE LETTER RULINGS ...... 3-22 A. Priv. Ltr. Rul. 201416006 (January 17, 2014 ...... 3-22 B. Priv. Ltr. Rul. 201424017 (March 12, 2014) ...... 3-22 C. Priv. Ltr. Rul. 201444022 (October 31, 2014) ...... 3-23 D. Priv. Ltr. Rul. 201452015 (September 16, 2014) ...... 3-24 E. Priv. Ltr. Rul. 201503001 (January 16, 2015) ...... 3-25
VI. CHIEF COUNSEL ADVICE, TECHNICAL ADVICE MEMORANDA AND ACTION ON DECISION ...... 3-26 A. Chief Counsel Advice 201415002 (February 11, 2014) ...... 3-26 B. Chief Counsel Advice 201436048 (April 29, 2014) ...... 3-26 C. Chief Counsel Advice 201436049 (May 20, 2014) ...... 3-28 D. Chief Counsel Advice 201445009 (June 6, 2014) ...... 3-29 E. Chief Counsel Advice 201446021 (July 23, 2014) ...... 3-29 F. Chief Counsel Advice 201451027 (October 1, 2014) ...... 3-29 G. Chief Counsel Advice 201504010 (December 17, 2014) ...... 3-29 H. Technical Advice Memo. 201437012 (April 18, 2014) ...... 3-30 I. Action On Decision 2015-1 I.R.B. 2015-6 (Feb. 9, 2015)...... 3-30
VII. CASES ...... 3-31 A. ABC Beverage Corp. v. U.S., 113 AFTR 2d 2014-2536 (6th Cir. 2014) ...... 3-31
3-iii Tax Conference, 28th Annual, May 21, 2015
B. Almquist v. Comm’r, T.C. Memo 2014-40 ...... 3-33 C. Annuzzi v. Comm’r, T.C. Memo 2014-233 ...... 3-33 D. Estate of Belmont v. Comm’r, 144 T.C. No. 6 (2014) ...... 3-35 E. Blangiardo v. Comm’r, T.C. Memo 2014-110 ...... 3-36 F. Boree v. Comm’r, T.C. Memo 2014-85...... 3-37 G. Brinkley v. Comm’r, T.C. Memo 2014-227 ...... 3-38 H. Bross Trucking v. Comm’r, T.C. Memo 2014-107 ...... 3-40 I. Cantor v. Comm’r, T.C. Summary Opinion 2014-103 ...... 3-41 J. Cavallaro v. Comm’r, T.C. Memo 2014-189...... 3-42 K. Chandler v. Comm’r, 142 T.C. No. 16 (2014) ...... 3-44 L. Chemtech Royalty Associates, LP v. U.S., 114 AFTR 2d 2014-5940 (5th Cir. 2014) ...... 3-44 M. Copeland v. Comm’r, T.C. Memo 2014-226 ...... 3-45 N. Cosentino v. Comm’r, T.C. Memo 2014-186 ...... 3-46 O. Debough v. Comm’r, 142 T.C. No. 17 (2014) ...... 3-48 P. Estate of Elkins v. Comm’r, 114 AFTR 2d 2014-5985 (5th Cir. 2014) ...... 3-48 Q. Frank Aragona Trust v. Comm’r, 142 T.C. No. 9 (2014) ...... 3-50 R. Gateway Hotel Partners, LLC v. Comm’r, T.C. Memo 2014-5 ...... 3-51 S. Estate of Giustina v. Comm’r, 114 AFTR 2d 2014-6848 (9th Cir. 2014) ...... 3-53 T. Gragg v. U.S., et al., 113 AFTR 2d 2014-1647 (DC CA 2014) ...... 3-54 U. Herwig v. Comm’r, T.C Memo 2014-95 ...... 3-55 V. Howard Hughes Company, LLC v. Comm’r, 142 T.C. No. 20 (2014) ...... 3-55 W. Estate of Kessel v. Comm’r, T.C. Memo 2014-97 ...... 3-57 X. Long v. Comm’r, 114 AFTR 2d 2014-6657 (11th Cir. 2014) ...... 3-58 Y. Mountanos v. Comm’r, T.C. Memo 2014-138 ...... 3-59 Z. Mylander v. Comm’r, T.C. Memo 2014-191 ...... 3-61 AA Oderio v. Comm’r, T.C. Memo 2014-39 ...... 3-62 BB. Ohana v. Comm’r, T.C. Memo 2014-83 ...... 3-62 CC. Palmer Ranch Holdings Ltd. v. Comm’r, T.C. Memo 2014-79 ...... 3-63 DD. Phan v. Comm’r, T.C. Summary Opinion 2015-1 ...... 3-64 EE. Pilgrim’s Pride Corp. v. Comm’r, (115 AFTR 2d 2015-930 (5th Cir. 2015) .... 3-65 FF. Pool v. Comm’r, T.C. Memo 2014-3 ...... 3-66 GG. Puentes v. Comm’r, T.C. Memo 2014-224 ...... 3-67
3-iv Changes in Real Estate, Pass-Through Entities, and Estate Planning
HH. RERI Holdings I v. Comm’r, T.C. Memo 2014-99 ...... 3-67 II. Estate of Richmond v. Comm’r, T.C. Memo 2014-26 ...... 3-68 JJ. Estate of Sanders v. Comm’r, T.C Memo 2014-100 ...... 3-70 KK. Schmidt v. Comm’r, T.C. Memo 2014-159 ...... 3-71 LL. Seismic Support Services, LLC v. Comm’r, T.C. Memo 2014-78 ...... 3-72 MM. Shea Homes, Inc. v. Comm’r, 142 T.C. No. 3 (2014) ...... 3-73 NN. SI Boo, LLC, et al. v. Comm’r, T.C. Memo. 2015-19...... 3-74 OO. Stine v. Comm’r, 115 AFTR 2d 2015-637 ...... 3-76 PP. Tolin v. Comm’r, T.C. Memo 2014-65 ...... 3-76 QQ. VisionMonitor Software, LLC v. Comm’r, T.C. Memo 2014-182 ...... 3-77 RR. Wachter v. Comm’r, 142 T.C. No. 7 (2014) ...... 3-79 SS. Wade v. Comm’r, T.C. Memo 2014-169 ...... 3-79 TT. Williams v. Comm’r, T.C. Memo 2014-158 ...... 3-80
3-v
Changes in Real Estate, Pass-Through Entities, and Estate Planning
I. LEGISLATIVE DEVELOPMENTS A. Achieving a Better Life Experience Act of 2014. Achieving a Better Life Experience Act of 2014 (the “ABLE Act”), Pub. L. No. 113-295, is designed to encourage and assist individuals in saving private funds for the purpose of supporting individuals with disabilities and to provide secure funding for disability-related expenses of beneficiaries with disabilities that will supplement benefits provided through private insurance. To achieve such purposes, the ABLE Act provides for a new type of tax-advantaged savings program, similar to a traditional educational saving program. 1. Qualified ABLE Program. The ABLE Act creates a tax-advantaged savings program, established and maintained by a state or an agency or instrumentality of a state under which a person can make contributions for the benefit of an individual who is eligible to have an “Able Account” (as defined below). a. An individual is considered eligible to have an Able Account if the individual is entitled to benefits based on blindness or disability under Title II or XVI of the Social Security Act, and such blindness or disability occurred before the individual attained the age of 26 or a disability certification is filed with the Service for such individual. b. A disability certification is a certification by the individual or the parent/guardian of the individual that certifies that the individual is disabled or blind and that such disability or blindness occurred before the individual attained the age of 26, and includes a copy of the individual’s diagnosis which is signed by a physician meeting the criteria of Section 1861(r)(1) of the Social Security Act. 2. Tax-Advantaged ABLE Accounts. a. The ABLE Act creates a new type of Section 529 account (an “ABLE Account”) for a “designated beneficiary”. (1) Similar to a traditional Section 529 account: (a) contributions to the account are made on an after- tax basis, (b) the assets in the account grow tax-free, and (c) withdrawals from the account are tax–free if the money is used for eligible expenses, which in this case would be disability-related expenses. b. Each disabled person is limited to one ABLE account. 3. Amounts in an individual’s ABLE Account, contributions to such an Account, and distributions to pay qualified disability expenses are generally disregarded in determining an individual’s eligibility for assistance authorized by a Federal means-tested program. However, amounts (including earnings) in an ABLE account in excess of $100,000 are considered a resource of the designated beneficiary, and distributions from an ABLE account for housing expenses are considered income under the supplemental security income program.
3-1 Tax Conference, 28th Annual, May 21, 2015
4. Qualified Disability Expenses. Withdrawals from an ABLE Account are tax-free if used for qualified disability expenses, which include, but are not limited to, education; housing; transportation; employment training and support; assistive technology and personal support services; health, prevention and wellness; financial management and administrative services; and legal fees. B. Tax Increase Prevention Act of 2014. The Tax Increase Prevention Act of 2014 (“TIPA 2014”), Pub. L. No. 113-295, extended certain expiring provisions and made technical corrections to amend the Internal Revenue Code. 1. Election to Claim Itemized Deductions for State and Local Sales Taxes. Under prior law, for tax years beginning after December 31, 2003 and before January 1, 2014, taxpayers could elect to take an itemized deduction for state and local general sales taxes instead of an itemized deduction for state and local income taxes. This law was especially beneficial to individuals who resided in states with no individual income tax. TIPA 2014 retroactively restored and extended the deduction through December 31, 2014. 2. Mortgage Forgiveness Exclusion. Income resulting from the discharge of “qualified principal residence indebtedness” is excluded from gross income. Under prior law, the discharge needed to occur after December 31, 2006 and before January 1, 2014. Under TIPA 2014, this exclusion was retroactively extended through December 31, 2014. 3. Mortgage Premium Insurance Deduction. TIPA 2014 retroactively extended the provision permitting taxpayers to take an itemized deduction for certain mortgage insurance premiums, such as private mortgage insurance or mortgage insurance provided by the Department of Veteran Affairs, through December 31, 2014. 4. Extension of New Energy Efficient Home Credit for Contractors. TIPA 2014 retroactively extended the provision permitting certain eligible contractors to claim a general business credit for each new energy efficient home that the contractor constructed and was acquired by a person from the contractor for use as a residence through December 31, 2014. 5. Extension of Bonus Depreciation. Under prior law, taxpayers were entitled to a bonus depreciation deduction equal to 50% of the basis of certain eligible property. TIPA 2014 retroactively extended the placed-in-service date requirement of eligible property for one year until December 31, 2014. In addition, the timely acquisition rules were also extended for one year, so that, in general, the property could be acquired by the taxpayer either after December 31, 2007 and before January 1, 2015 (if no written binding contract for the acquisition was in effect before January 1, 2008) or under a written binding contract entered into after December 31, 2007 and before January 1, 2015. 6. Increase in Section 179 Expensing for 2014. Under prior law, the maximum amount of the deduction under Section 179 for 2014 was $25,000, which was phased out for each dollar of qualifying property placed in service during the taxable year in excess of $200,000. This amount, however, was significantly lower than the Section 179 deduction amount for 2010 through 2013, during which the maximum amount of the deduction was $500,000, and the phase-out threshold was $2 million. TIPA 2014 extended the $500,000 deduction limitation and $2 million phase-out threshold retroactively for 2014.
3-2 Changes in Real Estate, Pass-Through Entities, and Estate Planning
7. Additional Extension of Time to Elect the Acceleration of AMT and R&D Credits. a. The Housing Assistance Tax Act of 2008, Pub. L. No. 110-289, permitted corporations to make an election, for the first taxable year of the taxpayer ending after March 31, 2008, to accelerate the use of the alternative minimum tax and research and development credit carryovers, in lieu of the bonus depreciation tax benefit included in the Economic Stimulus Act of 2008. This provision was extended by the American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5, and the American Taxpayer Relief Act of 2012, Pub. L. No. 112-240. TIPA 2014 provided an additional retroactive extension. b. To take into account the extension of the placed-in-service deadline for qualified property eligible for bonus depreciation, TIPA 2014 provides a “round 4 extension” to cover property placed in service after December 31, 2013 and before January 1, 2015. For round 4 extension property, bonus depreciation cannot be exchanged for any research credits from tax years beginning before January 1, 2006. (1) If a taxpayer previously elected to forgo bonus depreciation for the acceleration of certain credits, it can elect to decline to have the election apply to round 4 extension property. Otherwise, a separate computation must be made for round 4 extension property. (2) If a taxpayer did not make a previous election, it can make the election for its first taxable year ending after December 31, 2013. This election will be applicable only to eligible round 4 extension property. 8. Extension of Fifteen-Year Straight-Line Cost Recovery for Certain Real Property. Under prior law, qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property were all depreciated on the straight-line method over a 15-year recovery period. To qualify for such treatment, the property needed to be placed in service before January 1, 2014. TIPA 2014 retroactively extended the placed-in- service date through December 31, 2014. 9. Qualified Small Business Stock. Under prior law, taxpayers, other than corporations, were not subject to regular or AMT tax on the gain from the sale or exchange of qualified small business stock held for more than 5 years, if such stock was acquired after September 27, 2010 and before January 1, 2014. TIPA 2014 retroactively restored and extended the acquisition date until January 1, 2015. II. 2014-2015 PRIORITY GUIDANCE PLAN (UPDATED AS OF DECEMBER 31, 2014, RELEASED JANUARY 29, 2015) A. Financial Institutions and Products. 1. Guidance under Section 166 on the conclusive presumption of worthlessness for bad debts. Notice 2013-35, 2013-24 I.R.B. 1240, which requested comments on the existing rules, was published on June 10, 2013.
3-3 Tax Conference, 28th Annual, May 21, 2015
2. Regulations revising the RIC asset test examples in Reg. §1.851-5. Proposed Regulations were published on August 2, 2013. 3. Revenue Procedure that will modify Rev. Proc. 2011-16, 2011-5 I.R.B. 440, relating to the treatment of distressed debt under Section 856. Rev. Proc. 2014-51, 2014-37 I.R.B. 543, was published on August 18, 2014. 4. Final Regulations under Section 856 clarifying the definition of real property for purposes of the rules for real estate investment trusts. Proposed Regulations were published on May 14, 2014. 5. Guidance clarifying the definition of income in Section 856(c)(3) for purposes of the real estate investment trust qualification tests. 6. Regulations relating to accruals of interest (including discount) on distressed debt. B. General Tax Issues. 1. Regulations under Section 42 relating to compliance monitoring, including issues identified in Notice 2012-18, 2012-10 I.R.B. 438. 2. Final Regulations under Section 45D that revise and clarify certain rules relating to the recapture of the new markets tax credit. Proposed Regulations were published August 11, 2008. 3. Guidance on the energy credit under Section 48. 4. Guidance under Sections 61(a)(12) and 1001 regarding whether a recourse purchase-money home mortgage loan is treated as a nonrecourse loan from inception if, under a state anti-deficiency statute, the lender cannot pursue the homeowner for the difference between the amount of the loan and the amount realized on a foreclosure or short sale of the home. 5. Revenue Ruling under Section 108 regarding the application of the qualified real property business indebtedness exclusion for real estate developers. 6. Final Regulations under Sections 108 and 7701 concerning bankruptcy and insolvency rules and disregarded entities. Proposed Regulations were published on April 13, 2011. 7. Regulations on delay rentals under Sections 263A and 612. 8. Regulations under Section 280A regarding deductions for expenses attributable to the business use of homes and rental of vacation homes. 9. Guidance regarding material participation by trusts and estates for purposes of Section 469. 10. Final Regulations under Section 1411, as added by Section 1402 of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation
3-4 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Act of 2010, regarding additional issues related to the net investment income tax. Proposed Regulations were published on December 2, 2013.
C. Gifts, Estates and Trusts. 1. Revenue Procedure under Section 2010(c) regarding the validity of a QTIP election on an estate tax return filed only to elect portability. 2. Guidance under Section 2053 regarding personal guarantees and the application of present value concepts in determining the deductible amount of expenses and claims against the estate. 3. Regulations under Section 2704 regarding restrictions on the liquidation of an interest in certain corporations and partnerships. D. Partnerships. 1. Regulations under Section 108(e)(7). 2. Regulations under Section 469(h)(2) concerning limited partners and material participation. Proposed Regulations were published on November 28, 2011. 3. Regulations under Section 707 related to disguised sales of property. Proposed Regulations were published on January 30, 2014. 4. Regulations under Section 752 regarding related person rules. Proposed Regulations were published on December 16, 2013. E. Tax Accounting. 1. Guidance under Section 453B regarding nonrecognition of gain or loss on the disposition of certain installment obligations. Proposed Regulations were published on December 23, 2014. 2. Guidance under Section 460 regarding home construction contracts and rules for certain changes in method of accounting for long-term contracts. F. Tax Administration. 1. Regulations under Section 6166 regarding the furnishing of security in connection with an election to pay the estate tax in installments. 2. Guidance under Section 7701(o) to coordinate the entity classification election with elections under Subchapter M. 3. Guidance under Sections 7701(o) and 6662(b)(6) regarding codification of the economic substance doctrine by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010. Prior guidance was issued as Notice 2010-62, 2010-40 I.R.B. 411. New guidance was issued as Notice 2014-58, 2014-44 I.R.B. 746.
3-5 Tax Conference, 28th Annual, May 21, 2015
III. PROPOSED, TEMPORARY AND FINAL REGULATIONS
A. Sections 162(a) and 263(a) (Deduction and Capitalization of Expenditures Related to Tangible Property).
1. Overview. Section 263(a) generally requires the capitalization of amounts paid to acquire, produce or improve tangible property. Section 162 allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The Final Regulations provide a general framework for distinguishing capital expenditures from supplies, repairs, maintenance and other deductible business expenses. The Final Regulations retain many of the provisions of the Temporary Regulations issued on December 27, 2011 (the “2011 Temporary Regulations”), which revised Proposed Regulations issued in 2008 (the “2008 Proposed Regulations”).
2. Materials and Supplies. In general, the Final Regulations follow the 2011 Temporary Regulations for materials and supplies.
a. Minimum acquisition or production cost threshold. The 2011 Temporary Regulations provided an acquisition or production cost threshold of $100 for materials and supplies. Several commentators wanted to raise the limitation to $500 or $1,000. The Final Regulations increased the $100 threshold to $200.
b. Election to capitalize certain materials and supplies. The 2011 Temporary Regulations permitted a taxpayer to elect to capitalize and depreciate as a separate asset amounts paid for certain materials or supplies. Several commenters noted that the rule under the 2011 Temporary Regulations could lead to problematic results, such as permitting a component acquired to improve a unit of tangible property owned by the taxpayer to be treated as an asset and depreciated over a recovery period different from the unit of tangible property intended to be improved. To address these concerns, the Final Regulations retain the rule permitting a taxpayer to elect to capitalize and depreciate amounts paid for certain materials and supplies, but provide that this rule is applicable only to rotable, temporary or standby emergency spare parts.
c. Election to capitalize certain materials and supplies under the de minimis rule. The 2011 Temporary Regulations provided that a taxpayer could elect to apply the de minimis rule to the costs of acquiring or producing qualified materials or supplies. There were numerous comments on the application of the de minimis rule provided in the 2011 Temporary Regulations to materials and supplies under Temp. Reg. §1.162-3T(f) and the general de minimis rule under Temp. Reg. § 1.263(a)-2T(g). The Final Regulations retain the de minimis rule and more clearly coordinate the de minimis rule applicable to materials and supplies under Section 162 and the general de minimis rule under Section 263.
3. Amounts Paid to Acquire or Produce Tangible Property. The 2011 Temporary Regulations required capitalization of amounts paid to acquire or produce tangible property that had a useful life substantially beyond the taxable year, including amounts paid to defend or perfect title to tangible property.
3-6 Changes in Real Estate, Pass-Through Entities, and Estate Planning
a. De minimis safe harbor. The 2011 Temporary Regulations provided a de minimis rule, which stated that a taxpayer was not required to capitalize amounts paid for the acquisition or production of property if the taxpayer (1) had an applicable financial statement (“AFS”), (2) had written accounting procedures treating as an expense for non-tax purposes the amounts paid for property costing less than a specified dollar amount (i.e., the de minimis costs); and (3) recognized the de minimis costs as expenses on its AFS. The aggregate amounts paid and not capitalized under the de minimis rule had to be less than or equal to the greater of (a) 0.1 percent of the taxpayer’s gross receipts for the year, or (b) 2 percent of the taxpayer’s total depreciation and amortization for the year as determined in its AFS (the “Safe Harbor Ceiling”).
(1) Commenters raised concerns about the administrative burden the Safe Harbor Ceiling would place on taxpayers and the complexities inherent in the application of the ceiling requirements for consolidated groups.
(2) The Final Regulations eliminate the Safe Harbor Ceiling and, instead, provide that a taxpayer with an AFS may rely on the de minimis safe harbor if the amount paid for the property does not exceed $5,000 per invoice, or per item as substantiated by the invoice. Taxpayers without an AFS may rely on the de minimis safe harbor if the amount paid for the property does not exceed $500 per invoice, or per item as substantiated by the invoice.
(3) In addition, the Final Regulations provide that the de minimis safe harbor also applies to financial account procedures that expense amounts paid for property with an economic useful life of 12 months or less as long as the amount per invoice (or per item) does not exceed $5,000.
b. Annual election. The Final Regulations clarify that the de minimis rule is not mandatory and must be elected annually.
4. Amounts Paid to Improve Tangible Property. When applying improvement rules, a determination of the appropriate unit of property must first be made. Amounts paid for an improvement to a smaller unit of property will be more likely to materially increase its value. In contrast, amounts paid for improvements to a larger unit of property may be more likely to be a simple repair.
a. Determining the unit of property. The 2011 Temporary Regulations generally defined a unit of property as consisting of all the components of the unit of property that were functionally interdependent, but provided special rules for determining the unit of property for buildings, plant property and network assets.
(1) The Final Regulations retain the general rule set forth in the 2011 Temporary Regulations that the unit of property for a building comprises the building and its structural components.
(2) The Final Regulations also retain the rule set forth in the 2011 Temporary Regulations which requires that a taxpayer apply the improvement standards separately to the primary components of the building, which is the building structure or any of
3-7 Tax Conference, 28th Annual, May 21, 2015
the specifically defined building systems (i.e., the HVAC system, the plumbing system, the electrical system, all escalators, all elevators, the fire protection and alarm system, the security system and the gas distribution system).
(3) The Final Regulations retain the rule set forth in the 2011 Temporary Regulations that, for condominiums and cooperative housing corporations, the unit of property is the individual unit “owned” by the taxpayer. In addition, if improvements are made to the building structure that is part of the condominium or cooperative unit or to the portion of any building system, then the individual unit is considered “improved”.
b. Costs during improvement. The 2008 Proposed Regulations provided that a taxpayer must capitalize all the direct costs of an improvement and all the indirect costs that directly benefit or are incurred by reason of an improvement in accordance with the rules set forth in Section 263A. The 2008 Proposed Regulations did not prescribe a plan of rehabilitation as traditionally described in the case law. The 2011 Temporary Regulations and the Final Regulations follow the 2008 Proposed Regulations.
(1) Removal Costs:
(a) The 2011 Temporary Regulations did not provide a separate rule for the treatment of removal costs and, instead in the preamble to the 2011 Temporary Regulations, stated that the costs of removing a component of a unit of property should be analyzed in the same manner as any other indirect costs incurred during a repair or improvement to property.
(b) The Final Regulations provide a specific rule clarifying the treatment of removal costs.
(i) The Final Regulations state that if, a taxpayer disposes of a depreciable asset for Federal tax purposes and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, the costs of removing the asset or component are not required to be capitalized under Section 263(a).
(ii) The Final Regulations also provide that, if a taxpayer disposes of a component of a unit of property and the disposal is not a disposition for Federal tax purposes, then the taxpayer must deduct or capitalize the costs of removing the component based on whether the removal costs directly benefit or are incurred by reason of a repair to the unit of property or an improvement to the unit of property.
(2) Safe Harbor for Small Taxpayers: The 2011 Temporary Regulations did not provide any special rules for small taxpayers to assist them in applying the general rules for improvements to buildings. The Final Regulations include a safe harbor election for building property held by taxpayers with gross receipts of $10 million or less (a “Qualifying Small Taxpayer”). The Final Regulations permit a Qualifying Small Taxpayer to elect not to apply the improvement rules to an eligible building property if the total amount paid during the taxable year for repairs, maintenance, improvements and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. An eligible building includes a building that is owned or leased by the Qualifying
3-8 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Small Taxpayer, provided that the unadjusted basis of the building unit of property is $1 million or less.
c. Betterments. The 2011 Temporary Regulations provided that an amount paid results in a betterment if it (1) ameliorates a material condition or material defect that existed prior to the acquisition or arose during the production of the property, (2) results in a material addition to the unit of property, or (3) results in a material increase in the capacity, productivity, efficiency, strength, or quality of the unit of property or its output. The Final Regulations largely follow the 2011 Temporary Regulations.
d. Restorations. The 2011 Temporary Regulations provided that an amount paid to restore a unit of property is considered to improve a unit of property if the restoration satisfies certain conditions, such as where the repair is for damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss or returns the unit of property to its ordinary efficient operating condition. The Service and the Treasury received many comments regarding the 2011 Temporary Regulations on restoration. In general, the Final Regulations retain the restoration standards set forth in the 2011 Temporary Regulations. However, the Final Regulations revise the major component rule and the casualty loss rule.
(1) The 2011 Temporary Regulations provided that an amount paid for the replacement of a major component or substantial structural part of a unit of property was an amount paid to restore (and, therefore, improve) the unit of property. Determination of whether a component was “major” or “substantial” depended on both qualitative and quantitative factors. The Final Regulations define “major component” and “substantial structural part”. A “major component” is defined as a part or combination of parts that perform a discrete and critical function in the operation of the unit of property. A “substantial structural part” is defined as a part or combination of parts that comprises a large portion of the physical structure of the unit of property.
(2) In response to commenters’ suggestions, the Final Regulations revise the casualty loss rule to permit a deduction, where otherwise permissible, for amounts spent in excess of the adjusted basis of the property damaged in a casualty event. Thus, a taxpayer is still required to capitalize amounts paid to restore damage to property for which the taxpayer has properly recorded a basis adjustment, but the costs required to be capitalized under the casualty loss rule are limited to the excess of (a) the taxpayer’s basis adjustments resulting from the casualty event, over (b) the amount paid for restoration of damage to the unit of property that are otherwise considered capitalized restorations. Casualty-related expenditures in excess of this limitation are not treated as restoration costs under Section 263 and may be deducted as repair and maintenance expenses, if they qualify as ordinary and necessary business expenses under Section 162.
5. Adaptation to a New or Different Use. The 2011 Temporary Regulations required a taxpayer to capitalize amounts paid to adapt a unit of property to a new or different use. The Final Regulations retain the substantive rules of the 2011 Temporary Regulations and add additional examples to illustrate the rules.
3-9 Tax Conference, 28th Annual, May 21, 2015
6. Election to Capitalize Repair and Maintenance Costs. The Final Regulations permit a taxpayer to elect to treat amounts paid during the taxable year for repair and maintenance to tangible property as amounts paid to improve that property and as assets subject to depreciation, as long as the taxpayer incurs the amounts in carrying on a trade or business and the taxpayer treats the amounts as capital expenditures on its books and records. Once made, the election cannot be revoked.
7. Effective Date. The Final Regulations generally apply to taxable years beginning on or after January 1, 2014. Alternatively, by and large, a taxpayer may choose to apply the Final Regulations to taxable years beginning on or after January 1, 2012. Finally, a taxpayer may also choose to apply the 2011 Temporary Regulations to taxable years beginning on or after January 1, 2012 and before January 1, 2014.
B. Sections 195, 708 and 709 (Deduction of Start-Up Expenditures and Organizational Expenses Following a Technical Termination of a Partnership).
1. Overview. The Service and the Treasury Department became aware that certain taxpayers were taking the position that a technical termination under Section 708(b)(1)(B) entitled the partnership immediately to deduct unamortized start-up expenses and organizational expenses to the extent provided under Section 165. Believing this result was contrary to Congressional intent, Proposed Regulations were published on December 9, 2013 and Final Regulations were published on July 23, 2014.
2. Basic Rule. The basic rule under the Final Regulations is that a new partnership formed due to a technical termination must continue amortizing expenses allowed under Section 195 and Section 709 over the same amortization period adopted by the terminating partnership.
3. Effective Date. The Final Regulations apply to technical terminations that occur on or after December 9, 2013.
C. Section 453B (Gain or Loss on Disposition of Installment Obligations). 1. Overview. On December 23, 2014, the Treasury and Service issued Proposed Regulations under Section 453B. In general, under Section 453B(a), gain or loss is recognized upon the satisfaction of an installment obligation at other than its face value. Reg. §1.453-9(c)(2) provides an exception to this general rule and states that, if the Code provides an exception to the recognition of gain or loss for certain dispositions, then gain or loss is not recognized under former Section 453(d) on the disposition of an installment obligation within that exception. The exceptions identified in the Treasury Regulation include certain transfers to corporations under Sections 351 and 361, contributions to partnerships under Section 721 and distributions to partners under Section 731. Under Rev. Rul. 73-423, 1973-2 C.B. 161, the exception provided in Reg. §1.453-9(c)(2) does not apply to the transfer of an installment obligation that results in a satisfaction of the obligation. The Proposed Regulations republished the general rule in Reg. §1.453-9(c)(2) and incorporated and expanded the holding of Rev. Rul. 73-423.
3-10 Changes in Real Estate, Pass-Through Entities, and Estate Planning
2. Exception to the General Rule. Prop. Reg. §1.453B-1(c)(1)(i) provides that, if the Code provides an exception to the recognition of gain or loss for certain dispositions, no gain or loss is recognized under Section 453B on any such disposition. The Proposed Regulations identify several exceptions: certain transfers to corporations under Sections 351 and 361, contributions to partnerships under Section 721 and distributions to partners under Section 731 (except as provided in Section 704(c)(1)(B), 736, 737 or 751(b)). 3. Exception to the Exception to the General Rule. Prop. Reg. §1.453B- 1(c)(1)(ii) provides that the above-mentioned exception does not apply to dispositions that result in a satisfaction of an installment obligation. The Proposed Regulations provide two examples of dispositions subject to this rule: the receipt of stock of a corporation from such corporation in satisfaction of the installment obligation of the corporation and the receipt of an interest in a partnership from such partnership in satisfaction of an installment obligation of the partnership. 4. Effective Date. The Proposed Regulations are to apply to satisfactions, distributions, transmissions, sales or other dispositions of installment obligations that occur after the date the Proposed Regulations are published as Final Regulations. D. Sections 707 and 752 (Disguised Sales and Partnership Liabilities). 1. Overview. On January 20, 2014, the Service and the Treasury Department issued Proposed Regulations that address the rules for disguised sales of partner interests under Section 707 and the treatment of partnership recourse and nonrecourse liabilities under Section 752. It should be noted that Proposed Regulations were issued on December 13, 2013 (see Part II. Item I.), which also discuss Section 752 and the treatment of recourse partnership liabilities. However, those Proposed Regulations address different issues. The Proposed Regulations issued on December 13, 2013 focus on the treatment of partnership recourse liabilities where multiple partners bear the economic risk of loss and amend the application of the partnership recourse liability rules as they apply to related partners. The Proposed Regulations discussed herein focus on whether an obligation to make a payment with respect to a partnership liability will be recognized under Section 752. 2. Debt Financed Distributions. The Proposed Regulations clarify the debt- financed distribution exception under the disguised sales rules. Specifically, the Proposed Regulations provide that, if more than one exception to the disguised sale rules apply, the transfer should be first determined under the debt-financed distribution exception. In addition, the Proposed Regulations clarify that the debt-financed distribution exception applies in a tiered partnership setting. Prop. Regs. §§1.707-5(b)(1) and (3). 3. Preformation Capital Expenditures. The existing Regulations currently provide an exception for preformation capital expenditures. This exception generally applies only to the extent that the reimbursed capital expenditures do not exceed 20% of the fair market value of such property at the time of the contribution. This fair market value limitation does not apply if the fair market value of the contributed property does not exceed 120% of the partner’s adjusted basis in the contributed property. The Proposed Regulations amend this exception. First, the Proposed Regulations provide how the exception applies in the case of multiple property transfers. Specifically, they provide that the determination of whether the fair market value limitation and the exception to the fair market value limitation apply to reimbursements of
3-11 Tax Conference, 28th Annual, May 21, 2015
capital expenditures is made separately for each property that qualifies for the exception. In addition, the Proposed Regulations provide that, to the extent a partner funded a capital expenditure through borrowing and economic responsibility for that borrowing has shifted to another partner, the exception for preformation expenditures should not apply because there is no outlay of the partner to reimburse. Prop. Reg. §1.707-4(d). 4. Anticipated Reduction. Believing that the anticipated reduction rule should not apply to a reduction that is subject to the entrepreneurial risks of partnership operations, the Service and the Treasury added a new provision in the Proposed Regulation which adopts this approach. Prop. Reg. §1.707-5(b)(2). 5. Partner’s Share of Partnership Recourse Liabilities. The existing Regulations under Section 752 provide that a partner’s share of a recourse liability equals the portion of the liability for which the partner (or related person) bears the economic risk of loss. The Service and the Treasury Department were concerned that some partners (or related persons) entered into payment obligations that were not “commercial” solely to achieve an allocation of partnership liability to such partner. As a result, the Proposed Regulations provide that obligations to make a payment with respect to a partnership liability (excluding those imposed by state law) will not be recognized for purposes of Section 752 unless certain factors are present. For example, the partner (or related person) must maintain a commercially reasonable net worth during the term of the payment obligation, must provide commercially reasonable documentation regarding its financial condition, and receive arm’s length consideration for assuming the payment obligation. The net worth requirement does not apply to an individual and a decedent’s estate. The Proposed Regulations also prevent “bottom-dollar” guarantees from being recognized for purposes of Section 752 by providing that, in the case of guarantees, an obligation of a partner or related person is recognized only if the partner or related person is liable for up to the full amount of the payment obligation. Prop. Reg. §1.752-2(b)(3). Further, to prevent partners (or related persons) from attempting to use structures or arrangements to circumvent the rules, the Proposed Regulations revise the anti-abuse rule under Reg. §1.752-2(j) to address the use of intermediaries, tiered partnerships or similar arrangements to avoid the bottom-dollar guarantees. 6. Partner’s Share of Partnership Nonrecourse Liabilities. Reg. §1.752-3 contains rules for determining partnership nonrecourse liabilities. The Proposed Regulations replace two of the current methods (the significant item method and the alternative method) with a new method. Under the new method, a partner’s profit interest is determined based on the partner’s “liquidation value” percentage. The liquidation value of a partner’s interest is the amount of cash the partner would receive with respect to its interest if, immediately after formation of the partnership or the occurrence of certain events under Reg. §1.704-1(b)(2)(iv), the partnership sold all of its assets for cash equal to the fair market value of such property, satisfied all of its liabilities (other than those described in Reg. § 1.752-7), paid an unrelated third party to assume all of its Reg. §1.752-7 liabilities in a fully taxable transaction, and then liquidated. 7. Effective Date. The Proposed Regulations are to apply to transactions that occurred or liabilities incurred or assumed by a partnership on or after the date the Proposed Regulations are finalized. The Proposed Regulations provide transitional relief for any partner whose allocable share of partnership liabilities under Reg. §1.752-2 exceeds its adjusted basis in
3-12 Changes in Real Estate, Pass-Through Entities, and Estate Planning
its partner interest on the date the Proposed Regulations are finalized. Under the transitional relief, the partner can continue to apply the existing Regulations under Reg. §1.752-2 for a seven-year period to the extent that the partner’s allocable share of partnership liabilities exceeds the partner’s adjusted basis in its partner interest on the date the Proposed Regulations are finalized. E. Section 752 (Partner’s Share of Recourse Partnership Liabilities). 1. Overview. Section 752 provides, in general, that any increase in a partner’s share of partnership liabilities will be considered a contribution of money by such partner to the partnership. When determining a partner’s share of partnership liability, the Regulations under Section 752 distinguish between recourse and nonrecourse liabilities. On December 13, 2013, the Service and the Treasury Department issued Proposed Regulations which provide guidance as to when and the extent to which a partner is treated as bearing the economic risk of loss if multiple partners bear the economic risk of loss with respect to the same liability and amend the application of the partnership recourse liability rules as they apply to related partners. As discussed in Section Part II. Item H., on January 20, 2014 the Service and the Treasury Department issued Proposed Regulations that also discuss Section 752 and the treatment of recourse partnership liabilities. However, those Proposed Regulations address whether an obligation to make a payment with respect to a partnership liability will be recognized under Section 752. 2. Overlapping Risk of Loss. Addressing the uncertainty as to how partners should share a partnership liability if multiple partners bear the economic risk of loss with respect to the same liability, the Service and Treasury Department turned to Temp. Reg. §1.752- 1T(d)(3)(i) that preceded the existing Final Regulations under Section 752. a. The Temporary Regulations address the issue by providing that, if the aggregate amount of the economic risk of loss that all partners agreed to bear with respect to a partnership liability exceeds the amount of such liability, then the economic risk of loss borne by each partner with respect to such liability equals the amount determined by multiplying the amount of such liability by the fraction obtained by dividing the amount of the economic risk of loss that such partner is determined to bear with respect to that liability by the sum of such amounts for all partners. b. The Proposed Regulations adopt the rule from the Temporary Regulations. Prop. Reg. §1.752-2(a)(2). 3. Tiered Partnerships. Currently, the Section 752 Regulations allocate a recourse liability of a lower-tier partnership to an upper-tier partnership if either that upper-tier partnership or one of its partners bears the economic risk of loss for the liability. However, when a partner in the upper-tier partnership is also a partner in the lower-tier partnership, and that partner bears the economic risk of loss with respect to a liability of the lower tier partnership, the current Regulations do not provide guidance as to how the lower-tier partnership should allocate the liability between the upper-tier partnership and the partner. The Service believed that the lower-tier partnership should allocate the liability directly to the partner. Therefore, the Proposed Regulations modify the tiered-partnership rules in Reg. §1.752-2(i)(2) to prevent a liability of a lower-tier partnership from being allocated to an upper-tier partnership when a
3-13 Tax Conference, 28th Annual, May 21, 2015
partner in both the lower-tier partnership and the upper-tier partnership bears the economic risk of loss for such liability. Prop. Reg. §1.752-2(i). 4. Related Persons. a. Under Reg. §1.752-4(b)(1), in general, a person is related to a partner if the partner bears a relation to such person that is specified in Section 267(b) or Section 707(b)(1), except that 80% is substituted for 50%. The Service and the Treasury Department believed that partners in a partnership, where that partnership owns stock in a corporation that is a lender to the partnership or has a payment obligation with respect to a liability of its partnership owner, should not be treated as related—through ownership of the partnership—to the corporation. Therefore, the Proposed Regulations disregard Section 267(c)(1) in determining whether a partner in a partnership is considered as owning stock in a corporation, to the extent the corporation is a lender or has a payment obligation with respect to a liability of the partnership owner. Prop. Reg. §1.752-4(b). b. In addition, Reg. §1.752-4(b)(2)(i) provides that, if a person is related to more than one partner in a partnership, the related party rules are applied by treating the person as related only to the partner with whom there is the highest percentage of relate ownership (i.e., the greatest percentage rule). The Proposed Regulations remove the greatest percentage rule and provide that, if a person is a lender or has a payment obligation for a partnership liability and is related to more than one partner, those partners share the liability equally. c. Reg. §1.752-4(b)(2)(iii) provides that persons owning interests directly or indirectly in the same partnership are not treated as related persons for purposes of determining the economic risk of loss borne by each of them for the liabilities of the partnership. This is known as the related partner exception. To clear up any misunderstanding resulting from the decision in IPO II v. Comm’r, 122 T.C. 295 (2004), the Proposed Regulations provide that the related partner exception applies only when a partner bears the economic risk of loss for a liability of the partnership because the partner is a lender or has a payment obligation for the partnership liability. Prop. Reg. §1.752-4(b)(2). 5. Effective Date. The Proposed Regulation are to apply to liabilities incurred or assumed by a partnership on or after the date the Proposed Regulations are published as Final Regulations, other than liabilities incurred or assumed by a partnership pursuant to a written binding contract in effect prior to that date. F. Section 856 (Definition of Real Estate Investment Trust Property). 1. Overview. On May 9, 2014, the Service and the Treasury Department issued Proposed Regulations under Section 856 (the “Proposed Regulations”) to clarify the definition of “real property” for purposes of Code Sections 856 through 859. In brief, the Proposed Regulations define real property to include land, inherently permanent structures and structural components. In determining whether an item fits within the definition of real property, the Proposed Regulations test whether an item is a distinct asset, which is the unit of property to which the definitions in the Proposed Regulations apply. In addition, the Proposed Regulations
3-14 Changes in Real Estate, Pass-Through Entities, and Estate Planning identify certain types of intangible assets that are real property or interests in real property for purposes of Sections 856 through 859.
2. Land. The Proposed Regulations define land to include not only a parcel of ground, but the air and water space directly above the parcel. Land includes crops and other natural products of land until the crops or other natural products are detached or removed from the land. Prop. Reg. §1.856-10(c).
3. Inherently Permanent Structures.
a. Under Section 856 through 859, inherently permanent structures and their structural components are considered real property. The Proposed Regulations clarify that inherently permanent structures are structures, including buildings, provided they have a passive function (such as to contain, support, shelter, cover or protect) and do not serve an active function (such as to manufacture, create, produce, convert or transport). Prop. Reg. §1.856- 10(d)(2)
b. The Proposed Regulations provide a safe harbor list of distinct assets that are buildings, as well as a list of distinct assets that are “other inherently permanent structures”. The safe harbor list includes (but is not limited to): houses; apartments; hotels; factory and office buildings; barns; microwave transmissions; cell, broadcast and electrical transmission towers; swimming pools; pipelines; and outdoor advertising displays for which an election was properly made under Section 1033(g). Prop. Reg. §1.856-10(d)(2)(iii).
c. If a distinct asset is not listed on the safe harbor list and does not serve an active function, a facts and circumstances analysis is necessary. Prop. Reg. §1.856- 10(d)(2)(iv). The following factors are taken into account:
(1) The manner in which the distinct asset is affixed to real property;
(2) Whether the distinct asset is designed to be removed or to remain in place indefinitely;
(3) The damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed;
(4) Any circumstance that suggests that the expected period of affixation is not indefinite; and
(5) The time and expense required to remove the distinct asset.
4. Structural Components.
a. The Proposed Regulations define structural components as any distinct asset that is a constituent part of and integrated into an inherently permanent structure; serves the inherently permanent structure in its passive function; and, even if capable of producing income other than consideration for the use or occupancy of space, does not produce
3-15 Tax Conference, 28th Annual, May 21, 2015 or contribute to the production of such income. The Proposed Regulations further provide that structural components are real property only if the interest held therein is included with an equivalent interest held by the taxpayer in the inherently permanent structure to which the structural component is functionally related. Prop. Reg. §1.856-10(d)(3)(i).
b. The Proposed Regulations provide a safe harbor list of distinct assets that are structural components. The safe harbor list includes (but is not limited to): wiring; plumbing systems; central heating and air conditioning systems; elevators or escalators; permanent coverings of wall, floors and ceilings; windows; doors; insulation; chimneys; and central refrigeration systems. Prop. Reg. §1.856-10(d)(3)(ii).
c. If a distinct asset is not listed on the safe harbor list, a facts and circumstances analysis is necessary. Prop. Reg. §1.856-10(d)(3)(iii). The following factors are taken into account:
(1) The manner, time and expense of installing and removing the distinct asset;
(2) Whether the distinct asset is designed to be moved;
(3) The damage that removal of the distinct asset would cause to the item itself or to the inherently permanent structure to which it is affixed;
(4) Whether the distinct asset serves a utility-like function with respect to the inherently permanent structure;
(5) Whether the distinct asset serves the inherently permanent structure in its passive function;
(6) Whether the distinct asset produces income from consideration for the use or occupancy of space in or upon the inherently permanent structure;
(7) Whether the distinct asset is installed during construction of the inherently permanent structure;
(8) Whether the distinct asset will remain if the tenant vacates the premises; and
(9) Whether the owner of the real property is also the legal owner of the distinct asset.
5. Intangible Assets That Are Real Property. The Proposed Regulations provide that certain intangible assets are real property for purposes of Sections 856 through 859. To be real property, the intangible asset must derive its value from tangible real property and be inseparable from the tangible real property from which the value is derived. Prop. Reg. §1.856- 10(f)(1).
3-16 Changes in Real Estate, Pass-Through Entities, and Estate Planning
6. Distinct Asset.
a. The Proposed Regulations provide that each distinct asset is tested individually to determine whether the distinct asset is real or personal property. Certain distinct assets are specifically listed in the Proposed Regulations safe harbors as types of buildings, other inherently permanent structures and other structural components (as described above). Prop. Reg. §1.856-10(e)(1).
b. Other assets not described in one of the safe harbors are tested under a facts and circumstances test. Prop. Reg. §1.856-10(e)(2). The following factors are taken into account:
(1) Whether the item is customarily sold or acquired as a single unit, rather than as a component part of a larger asset;
(2) Whether the item can be separated from a larger asset, and if so, the cost of separating the item from the larger asset;
(3) Whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is part; and
(4) Whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset.
7. Effective Date. The Service and the Treasury Department view the Proposed Regulation as a clarification of the existing definition of real property and not as a modification that would cause a significant reclassification of property. As such, the Proposed Regulations are proposed to be effective for calendar quarters beginning after the Proposed Regulations are published as Final Regulations. G. Section 1366 (Debt Basis for S Corporation Shareholders). 1. Overview. On June 11, 2012, the Treasury Department and the Service issued Proposed Regulations dealing with the often-disputed issue of whether a shareholder has debt basis for purposes of Section 1366(d)(1)(B). On July 23, 2014, the Service issued Final Regulations, which adopted the Proposed Regulations without substantive changes. 2. Debt Basis. In order to increase a shareholder’s debt basis, the loan must represent “bona fide indebtedness of the S corporation that runs directly to the shareholder”. The Regulations do not shed any light on what constitutes “bona fide indebtedness”, and instead state that whether indebtedness is bona fide will be determined under “general Federal tax principles” and “upon all the facts and circumstances”. Reg. §1.1366-2(a)(2)(i). However, the preamble clarifies that an S corporation shareholder is not required to satisfy the “actual economic outlay” doctrine to create debt basis. Although one commentator suggested that language be added to the Regulations providing that economic outlay is no longer the standard used to determine whether a shareholder obtains basis of indebtedness, the Treasury Department and the Service did not believe that was necessary. The Final Regulations also left unchanged the conclusion in Rev. Rul. 81-187, 1981-2 C.B. 167, that a shareholder of an S corporation does not increase his
3-17 Tax Conference, 28th Annual, May 21, 2015 or her stock basis upon the contribution of the shareholder’s own unsecured demand note to the corporation. 3. Shareholder Guarantee. The Final Regulations provide that an S corporation shareholder does not obtain debt basis merely by guaranteeing a loan or by acting as a surety, accommodation party, or in any similar capacity relating to a loan. When a shareholder makes a payment on bona fide indebtedness for which the shareholder has acted as a guarantor or in a similar capacity, the shareholder may at such time increase his debt basis to the extent of such payment. Reg. §1.1366-2(a)(2)(ii) 4. Examples. The Final Regulations include four examples, two of which deal with variations on the “incorporated pocketbook” theory in which a shareholder’s debt basis increases upon a loan to the S corporation from an entity related to the shareholder. In these types of transactions, an S corporation shareholder claims that a transfer from a related entity directly to the shareholder’s S corporation was made on the shareholder’s behalf and is, in substance, a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corporation. a. Back-to-Back Loan Transaction. A is the sole shareholder of two S corporations, S1 and S2. S1 loaned $200,000 to A. A then loaned $200,000 to S2. Whether the loan from A to S2 constitutes bona fide indebtedness is determined under general Federal tax principles and depends upon all of the facts and circumstances. If A’s loan to S2 constitutes bona fide indebtedness, the back-to-back loans increase A’s basis of indebtedness. b. Loan Restructuring Through Distributions Example. A is the sole shareholder of two S corporations, S1 and S2. In May 2014, S1 made a loan to S2. In December 2014, S1 assigned its creditor position in the note to A by making a distribution to A of the note. Under local law, after S1 distributed the note to A, S2 was relieved of its liability to S1 and was directly liable to A. Whether S2 is indebted to A, rather than S1, is determined under general Federal tax principles and depends upon all of the facts and circumstances. If the note constitutes bona fide indebtedness from S2 to A, the note increases A’s basis of indebtedness in S2. 5. Effective Date. The Final Regulations regarding indebtedness between an S corporation and its shareholder apply to any transaction occurring on or after July 23, 2014. In addition, S corporations and their shareholders may rely on these Final Regulations with respect to indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a year for which the period of limitation on the assessment of tax has not expired before July 23, 2014. IV. REVENUE PROCEDURES AND LEGAL ADVICE
A. Rev. Proc. 2014-12, 2014-3 I.R.B. 415 In response to Historic Boardwalk Hall, LLC v. Comm’r, 694 F.3d 425 (3rd Cir. 2012), where the Court held that the investor in a rehabilitation project was not a bona fide partner because it lacked a meaningful stake in either the success or failure of the partnership, this Revenue Procedures establishes the safe harbor requirements under which the Service will not challenge the allocation of the rehabilitation tax
3-18 Changes in Real Estate, Pass-Through Entities, and Estate Planning
credits by a partnership to its partners. This Revenue Procedure applies only with respect to the allocation of the rehabilitation credits. To satisfy the safe harbor provisions, among other items, (i) the managers of the partnership must have at least a one percent interest in each material item of partnership income, gain, loss, deduction and credit; (ii) the investor must contribute 20% of its total expected capital contribution as of the date the building is placed in service; (iii) at least 75% of the investor’s total expected capital contribution must be fixed before the date the building is placed in service; (iv) no person involved in any part of the transaction can directly or indirectly guarantee the investor’s ability to claim the rehabilitation credit; and (v) there can be no call option to purchase or redeem the investor’s interest at a future date; however, the investor can have a contractual right to require a person involved in the transaction to purchase its interest at a future date, so long as the price is not more than fair market value (as determined at the time of sale). The Revenue Procedure is effective for the allocation of rehabilitation credits made by a partnership to its partners on or after December 30, 2013. If a building was placed in service prior to December 30, 2013 and the partnership and its partners satisfied all the requirements for the safe harbor provided in the Revenue Procedure at the time the building was placed in service, the Service will not challenge the partnership’s allocation of rehabilitation credits to investors which are in accordance with Section 704(b). B. Rev. Proc. 2014-20, 2014-9 I.R.B. 614 Section 108(a)(1)(D) provides an exclusion for discharge of indebtedness income if the indebtedness discharged is considered qualified real property business indebtedness (“QRPBI”). To qualify as QRPBI, the indebtedness must be incurred or assumed by the taxpayer in connection with real property used in a trade or business and be “secured by such real property”. This Revenue Procedure provides a safe harbor under which the Service will treat indebtedness that is secured entirely by the ownership interest in a disregarded entity holding real property as indebtedness that is secured by real property for purposes of Section 108(c)(3)(A). The following requirements must be satisfied in order to qualify for the safe harbor: 1. The taxpayer or wholly disregarded entity of the taxpayer (the “Borrower”) must incur indebtedness. 2. The Borrower, directly or indirectly, must own 100% of the ownership interest in a separate disregarded entity owning real property (“Property Owner”). Borrower cannot be the same entity as Property Owner. 3. The Borrower must pledge to the lender a first priority security interest in Borrower’s ownership interest in Property Owner. Any further encumbrance on the pledged ownership interest must be subordinated to the lender’s security interest in Property Owner. 4. At least 90 percent of the fair market value of the total assets (immediately before the discharge) directly owned by Property Owner must be real property used in a trade or business and any other assets held by Property Owner must be incidental to Property Owner's acquisition, ownership and operation of the real property.
3-19 Tax Conference, 28th Annual, May 21, 2015
5. Upon default and foreclosure on the indebtedness, the lender must replace Borrower as the sole member of Property Owner If a taxpayer does not satisfy the safe harbor requirements, it is not precluded from arguing, based on facts and circumstances, that its debt satisfies the “secured by” requirement under Section 108(c)(3)(A). The Revenue Procedure is effective for taxpayers who make an election under Section 108(c)(3) regarding discharge indebtedness on or after February 5, 2014. C. Rev. Proc. 2014-51 2014-37 I.R.B. 543. This Revenue Procedure provides guidance regarding a taxpayer’s qualification as a real estate investment trust (a “REIT”) in the context of transactions involving debt secured by real estate which has declined in value. It modifies and supersedes Rev. Proc. 2011-16, 2011-5 I.R.B. 440, which provided a safe harbor to allow REITs to treat certain loan modifications occasioned by default or reasonably foreseeable default as not being a new commitment to make or purchase a loan for purposes of the 75% income test. The prior Rev. Proc. also provided a safe harbor for determining the extent to which a REIT could treat certain loans as real estate assets for purposes of the 75% asset test. (The 75% asset test provides that at least 75% of a REIT’s assets must be represented by real estate assets, cash and cash items, and government securities.) Specifically, Rev. Proc. 2011-16 provided that the Service would not challenge a REIT treatment of certain loans as being in part “a real estate asset” if the REIT treated the loan as being a real estate asset in an amount equal to the lesser of the value of the loan or the loan value of the real property securing the loan as determined under the Regulations and the Revenue Procedure. The Service became aware that, when the value of the real property securing the loan increased after the REIT originated or acquired the loan, the 75% asset test could produce “anomalous results” under Rev. Proc. 2011-16’s safe harbor. Specifically, the concern was that under Rev. Proc. 2011-16, the numerator (in calculating the 75% asset test) was equal to the lesser of the value of the loan or the value of the real property securing the loan. Therefore, the numerator would stay constant even if the value of the collateral increased. However, if the value of the collateral increased, the denominator would increase because it was calculated based on the value of the REIT’s real estate assets. To address the anomalies that could arise if the collateral increased in value, this Revenue Procedure provides that the Service will not challenge a REIT’s treatment of a loan as being in part a “real estate asset” for purposes of the 75% asset test, if the REIT treats the loan as being a real estate asset in an amount equal to the lesser of:
1. The value of loan is determined according to Reg. §1.856-3(a); or
2. The greater of: (a) the current value of the real property securing the loan or (b) the loan value of the real property securing the loan as determined under the Regulations or this Revenue Procedure.
This Revenue Procedure applies only to a modification of a mortgage loan which is held by a REIT, if the modification was occasioned by default or the modification satisfies two conditions – namely, that the REIT or servicer of the loan reasonably believes that there is a
3-20 Changes in Real Estate, Pass-Through Entities, and Estate Planning
significant risk of default on the pre-modified loan upon maturity of the loan or at an earlier date and the REIT or servicer of the loan reasonably believes that the modified loan presents a substantially reduced risk of default, as compared with the pre-modified loan.
D. Rev. Proc. 2015-20, 2015-9 I.R.B. 694. This Revenue Procedure permits a small business taxpayer (defined as a business with total assets of less than $10 million or average annual gross receipts of $10 million or less for the three prior tax years) to make certain changes in its method of accounting in order to comply with the recently released tangible property regulations (the “Tangible Property Regulations”) “solely through the filing of a federal tax return” and, thus, without need to file an IRS Form 3115, “Application for Change in Accounting Method”. (See Part III.A.1. for a description of the Tangible Property Regulations.) In addition, the Revenue Procedure allows a small business taxpayer to make such a change in its method of accounting without making an adjustment under Section 481. In general, a change in method of accounting requires an adjustment under Section 481. Section 481 requires taxpayers to make adjustments to taxable years preceding the year of change in order to prevent the duplication or omission of income or a deduction relating to transactions occurring in a year prior to the year of change. This Revenue Procedure provides that a small business that changes its method of accounting for tax years beginning on or after January 1, 2014, to comply with the Tangible Property Regulations, may calculate the Section 481(a) adjustment that takes into account only amounts paid or incurred and dispositions in tax years beginning on or after January 1, 2014. However, a taxpayer who chooses to calculate such a Section 481 adjustment does not receive audit protection for amounts paid or incurred in tax years beginning prior to January 1, 2014. E. Legal Advice Issued by Associate Chief Counsel AM 2014-003 (POSTN-122768- 13). In this Legal Advice, the Service explained the tax consequences under Section 465 of certain guarantees by a member of a limited liability company (“LLC”) classified as a partnership for Federal income tax purposes. After citing the relevant law, the Advice discusses the general application of Section 465 to members of an LLC and concludes that a member is at risk with respect to LLC debt guaranteed by such member without regard to whether the member waives any right to subrogation, reimbursements or indemnification against the LLC, but only to the extent that such member has no right of contribution or reimbursement from persons other than the LLC; the member is not otherwise protected against loss within the meaning of Section 465(b)(4); and the guarantee is bona fide and enforceable by creditors of the LLC under local law. The Advice then discusses the consequences of a member of the LLC guaranteeing qualified nonrecourse financing. By definition, under Section 465(b)(6), a liability is considered qualified nonrecourse financing if no person is personally liable for repayment. Therefore, when a member of an LLC guarantees LLC qualified nonrecourse financing, the debt is no longer considered qualified nonrecourse financing. As a result, the non-guaranteeing members who previously included a portion of the qualified nonrecourse financing in their amount at risk can no longer include that amount of the debt in determining their amount at risk. Any reduction that would cause a member’s at-risk amount to fall below zero will trigger recapture of losses under Section 465(e). The at-risk amount of the member that guarantees LLC debt is increased, but only to the extent that such debt was not previously taken into account by
3-21 Tax Conference, 28th Annual, May 21, 2015
that member and that member has no right of contribution or reimbursement from persons other than the LLC; the member is not otherwise protected against loss within the meaning of Section 465(b)(4); and the guarantee is bona fide and enforceable by creditors of the LLC under local law. The Advice specifically stated that it did not address the effect of a member guarantee of qualified nonrecourse financing in the context of a single member LLC taxed as a disregarded entity for Federal tax purposes, because the member at risk amount generally will not be affected by the guarantee. V. PRIVATE LETTER RULINGS
A. Priv. Ltr. Rul. 201416006 (January 17, 2014). Taxpayer and two of its affiliates each desired to enter into a reverse like-kind exchange under the safe harbor provisions of Rev. Proc. 2000-37, 2000-2 C.B. 308 with EATX, an exchange accommodation titleholder. EATX was not related to Taxpayer or its affiliates. Each of Taxpayer and its affiliates had a bona fide intent to acquire Property as replacement property in a Section 1031 exchange at the time EATX acquired qualified indicia of ownership in Property. Under Taxpayer’s qualified exchange accommodation agreement (“QEAA”), Taxpayer’s right to acquire Property was subject to it giving notice to EATX of its intent to acquire Property. However, if either of Taxpayer’s affiliates gave notice to EATX to acquire Property, EATX had no further obligation to transfer Property to Taxpayer. Taxpayer’s affiliates each entered into their own respective QEAAs, listing Taxpayer and the other affiliate as the other parties that may acquire Property, under substantially the same terms and conditions. Taxpayer represented that its exchange would satisfy the requirements for a deferred exchange in Reg. § 1.1031(k)-1 and the safe harbor provisions for reverse exchanges in Rev. Proc. 2000-37. At the time EATX acquired a qualified indicia of ownership in Property, it was not clear whether Taxpayer or one of its affiliates would complete the exchange within the 180-day period permitted for a QEAA under Rev. Proc. 2000-37. The Service concluded that Taxpayer’s arrangement to acquire Property constituted a QEAA, which was separate and distinct from the QEAAs entered into by its affiliates, with separate application of the identification rules of Reg. § 1.1031(k)-1(c). Thus, Taxpayer’s QEAA was not invalid merely because Taxpayer’s right to acquire Property terminated upon prior notice by either of its affiliates to EATX of its intent to acquire Property. This conclusion was based on the fact that Rev. Proc. 2000-37, as modified by Rev. Proc. 2004- 51, 2004-2 C.B. 294, does not prohibit an accommodation party from serving as an exchange accommodation titleholder for the same parked property. B. Priv. Ltr. Rul. 201424017 (March 12, 2014). Taxpayer, a real estate investment trust (“REIT”), owned properties that it leased on a triple-net lease basis to unrelated tenants. The tenants used the properties for the production of certain crops. Taxpayer purchased certain commercial plants, substantially all of which were mature and were expected to produce a commercially harvestable corp. The commercial plants had complex root systems. The issue of this Ruling was whether the commercial plants were “real property” under Section 856. Based on Hutchins v. King, 68 U.S. 53 (S. Ct. 1863) where the Court held that standing timber was
3-22 Changes in Real Estate, Pass-Through Entities, and Estate Planning
treated as real property, Adjes v. Comm’r, 74 T.C. 1005 (1980), and Rev. Rul. 67-51, 1967-1 C.B. 68, where the Court and Service, respectively, held that trees are part and parcel of the land, the Service ruled that the commercial plants were natural products of the land and constituted “real property” under Section 856, until severed from the property. C. Priv. Ltr. Rul. 201444022 (October 31, 2014). Taxpayer, a real estate investment trust (“REIT”), had two classes of outstanding limited liability company interests—common shares and preferred shares. Taxpayer was externally managed by Advisor, which received a base fee and incentive fee for its services to Taxpayer. Advisor’s fees were based on the net asset value (“NAV”) of Taxpayer. Taxpayer proposed to create two classes of shares—Class A shares and Class B shares. Taxpayer proposed to amend its agreement with Advisor such that the base fee would be determined only by reference to the portion of Taxpayer’s NAV that was attributable to the Class A shares. The incentive fee would accrue and be payable with respect to the Class A NAV and the Class B NAV separately, but based on otherwise identical formulas (i.e., pursuant to the same formula, but based on each class’s share of Taxpayer’s NAV). Taxpayer wanted to convert all outstanding common shares into Class A shares and authorize the issuance of Class B shares. Taxpayer proposed to extend a one-time offer to its shareholders, which would allow each shareholder to convert a specified number of Class A shares into Class B shares. In addition, new investors who purchased a threshold amount of shares would be entitled to purchase a set percentage of Class B shares. On each quarterly dividend date, the Class B shares would be entitled to receive a “special dividend” which would be equal to a percentage of the Class B NAV. The Class B special dividend initially would be equal to the reduction in the amount of the base fee formerly charged by Advisor with respect to the portion of the aggregate NAV of the Class B shares. If, in the future, the base fee were charged on a different basis, the amount of the special dividend would not be adjusted in the absence of a shareholder vote approving the adjustment. For purposes of determining the NAV of each class of shares, the special dividend would be treated as an amount similar to an expense that was borne pro rata by the Class A shares and the Class B shares. To qualify as a REIT, numerous asset, income, ownership and distribution requirements must be satisfied. One requirement is set forth in Section 857(a)(1), which requires, in part, that a REIT’s deduction for dividends paid for a tax year must equal or exceed 90% of its REIT taxable income for the tax year. Section 562 provides, in general, that the amount of any distribution will not be considered as a dividend for purposes of computing the dividends paid deduction, unless the distribution is pro rata. In other words, a preferential dividend does not count as a dividend eligible for the dividends paid deduction. In Rev. Proc. 99-40, 1999-2 C.B. 565, the Service described conditions under which distributions made to a shareholder of a regulated investment company (“RIC”) could vary and, nevertheless, be deductible as dividends under Section 562. Although the Service acknowledged that REITs are similar to RICs, it stated that Congress did not extend the liberalization of the RIC preferential dividend rules to REITs. Moreover, the Service stated that, when Congress liberalized certain rules for RICs, it reflected Congress’s belief that differences
3-23 Tax Conference, 28th Annual, May 21, 2015 due to savings in administrative costs attributable to the size of a shareholder’s holdings were allowed. In this case, the Service stated that the differences in distributions were intended to allocate investment advisory fees differently. The Service further stated that this arrangement, in substance, implemented a tiered investment advisory fee structure based on the amount invested for shareholders whose shares otherwise conferred substantially the same rights and obligations. Taxpayer asserted that the special dividend was not linked to the amount of the Advisor’s base fee because, if the base fee were charged on a different basis in the future, the amount of the special dividend would not be adjusted in the absence of a shareholder vote approving the adjustment. However, the Service did not believe that this fact changed the substance of the proposed dividend. Therefore, it ruled that the special dividend paid by Taxpayer with respect to the proposed two classes of common shares would be treated as a preferential dividend under Section 562(c), making the distribution ineligible for the dividends paid deduction. This could, in turn, result in Taxpayer failing to meet its 90% distribution requirement and cause it to fail to qualify as a REIT. D. Priv. Ltr. Rul. 201452015 (September 16, 2014). A state created a fund as a corporate governmental agency (the “Fund”). The Fund constituted a political subdivision and public benefit corporation to facilitate the timely construction of elementary and secondary schools and certain other buildings. As part of its program, the Fund contemplated the construction of high-rise structures above the school structures. Under the Fund’s originating legislation, its real property was exempt from real property taxes. The legislation also provided that, in general, if the easements, space rights, air rights or other fee or leasehold interests were held by the owner/developer, then the lease or other agreement would provide for the payment to the Fund of an amount equal to the real property taxes that would have been paid with respect to such interest. Taxpayer, a limited liability company, was the tenant under a lease of the land underlying the property on which the building would be constructed. The Fund was the fee owner of the property and the landlord under the lease. Taxpayer planned to convert its leasehold interest in the property to condominiums. The landlord of the condominiums would be the Fund. Taxpayer intended to sell certain units in the condominium to third parties pursuant to an offering plan approved by the State’s Attorney General. Each purchaser of a condominium unit would acquire from Taxpayer a qualified leasehold condominium interest in the condominium unit and would pay its proportionate share of the common charges of the condominium to the condominium’s board of managers. The condominium leases required Taxpayer, as tenant, to make certain payments in lieu of taxes (“PILOT”) in amounts similar to the amount of real estate taxes that would otherwise be payable if the property were not exempt from real estate taxes. However, unlike real estate taxes, the PILOT is not separately billed to each unit owner. Instead, the PILOT is collected by the condominium’s board of managers from the unit owners pro rata in accordance with their interest in the residential section and included with their proportionate common charges for their condominium units and paid to landlord under the condominium lease.
3-24 Changes in Real Estate, Pass-Through Entities, and Estate Planning
The issue of this Ruling was whether the PILOT payments would constitute real property taxes allowable as a deduction to the payor under Section 164. In making its decision, the Service relied on Rev. Rul. 71-149, 1971-1 C.B. 103, which held that tax equivalency payments to the New York City Educational Construction Fund by a cooperative housing corporation could be deducted as payments of real estate taxes because the payments satisfied a three-prong test: (1) the payments were measured by and were equal to the amounts specified by the regular taxing statutes; (2) the payments were imposed by a specific state statute; and (3) the proceeds were designated for a public purpose. In this case, the Service ruled that the PILOT obligations would satisfy the test of Rev. Rul. 71-49. Consequently, it ruled that the PILOT payments to be made pursuant to the condominium lease to the Fund (or to the city if it reacquired the Property) would constitute real property taxes allowable as a deduction by the payor under Section 164 and that the Taxpayer, as a unit owner, would be entitled to deduct as real property taxes under Section 164 the portion of the common charges paid by the Taxpayer to the condominium board as applied by the board toward the PILOT obligations. E. Priv. Ltr. Rul. 201503001 (January 16, 2015). Taxpayer, a storage company, intended to elect to be treated as a real estate investment trust (“REIT”). Taxpayer’s storage facilities included extensive internal physical improvements, including a racking and shelving system (the “Steel Racking Structures”). The Steel Racking Structures had multiple levels (each level up to 24 feet high), aisles and shelving. To ensure the building’s structural integrity, the Steel Racking Structures were attached to the floors but not to the ceiling or sides of the buildings. Each Steel Racking Structure required a building permit and a certificate of occupancy from the relevant municipality. The Steel Racking Structures were not reused in another facility. Taxpayers requested a ruling on whether the Steel Racking Structures would be treated as real property for purposes of Section 856. After reviewing Rev. Rul. 71-220, 1971-1 C.B. 210, which concluded that certain mobile homes situated on a planned site were real property within the meaning of Section 856, the Service concluded that the Steel Racking Structures were comparable to the assets described in Rev. Rul. 71-220 and, therefore, qualified as real property assets. In making its decision, the Service also distinguished this situation from Rev. Rul. 75-424, 1975-2 C.B. 269, which considered whether various components of a microwave transmission system were real estate assets for purposes of Section 856. That Revenue Ruling held that certain prewired modular racks were considered “assets accessory to the operation of a business” and so were not real estate assets. In this case, the Service stated that the Steel Racking Structures were used in the Taxpayer’s storage business and, therefore, were not considered an accessory to the operation of a business. Taxpayer requested several other rulings, including whether any portion of Taxpayer’s rents failed to qualify as “rents from real property” under Section 856(d). Taxpayer’s storage revenue consisted primarily of recurring periodic charges related to the storage of physical items for storage customers. In addition to the storage of items, the Taxpayer provided certain related services, which were charged separately. The charges for related services were not separately negotiated and did not necessarily represent an arm’s-length charge
3-25 Tax Conference, 28th Annual, May 21, 2015
for the related services on a stand-alone basis. Taxpayer represented that it would not be economical or practical for anyone except an affiliate of the party providing storage to provide the bulk of the related services. After Taxpayer’s conversion to a REIT, the bulk of the related services would be provided by a TRS. The TRS would receive the higher of the fee paid by the storage customer or the Section 482 arm’s-length fee for providing its services. The Service concluded that the storage customer payments for related services would not give rise to Taxpayer’s receipt of impermissible tenant services income and did not cause any portion of the rents received by Taxpayer to fail to qualify as “rents from real property”. VI. CHIEF COUNSEL ADVICE, TECHNICAL ADVICE MEMORANDA AND ACTION ON DECISION
A. Chief Counsel Advice 201415002 (February 11, 2014). This Advice focused on the interaction of Sections 108 and 469(g). Specifically, it addressed whether a foreclosure of real property subject to recourse debt was considered a fully taxable disposition for purposes of the passive activity rules, even if the foreclosure triggered cancellation of indebtedness income that was excluded from gross income under Section 108(a)(1)(B). Section 469(g) provides that, if a taxpayer disposes of his entire interest in a passive activity in a “fully taxable transaction” to an unrelated third party, then any suspended losses from that activity are “freed up” and can be used to offset any non-passive income of the taxpayer. After reviewing the legislative history of Section 469(g), the Advice concluded that a foreclosure where the taxpayer no longer possesses any interest in the real property is considered a fully taxable transaction under Section 469(g). The Advice further concluded that a taxpayer does not reduce the “freed up” non- passive losses by any cancellation of indebtedness income excluded under Section 108(a)(1)(B) in the year of the discharge. Under Section 108(b)(2)(F), any cancellation of indebtedness income from the tax year of the discharge reduces any passive activity loss and credit carryover of the taxpayer under Section 469(b) from the year of the discharge. However, under Section 108(b)(4), reductions to tax attributes required by Section 108(b) are made after determination of tax for the year of the discharge. In other words, in the view of the IRS only remaining Section 469(b) suspended loss carryovers are reduced under Section 108(b)(2)(F). B. Chief Counsel Advice 201436048 (April 29, 2014). Taxpayer owned an office building that it leased to A, a U.S. government agency. Taxpayer paid for renovations and building expansion of the property, for which A reimbursed Taxpayer in lump sum. The issue in this Advice relates to the reimbursements and tenant improvements. In this Advice, the Taxpayer and A signed a lease which provided that: (i) a portion of the rent included a fixed amount for tenant improvements (the “Tenant Improvement Allowance”) and (ii) the Tenant Improvement Allowance covered the buildout of the property, “except for lump sum reimbursable amounts”. Thereafter, Taxpayer and A signed a supplemental agreement under which A agreed to expand the premises. The supplemental agreement provided for an increase in the Tenant Improvement Allowance and additional lump payments to be made by A.
3-26 Changes in Real Estate, Pass-Through Entities, and Estate Planning
On Date 1, Date 2 and Date 4, Taxpayer received lump sum reimbursements for the cost of the tenant improvements under the lease. These amounts were not included in the stated rent. Taxpayer did not include the amount of the lump sum reimbursements in income in the year received and reduced the basis of the tenant improvements by these amounts for purposes of depreciation. The Service’s position was that these reimbursements were rental income in the year received and that the cost of the tenant improvements was to be increased by the amount of these reimbursements. Taxpayer’s position was that the lump sum reimbursements were not a substitute for rent and, instead, were reimbursements of costs that it incurred on behalf of the lessee. In order to determine if the cost of the tenant improvements was rental income to Taxpayer, the Chief Counsel reviewed the leases and information on A’s website. It also reviewed the pricing desk guide of A’s Public Building Service for purposes of interpreting the lease agreement’s provisions on tenant improvements, which indicated that certain lump sum payments were not intended to be part of the rent. The Service cited certain cases to support its position that the lump sum reimbursements were rental income, namely, Sleiman v. Comm’r, T.C. Memo 1997-530, aff’d 187 F.3d 1352 (11 Cir. 1999); Satterfield v. Comm’r, T.C. Memo 1975-203; and Martin v. Comm’r, 11 B.T.A. 850 (1928). The Chief Counsel found that each of the cases was distinguishable from this case because, in each of the cited cases, the Court found “that the intent of the parties was to treat the amount at issue as rent”. The Chief Counsel found that this case was more like McGrath v. Comm’r, T.C. Memo 2002-231, aff'd in an unpublished opinion (5th Cir. 2003), in which the Court found that some of the tenant improvements were a substitute for rent and some of the tenant improvements were capital expenditures by the lessee. The Service attempted to distinguish McGrath from the present case by arguing that McGrath involved improvements by a lessee, rather than improvements by a lessor. However, the Chief Counsel stated that in this case, the lessee incurred the cost of the improvements payable by a lump sum reimbursable amount through a billing arrangement with the lessor. As a result the Chief Counsel concluded that only amounts for tenant improvements included in the stated rent were rental income. The second issue addressed by the Advice is whether certain assets were tax- exempt use property, requiring Taxpayer to use the alternative depreciation system (“ADS”). The Service was proposing to adjust depreciation claimed by Taxpayer on certain tenant improvements placed in service on Date 1 and Date 3 based on Section 168(g)(1)(B), which provides that ADS must be used in the case of any property that is tax-exempt use property. However, with respect to tenant improvements placed in service on Date 1, because the Service stated that the facts did not indicate that the lease was a disqualified lease, the Chief Counsel concluded that the property was not tax-exempt use property. The Service also proposed to treat certain assets placed in service in Date 3 relating to the expansion premises as tax-exempt use property subject to ADS. These assets included 5-year property, 7-year property and 15-year property that were not qualified leasehold
3-27 Tax Conference, 28th Annual, May 21, 2015
improvement property. The Chief Counsel concluded that such properties were tax-exempt use property under Section 168(h) and had to be depreciated under the ADS. The Chief Counsel then addressed whether the Service could treat the disallowed depreciation resulting from the use of ADS as an adjustment required by a change in method of accounting. Because Taxpayer, on its Date 3 and Date 4 tax returns, had depreciated certain property which was tax-exempt use property under the general depreciation system and had deducted the additional first-year depreciation for these assets, but the assets had to be depreciated under the ADS and did not qualify for any additional first-year depreciation, the Chief Counsel concluded that such changes were changes in method of accounting under Treas. Reg. §1.446-1(e)(2)(ii)(d)(2). C. Chief Counsel Advice 201436049 (May 20, 2014). Management Company, a limited liability company treated as a partnership for Federal tax purposes, served as the investment manager for Managed Fund, which was a family of investment partnerships. Managed Fund conducted its investment activity through state limited partnerships (the “Funds”). The Funds were partnerships for Federal tax purposes. Each Fund carried on extensive trading and investing and had passive investors that were limited partners. Management Company was a general partner of each Fund. In consideration for Management Company’s services, the limited partnership agreement of each of the Funds provided for a payment of a management fee based upon each Fund’s assets under management. The Service audited Management Company. In the years at issue, Management Company’s gross receipts were entirely attributable to management fees for providing services to the Funds. Management Company had partners, all of whom were individuals. Each partner of Management Company worked full time and performed a wide range of professional services. Each partner owned a “unit” of Management Company and was allocated a distributive share of Management Company’s taxable income. Management Company treated all of its partners as limited partners not subject to self-employment tax on their distributive share. The issue was whether the partners of Management Company were “limited partners” exempt from self-employment tax under Section 1402 on their distributive shares of Management Company’s income. In concluding that the partners were subject to self-employment tax, the Chief Counsel reviewed Renkemeyer, Campbell, and Weaver LLP v. Comm’r, 136 T.C. 137 (2011), where the Tax Court ruled that practicing lawyers in a law firm organized as a Kansas limited liability partnership were not limited partners under Section 1402 and thus were subject to self- employment tax. The Chief Counsel concluded that, similar to Renkemeyer, the partners’ earnings were not in the nature of a return on a capital investment (even though the partners paid more than a nominal amount for their units). Instead, the earnings of each partner from Management Company were a “direct result of the services rendered on behalf of Management Company by its Partners”. Additionally, the Court reviewed the legislative history of Section 1402 and its predecessor Section 702(a)(8) and stated that the income earned by the partners was not income that was basically of an investment nature of the sort that Congress sought to exclude from self- employment tax.
3-28 Changes in Real Estate, Pass-Through Entities, and Estate Planning
D. Chief Counsel Advice 201445009 (June 6, 2014). The issue in this Advice was whether an investor who transferred money to the principals of an entity (the “Principals) to invest on her behalf was entitled to the safe harbor treatment for theft losses under Rev. Proc. 2009-20, 2009-14 I.R.B. 749, as modified by Rev. Proc. 2011-58, 2011-50 I.R.B. 849. The Office of Chief Counsel concluded that the investor should be entitled to the safe harbor treatment for theft losses because the Principals should be viewed as her agents. As agents, the Principals would not be able to participate in the realized losses. Therefore, the investor should be viewed as transferring cash or property to a fraudulent arrangement and, as a result, would be entitled to deduct the theft losses. E. Chief Counsel Advice 20144602 (July 23, 2014). Taxpayer was a C corporation on Date 1. On Date 2, it elected to be an S corporation. At that time, it had accumulated earnings and profits. Taxpayer’s majority shareholders revoked its S election effective on Date 3. During Taxpayer’s post-termination transition period (“PTTP”), it distributed a portion of its accumulated adjustments account (“AAA”) to its shareholders. On Date 4, Taxpayer made another election to be treated as an S corporation. Taxpayer requested a ruling regarding whether the AAA balance from its first S corporation period survived the end of the PTTP and Date 4. The Advice concluded that the S corporation’s AAA was reset to zero after the PTTP and remained at zero on Date 4. In making its decision, the Chief Counsel reviewed the legislative history at the time Congress enacted Subchapter S in 1958 and concluded that Congress’s intention was that the undistributed taxable income would expire at the end of any given S period. In addition, it looked at the “plain language” of Reg. §1.1368-2(a)(1), which provides that, on the first day of the first year for which the corporation is an S corporation, the balance of the AAA is zero. The Advice further noted that a shareholder’s outside basis will “not disappear when the S corporation status changes” because the “corporation retains the ability to make tax- free distributions from the shareholder’s outside basis[;] it simply must distribute out of its E&P first”. F. Chief Counsel Advice 201451027 (October 1, 2014). This Advice was intended to provide assistance regarding the mortgage interest deduction under Section 163. The Advice focuses on the scenario where more than one taxpayer is liable on a home mortgage obligation. The Chief Counsel stated that, if the mortgage payments are paid from a joint account, then the owners are each presumed to have paid one-half of the mortgage interest, in the absence of evidence showing that is not the case. The Advice also concluded that a person who is jointly and severally liable on a home mortgage debt is entitled to deduct all of the otherwise allowable interest on such debt, provided that such person actually pays all of the interest. G. Chief Counsel Advice 201504010 (December 17, 2014). This Advice focuses on whether a real estate agent or a mortgage broker is considered engaged in a “real property trade or business” under Section 469(c)(7). The Advice concludes that a real estate agent who brings together buyers and sellers of property is engaged in a real property trade or business while a mortgage broker, who is a broker of financial instruments, is not.
3-29 Tax Conference, 28th Annual, May 21, 2015
In reaching its conclusion, the Chief Counsel reviewed Section 469(c)(7), which defines “real property trade or business” to include a real property brokerage trade or business. However, because Congress removed “finance operations” from the list of qualifying real property trade or business activities from an earlier version of Section 469(c)(7), it concluded that it was reasonable to infer that Congress did not intend financing activities to be included in the definition of “real property brokerage”. The Chief Counsel also reviewed the Webster’s Dictionary definition of a “broker”, which is “a person who helps other people…to buy and sell property.” The Chief Counsel specifically noted that it would not look to the state law definition of the terms “real estate agent” or “mortgage broker” because such definitions were not determinative in this issue. H. Technical Advice Memo. 201437012 (April 18, 2014). Taxpayer established a Section 1031 LKE Program, as permitted by Rev. Proc. 2003-29, 2003-1 C.B. 971. Under the LKE Program, Taxpayer received one replacement property for each property relinquished. Taxpayer used an algorithm to match replacement properties to relinquished properties. The Service’s examination team determined that some of the replacement properties were ineligible for exchange under Section 1031 because they were held primarily for sale rather than for productive use in a trade or business or for investment. In response, Taxpayer asserted that it had other, previously unmatched replacement properties which should match with the eligible relinquished properties. (The “new” replacement properties were acquired within the relevant 45-day identification period.) Taxpayer argued that Section 1031 required it to re-match the eligible relinquished properties to the other, previously unmatched eligible replacement properties. The Service’s examination team disputed this position, arguing that Taxpayer’s matching of ineligible replacement properties with the relinquished properties was binding on Taxpayer upon filing of its return. Because Reg. §1.1031(k)-1(c)(4) expressly allows a taxpayer to identify multiple and alternative replacement properties in a deferred exchange, and because the previously unmatched replacement properties met the exchange, identification and receipt requirements, the Service ruled that the rematching was appropriate. The Service recognized that this Ruling placed an additional burden on the examination team resulting from Taxpayer’s ability to rematch property upon determination by the examination team that the originally matched replacement property was ineligible. However, it believed it was “an unavoidable burden inherent in [Section 1031] that does not irrevocably bind the taxpayer and the IRS to the position originally reported by the taxpayer on its return”. I. Action On Decision 2015-1 I.R.B. 2015-6 (Feb. 9, 2015). In Action on Decision (“AOD”) 2015-1, the Service stated that it will not follow the decision in four Tax Court cases, Estate of Martinez v. Comm’r, T.C. Memo 2004-150, Gracia v. Comm’r, T.C. Memo 2004-147, Mirachi v. Comm’r, T.C. Memo 2004-148, and Price v. Comm’r, T.C. Memo 2004-149. The issue in all four cases was whether a general partner who guaranteed the debt of a partnership and was not in bankruptcy in his individual capacity could exclude from gross income under Section 108(a) partnership debt cancelled in a Title 11 bankruptcy case of the partnership. In each of the four almost identical cases, the taxpayer was a general partner in the same general partnership. The partnership borrowed approximately $21 million from a bank. Each of the general partners executed a personal guaranty agreement, whereby they jointly and severally guaranteed the loan. Subsequently, the partnership filed for Chapter 11 bankruptcy.
3-30 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Each partner agreed to execute a contribution agreement and contribute $15,000 to the partnership’s bankruptcy estate in exchange for a release of all claims (or potential claims) of creditors against such partner that arose out of the partnership. The bankruptcy court approved the contribution agreements.
The partnership issued each partner a Schedule K-1, which allocated to such partner approximately $400,000 of discharge of indebtedness income. Each partner excluded this entire amount from his gross income. The Tax Court concluded that the partner’s debts in question were discharged “in a title 11 case” within the meaning of Section 108(d)(2), and, therefore, the partner’s discharge of indebtedness income was excludable from gross income under Section 108(a)(1)(A).
In this AOD, the Service stated that it disagreed with the Tax Court’s holdings. Because the partner was not under the jurisdiction of the bankruptcy court in a title 11 case as a debtor, the partner was not a “person…concerning [whom] a case under this Title [11] had been commenced”, and, therefore, the Service stated that the partner was not entitled to exclude his shares of the partnership cancellation of debt income under Section 108(a)(1)(A). VII. CASES
A. ABC Beverage Corp. v. United States, 113 AFTR 2d 2104-2536 (6th Cir. 2014). The issue in this case was whether a lessee, who buys certain leased property from the lessor for a price greater than the value of the property, can immediately deduct as a business expense the portion of the purchase price it paid to buy the unexpired lease. ABC was a Michigan corporation that made and distributed non-alcoholic beverages. Through a subsidiary, ABC acquired a company that held a long-term lease on a bottling plant in Missouri. Shortly thereafter, ABC concluded that the rent due under the lease exceeded its fair market value. Because the lease contained a purchase option, with the purchase price being the fair market value of the property, ABC exercised its purchase option. The parties disagreed about how to calculate the purchase price. ABC stated it would pay $9 million for the property, and the landlord countered with a price of $14.8 million. Eventually, the parties agreed to a purchase price of $11 million. ABC obtained three independent appraisals before it bought the property and all of the appraisals concluded that the value of the property without the lease was $2.75 million. On its tax return, ABC capitalized $2.75 million as the cost of purchasing the property and claimed a business expense of $6.25 million—the difference between the $9 million ABC calculated it would have to pay for the property and the $2.75 million appraised value. The Service disallowed the deduction and assessed an income tax deficiency of $2.5 million. ABC paid the assessment and sued for a refund. The Court began its analysis by examining Cleveland Allerton Hotel v. Comm’r, 166 F.2d 805 (6th Cir. 1948), where, based on facts similar to the case at hand, the Court reversed the Tax Court and allowed the taxpayer to deduct the portion of the purchase price in excess of the fair market value of the property as a business expense. The Court in Cleveland Allerton Hotel concluded that the “excess” price was paid “to escape the burdensome lease”.
3-31 Tax Conference, 28th Annual, May 21, 2015
The Government conceded that, if Cleveland Allerton Hotel remained good law, it controlled the outcome of this case and ABC would be permitted to deduct the lease expense. The Court stated that Cleveland Allerton Hotel would remain controlling authority unless an inconsistent decision of the Supreme Court or this Court en banc overruled the decision. The Court then reviewed four relevant cases and Section 167(c)(2) and concluded that no decision of the Supreme Court, nor any statutory change, required modification of the decision in Cleveland Allerton Hotel. First, the Court reviewed Millinery Center Building Corp. v. Comm’r, 350 U.S. 456 (1956), where the facts were similar to the case at hand, but the Court’s decision turned on whether the taxpayer had sufficient evidence to demonstrate that the rent under its lease was actually burdensome. Because Millinery Center Building did not discuss the issue at hand, the Court held that it did not require the Court to modify Cleveland Allerton. The Court then reviewed the decisions in Woodward v. Comm’r, 397 U.S. 572 (1970), Comm’r v. Idaho Power Co., 418 U.S. 1 (1974), and INDOPCO, Inc. v. Comm’r, 503 U.S. 79 (1992). The Court found that these three cases held that litigation expenses necessary to purchase a capital asset, construction expenses necessary to build a capital asset, and professional expenses necessary to facilitate the takeover of a capital asset, respectively, were capital expenditures. Therefore, the Court held that these decisions did not require it to modify Cleveland Allerton. Finally, the Court reviewed whether Section 167(c)(2) affected the Cleveland Allerton decision. Section 167 provides that, if any property is acquired subject to a lease, a taxpayer is prohibited from allocating any part of the property’s cost to the leasehold interest and requires the taxpayer to capitalize the entire cost of the property. Because Section 167 was enacted after Cleveland Allerton, the Court stated that it would “trump that case to the extent the two conflict”. ABC argued that Section 167 does not apply because “subject to a lease” modifies “acquired”, so the statute only applies if the purchased property remains subject to a lease after the purchase. The Government argued that the phrase modifies “property” so that Section 167 applies so long as the property was subject to a lease when acquired. In making its decision, the Court looked to U.S. v. Plavcak, 411 F.3d 655 (6th Cir. 2005), where the Court stated that the phrase “property is acquired subject to a lease” did not encompass a situation in which a lessee bought out the lease while acquiring the property, because the lease terminated upon its acquisition. However, the Court stated it thought the statute’s text was ambiguous and reviewed the legislative history of Section 167, but did not find that it shed light on the matter. Still, the Court thought that the phrase “acquired subject to a lease” was “best understood to encompass only those acquisitions in which the leased continue[d] after the purchase”. Therefore, because Section 167(c)(2) did not prohibit ABC from deducting the lease expense and because no decision of the Supreme Court required the Court to modify its decision, the Court ruled that Cleveland Allerton remained in full effect and, therefore, ABC was permitted to deduct the lease expense.
3-32 Changes in Real Estate, Pass-Through Entities, and Estate Planning
B. Almquist v. Comm’r, T.C. Memo 2014-40. In 2008, Talbot Almquist worked as an executive at Oakwood Worldwide (“Oakwood”) and received a salary of $180,748. Mr. Almquist estimated that he spent no more than 20 hours a week working for Oakwood, but provided no documentation to support this fact. In 2008, Mr. Almquist and his wife (“Taxpayers”) owned two rental real estate properties—the Indio property and the Naples property. Both of the properties were furnished and were rented out as fully furnished units. The Court noted that, generally, renting a furnished residential property requires more upkeep and time than renting an unfurnished property. Taxpayers provided the Court with one calendar and two different logs describing the hours worked on the rental properties. The first log was made about a year after the fact and was based on brief cryptic notes in Mr. Almquist’s personal spiral notebook daily records, calendar documents and e-mails. The first log indicated that Mr. Almquist worked 486 hours on the Indio property and 188 hours on the Naples property. The log also claimed that Mr. Almquist spent 101 hours looking for investment properties and attending open houses. After meeting with a revenue agent, Taxpayers created a second log listing additional time allocated to the rental activities. This log greatly expanded the entries and reported that Mr. Almquist spent additional hours on the rental properties. Taxpayers did not provide any new supporting documents or e-mails to support the entries in the second log. The first issue addressed by the Court was whether Mr. Almquist qualified as a real estate professional under Section 469(c)(7). (Taxpayers did not contend that Mrs. Almquist qualified as a real estate professional.) To qualify as a real estate professional, Mr. Almquist needed to demonstrate that he performed more than half of his services in a real property trade or business and performed more than 750 hours of service in a real property trade or business. However, because the first log provided by Taxpayers showed that Mr. Almquist only worked 775 hours (486 + 188 + 101) on real estate property while he worked somewhere between 885 and 980 hours at Oakwood, the Court held that Taxpayers failed to show that Mr. Almquist spent more than half of his services in a real estate trade or business.
Taxpayers contended that the Court should look to the second log in determining whether Mr. Almquist was a real estate professional. But, because the Court was not provided any supporting documentation or e-mail, the Court refused to accept Taxpayers’ “self-serving testimony”.
C. Annuzzi v. Comm’r, T.C. Memo 2014-233. Mel and Jean Annuzzi operated Annuzzi Concrete Services, Inc. (“ACS”). In 2009 and 2010, Mr. Annuzzi received a salary from ACS of $1,182,698 and $854,897, respectively. Additionally, during those two years, the Annuzzis claimed a net loss of $81,114 and $55,797, respectively, from a certain thoroughbred activity. The Service determined that the Annuzzis did not engage in the thoroughbred activity with an intent to profit during 2009 and 2010 and disallowed the deductions for these losses under Section 183. The issue in this case was whether the Annuzzis engaged in the thoroughbred activity with an intent to profit. In reaching its decision, the Court reviewed the Annuzzis’ thoroughbred activity. In the early 1980s, the Annuzzis began to purchase racehorses and co-owned most of their horses
3-33 Tax Conference, 28th Annual, May 21, 2015 with Terry Knight, a professional thoroughbred trainer. Mr. Knight co-owned more than 50 horses with the Annuzzis, and, in most cases, Mr. Knight and the Annuzzis each held a 50% ownership interest in the horse and paid 50% of the expenses. During 1981 through 1994, the Annuzzis had some success in their thoroughbred activity and earned modest profits in 1983, 1984, 1987, 1988 and 1994. Because Mr. Knight left California temporarily in 1985 and 1986, the Annuzzis did not participate in the thoroughbred activity during those years. The Annuzzis suffered annual losses from 1995 through the tax years at issue (2009 and 2010). The parties agreed that the Annuzzis’ thoroughbred activities should be analyzed under Section 183 as a single activity. The Court reviewed the list of factors set forth in Reg. §1.183-2(b) to be considered in determining whether the Annuzzis’ thoroughbred activity were engaged in for profit, including: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that the assets used in the activity would appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of the occasional profits earned from the activity; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation.
Based on case law, the Court stated that no single factor would be dispositive and, therefore, reviewed each factor to determine if it favored the Service or the Annuzzis, or was neutral. The Court found that three factors strongly favored the Annuzzis, three factors strongly favored the Service, two factors slightly favored the Annuzzis and one factor was neutral.
More specifically, the Court found that the Annuzzis had strongly demonstrated that they conducted their thoroughbred activity in a businesslike manner by keeping thorough and accurate records, disposing of horses that did not have significant breeding potential, and co- owning their horses with Mr. Knight. Although the Service attempted to argue that the Annuzzis’ lack of business plan and formal cashflow projections illustrated that they did not act in a businesslike manner, the Court stated that the Annuzzis’ “decision to forgo the creation of such documents for their thoroughbred activity [did] not evidence the lack of a profit objective.” The Court also found that the Annuzzis had strongly demonstrated their expertise and that of their advisors by their strong relationship with Mr. Knight. The Court focused on the facts that they constantly sought and received advice from Mr. Knight, took a hiatus from their thoroughbred activity when he left California, and purchased most of their horses in conjunction with him. Finally, the Court also found that the Annuzzis strongly demonstrated their expectation that the horses would appreciate in value because they bought the horses at a relatively low price, bought horses with good bloodlines, and engaged the expert training of Mr. Knight.
The Court found that the facts that the Annuzzis had many years of financial losses from their thoroughbred activity, that Mr. Annuzzi had earned a significant salary from ACS during the years at issue, and that the Annuzzis “clearly derived immense pleasure from their thoroughbred activity” led to the conclusion that three factors (the history of income or
3-34 Changes in Real Estate, Pass-Through Entities, and Estate Planning
losses, the financial status of the taxpayers, and the elements of personal pleasure) strongly favored the Service.
Of the remaining three factors, the Court found that two of them (the amount of occasional profits and the taxpayers’ time and effort) slightly favored the Annuzzis. With respect to the occasional profits factor, the Court focused on the fact that, although the Annuzzis earned minimal profits, thoroughbred activity is a “speculative business”. With respect to the taxpayers’ time and effort factor, although the Court found that the Annuzzis uncorroborated estimation that they jointly devoted between 55 to 60 hours a week to their thoroughbred activity was high, it found that Mr. Knight’s intense involvement led to the conclusion that this factor weighed in favor of the Annuzzis.
Finally, the Court found that the Annuzzis’ success in ACS did not play a role in establishing their success in thoroughbred racing because there was “little synergy” between the concrete business and the activity at issue, and so this factor (the success of taxpayer in carrying on other similar activities) was neutral.
Based on the facts that more factors weighed in favor of the Annuzzis than the Service and that Mr. Knight clearly “embarked on this venture with the intent to make a profit”, the Court found that the Annuzzis demonstrated an intent to earn a profit and were entitled to deduct the losses from their thoroughbred activity.
D. Estate of Belmont v. Comm’r, 144 T.C. No. 6 (2014). Decedent died on April 1, 2007. At the time of her death, Decedent’s only heirs were a brother, David Belmont (“David”), and a half-sister in Ohio. Decedent’s will provided that David would receive $50,000 and the “rest, residue, and remainder” would be distributed to the Columbus Jewish Foundation, a Section 501(c)(3) organization. At the time of her death, Decedent was the titled owner of two pieces of real property, a residence in Ohio and a condominium in California. She also had a retirement account with the State Teachers Retirement Pension Fund of Ohio (“STRPF”), which distributed a death benefit of approximately $243,000 to the estate. The distribution was income in respect of a decedent pursuant to Section 691.
On July 17, 2008, the Estate filed a Form 1041, “U.S. Income Tax Return for Estate and Trusts”, for its taxable period ended March 31, 2008. An accountant prepared the Form 1041. The Estate reported the income from the STRPF, interest income and a long-term capital loss. After claiming deductions for taxes, return preparation fees and other miscellaneous fees, the Estate claimed a $219,480 charitable contribution deduction on the basis of Decedent’s will leaving the residue of her estate to the Columbus Jewish Foundation. The Estate had not paid the charitable contribution to the Foundation at the time the Form 1041 was filed.
At the time of Decedent’s death, David resided in her California condominium. Following Decedent’s death, David attempted to negotiate a life tenancy in the California condominium in exchange for his $50,000 bequest. On February 14, 2008, the executrix of the Estate mailed David a letter stating that the Foundation did “not desire to hold real estate as an investment” and declined David’s offer. David did not vacate the property. On April 2, 2008,
3-35 Tax Conference, 28th Annual, May 21, 2015
David filed a creditor’s claim, asserting a life tenancy interest in the condominium on the basis of a “resulting trust” theory. Ultimately, David prevailed.
As a result of the litigation, the Estate incurred various expenses and had depleted its savings in its checking account to $185,000.
The issue in this case was whether the Estate was entitled to a $219,580 charitable contribution deduction. The Estate contended that during the taxable period ending on March 31, 2008, it permanently set aside $219,580 of its gross income for the benefit of the Columbus Jewish Foundation and, therefore, was entitled to a charitable contribution deduction for that amount under Section 642(c). The Service did not agree.
Section 642(c) provides that an estate is allowed a deduction from gross income, for amounts which, pursuant to the terms of the governing instrument, is, during the taxable year, permanently set aside for charitable purpose. Reg. §1.642(c)-2(d) provides that an amount is considered “permanently set aside” if the possibility that the amount set aside will not be devoted to such purpose or use is so remote as to be negligible.
The Estate argued that there was no “reasonably foreseeable possibility” that it would have incurred the unanticipated costs with litigating David’s claim on the California condominium. The Service disagreed and argued that it was appropriate for the Estate to consider David’s legal claims because they all were instituted before the Estate filed its Form 1041.
The Court agreed with the Service. Although it noted that it did not have the occasion to consider the “so remote as to be negligible” standard in the context of Section 642(c), it had examined identical language in connection with the regulations prescribed under Section 170, which prescribed “so remote as to be negligible” as “a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction.”
The Court concluded that the information that was known (or reasonably known) to the Estate when it filed its Form 1041 indicated that David’s claim to a life tenancy interest in the California condominium was more than negligible and that funds set aside for the Foundation would be depleted because of the ongoing and future litigation over the California condominium. As a result, the Court held that the $219,580 was not “permanently set aside” as required by Section 642(c).
E. Blangiardo v. Comm’r, T.C. Memo 2014-110. On April 21, 1995, Taxpayer, while married to his first wife, purchased Property A for $488,000. Taxpayer and his first wife became divorced, and Taxpayer’s first wife agreed to waive her interests in Property A in exchange for $500,000. Taxpayer remarried and, later, divorced his second wife. In 2006, Taxpayer paid his second wife $80,000 as payment for all claims she had (or might have) against him. On August 15, 2008, Taxpayer sold Property A for $2,250,000. On August 29, 2008, Taxpayer purchased Property B, a parcel of vacant land, for $1,430,000. Taxpayer
3-36 Changes in Real Estate, Pass-Through Entities, and Estate Planning
claimed that Property A was held for business use and he carried out a Section 1031 exchange, with his son, an attorney, acting as an intermediary. The Service rejected Taxpayer’s claim and determined that he had $1,512,000 of taxable gain from the sale of Property A. The Service moved for summary judgment, raising two issues: (1) that the sale of Property A and the acquisition of Property B did not constitute a valid Section 1031 exchange because Taxpayer failed to use a qualified intermediary and (2) that Taxpayer improperly increased his basis in Property A by the amounts paid to his former spouses incident to divorce. With respect to the first issue, Taxpayer acknowledged that there was no direct exchange of like-kind property and that the intermediary was his son. Because the Regulations are explicit that a lineal descendent is a disqualified person and the Regulations do not make an exception based on his/her profession, the Court held that Taxpayer’s disposition of Property A and subsequent acquisition of Property B was not a deferred exchange within the purview of Section 1031. With respect to the second issue, because Section 1041 provides that transfers incident to a divorce are treated as a gift and that the basis of the transferee of the property is the same as the adjusted basis of the transferor, the Court held that Taxpayer could not increase his basis in Property A by the settlement payments he paid incident to his divorces. As a result, the Court granted the Service’s motion for summary judgment. F. Boree v. Comm’r, T.C. Memo 2014-85. In 2002, Gregory Boree and a partner formed Glen Forest, LLC (“Glen Forest”). That year, Glen Forest purchased 1,982 acres of land (the “GF Property”) for $3.2 million. Immediately after the purchase, Glen Forest sold 280 acres of the GF Property. Also in 2002, Glen Forest sold 10 acres of the GF Property and began planning a residential development on the remaining land. In 2003, Glen Forest executed a declaration of covenants, conditions and restrictions and created a homeowners’ association (“HOA”) for the development of the GF Property. Glen Forest was described as the “developer” in these documents and was reserved the right to designate at least one member of the board of directors of the HOA if it held for sale in the ordinary course of business at least 5% of the acreage in all phases of the property. In 2004, Glen Forest sold 26 lots, and in 2005 Glen Forest sold 17 lots. That same year, the Borees bought out Mr. Boree’s partner and became the sole owners of Glen Forest. In 2006, Glen Forest sold 4 lots and entered into an agreement with Adrian Development (“Adrian”) that contained an option for Adrian to purchase Glen Forest’s remaining property. In 2007, Adrian purchased the remaining 1,067 acres for $9.6 million. On their Form 1040 for 2007, the Borees indicated that Mr. Boree’s occupation was “real estate professional” and reported long-term capital gain of $8,578,636 related to the Adrian transaction. The issue of this case was whether the gain from the sale of the real property in the Adrian transaction resulted in ordinary income or capital gain. The Service contended that the Company’s land sale produced ordinary income, while the Borees argued that the sale produced capital gain because Mr. Boree held the land for investment.
3-37 Tax Conference, 28th Annual, May 21, 2015
Section 1221 provides that a capital asset does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. The Court stated that the determination of whether the Borees held the lots primarily for sale to customers in the ordinary course of their trade or business was a factual inquiry. The Court focused on the frequency and substantiality of Mr. Boree’s sales because the Court of Appeals for the Eleventh Circuit—to which this case was appealable—often found that this was the most important factor in determining whether property was held for investment rather than for sale.
In determining that the income from the Adrian transaction was ordinary in nature, the Court focused on the facts that: (1) the Borees treated Glen Forest as a real estate business on their Form 1040 for 2005, 2006 and 2007, describing Mr. Boree’s “Principal business or profession” as “Land Investor” and “Real Estate Professional”; (2) Glen Forest subdivided the GF property, built a road and spent significant time and money on zoning activities; (3) between 2002 and 2006, the Borees sold approximately 60 lots comprising approximate 600 acres of the GF Property; and (4) the Borees’ intent did not change when they became the sole owners of Glen Forest.
The Service also asserted an accuracy-related penalty under Section 6662. Because the Borees did not establish reasonable cause for the underpayment or that the return was prepared in good faith, the Court sustained the Service’s determination relating to the Section 6662 penalty.
G. Brinkley v. Comm’r, T.C. Memo 2014-227. Taxpayer was a founder of Zave Networks, Inc. (“Zave”) and, as such, initially owned 9.8% of Zave’s stock. Taxpayer made elections under Section 83(b) with respect to all stock grants issued to him by Zave that were not immediately vested. However, each time investors infused capital into Zave, Taxpayer’s interest was diluted, and he threatened to leave the company if his interest fell below 3%. Nevertheless, in 2011, Taxpayer’s equity interest in Zave fell to less than 1%. In 2011, Google began merger negotiations with Zave. Zave’s chairman of the board of directors and another director informed Taxpayer that Zave was being sold for $93 million and that his stock was worth approximately $800,000. Taxpayer disagreed with the latter amount because he expected to receive 3% of the cash consideration paid by Google.
Zave sent Taxpayer multiple letter agreements to try to address his concerns. The first letter agreement stated that Taxpayer would receive 3.1/93rds of the aggregate cash consideration paid by Google less certain consideration Taxpayer already received for his shares of Zave stock. His attorneys and accountant reviewed this letter and advised Taxpayer that the use of the term “compensation” in the letter agreement indicated that the funds he would receive from the merger would be ordinary income. Taxpayer did not sign this letter agreement.
Zave sent Taxpayer a final letter agreement dated August 27, 2011. Under the heading “consideration”, Zave would pay Taxpayer $3,100,000 of the $93,000,000 purchase price offered by Google in exchange for all of Taxpayer’s shares and Taxpayer’s execution of a key employee offer letter and a proprietary information assignment agreement with Google, as required in the merger agreement. Taxpayer accepted this letter agreement without showing it to his tax advisors.
3-38 Changes in Real Estate, Pass-Through Entities, and Estate Planning
In addition, without consulting with any tax advisor, Taxpayer signed a consent of the shareholders assenting to Zave’s entering into the merger agreement. Taxpayer did not sign a consent as to the deferred compensation for service providers of Zave who held stock options.
After the merger, Taxpayer received a paycheck of approximately $1.9 million showing “stock compensation pay”. Zave treated this amount as ordinary income. Taxpayer’s tax advisor drafted Zave a demand letter, outlining his opinion that the transaction was capital in nature, and that Zave miscast it as ordinary. The demand letter referenced a letter agreement dated August 1, 2011, because the tax advisor was unaware of the final letter agreement. Taxpayer never received a response from Zave regarding the demand letter and did not pursue any alternative means to cause Zave to change its characterization of the income.
Taxpayer’s accountant prepared his 2011 tax return and reported estimated tax payments of $465,782 as a way to reclassify the amount that he had determined as having been wrongfully held from the $1.9 million shown on his 2011 Form W-2 as stock compensation. As part of his 2011 tax return, Taxpayer included a Form 4852 (a substitute for a Form W-2 statement) and reported wages of $176,728 (as opposed to $2,056,501.85 shown on his Form W- 2) and Federal income tax withheld of $42,524 (as opposed to $512,305.68). He also included an attachment to Form 4582 with an explanation that the $1.9 million of “stock compensation” wages was actually part of the stock purchase and not compensation.
At trial, Taxpayer maintained his position that the income he received as a result of the merger represented funds derived wholly from the sale of his stock and qualified for long- term capital gain tax treatment. The Service argued that all of Taxpayer’s merger-based income received in 2011 that was in excess of the determined value of his Zave stock was taxable as ordinary income.
In determining the tax treatment of the merger-based income, the Court found that Taxpayer “chose to ignore a lot of relevant information”. He did not disclose the merger agreement and stockholder consent to his tax advisors; he disregarded the approximately $800,000 determined value of his stock; and he ignored Zave’s consistent position that he treat the balance of the payments as compensation for services. In addition, the Court stated that the Taxpayer provided “no persuasive reason” why Zave, with its postmerger funds, would be willing to pay more for his stock than its determined value.
The Court concluded that Taxpayer used his 2011 income tax return as a means to attempt to “regain” the desired preferential tax treatment that he had earlier abandoned by not challenging Zave and that the preponderance of the evidence demonstrated that Taxpayer received the value of his stock and compensation for services previously rendered or to be rendered in the future. As a result, the Court sustained the Service’s determination.
The Court also upheld the imposition of 20% accuracy-related penalties. Although Taxpayer argued that he relied on his professional tax advisors to ensure that the capital gain treatment he desired would be achieved, the Court found that he chose to keep from his advisors essential facts and documents. In addition, the Court focused on the fact that he misrepresented information on his Federal tax forms when he reported withheld taxes as
3-39 Tax Conference, 28th Annual, May 21, 2015 estimated taxes. As a result, the Court held that Taxpayer failed to act with reasonable cause and good faith under Section 6664.
H. Bross Trucking, Inc. v. Comm’r, T.C. Memo 2014-107 . Taxpayer owned Bross Trucking Inc. (“Bross Trucking”), a trucking company that hauled construction-related materials and equipment. Bross Trucking leased its trucks and hired independent contractors as truck drivers. Its principal customers were businesses owned by Taxpayer’s family. In the late 1990s, Bross Trucking was under heightened regulatory scrutiny after several Department of Transportation complaints and negative investigation results. Eventually, Taxpayer ceased Bross Trucking operations in order to preempt its shutdown. In 2003, Taxpayer’s three sons started a new trucking business—LWK Trucking—to service Bross Trucking’s previous customers. LWK Trucking hired several previous Bross Trucking drivers as independent contractors and leased the trucks that Bross Trucking had previously leased, covering up the Bross Trucking logo until the leasing company had time to paint over it. LWK Trucking also expanded into additional service lines, including purchasing interest in a company that provides GPS products to construction contractors and hiring full-time mechanics to service LWK Trucking trucks as well as other fleets of trucks. In January 2011, the Service issued Taxpayer a notice of deficiency for 2004. The Service alleged that in 2004 Bross Trucking distributed appreciated intangible assets to Taxpayer, and then Taxpayer made gifts of such assets to his sons. The Service did not specify what property was distributed by Bross Trucking. However, the Service’s opinion brief suggested that Bross Trucking distributed a single asset—goodwill—which included established revenue stream, developed customer base, transparency of the continuing operation between the entities, established workforce and supplier relationships. With respect to allegations regarding the transfer of Bross Truck’s goodwill, the Court disagreed with the Service, and held that Bross Trucking’s goodwill was primarily owned and established by Taxpayer personally, and so Bross Trucking did not have its own corporate goodwill to transfer. The Court stated that the goodwill used by Bross Trucking was actually part of Taxpayer’s personal goodwill. Bross Trucking was not providing unique services, and instead its regular customers and resulting revenue stream existed because of Taxpayer’s relationship with the customers, most of whom were Taxpayer’s family members. Moreover, Taxpayer never transferred his personal goodwill to Bross Trucking because he never signed an employment contract or a noncompete agreement. Even if Bross Trucking had elements of its own goodwill at one time, the Court stated that it lost most of the goodwill by 2004 after its regulatory infractions and impending suspension. The Court pointed to the fact that LWK Trucking was so concerned about being associated with Bross Trucking that it covered the Bross Trucking logo on the trucks it leased until the leasing company had time to repaint them. Further, the Court noted that it was “unconvinced” that most of the workforce in place at Bross Trucking was transferred to LWK Trucking. The evidence showed that only about 50% of LWK Trucker’s employees formerly worked at Bross Trucking. Moreover, the Court stated that LWK Trucking engaged in services different from those performed at Bross Trucking, including GPS services and truck maintenance.
3-40 Changes in Real Estate, Pass-Through Entities, and Estate Planning
In addition, the Court focused on the facts that Bross Trucking did not distribute any cash assets and retained all the necessary licenses and insurance to continue its business. Further, Mr. Bross remained associated with Bross Trucking and was not involved in operating or owning LWK Trucking. Therefore, the Court held that Bross Trucking did not own and could not transfer Mr. Bross’s goodwill and did not transfer a workforce in place in 2004. Further, the Court stated that “there is no evidence that Bross Trucking transferred any other intangible assets to Mr. Bross”. Neither Mr. nor Mrs. Bross gave any Bross Trucking intangibles to anyone in 2004. I. Cantor v. Comm’r, T.C. Summary Opinion 2014-103. The issue presented in this case was whether the Taxpayer qualified as a real estate professional under Section 469(c)(7). During 2007 and 2008, Taxpayer was the sole proprietor of ABS Glass. ABS Glass provided a glazing service, which involved repairing and/or installing automobile windshields and windows (the automobile division) and repairing and/or installing glass and glass products in building (the residential division). Taxpayer was more involved with the residential division than the automobile division but he did not maintain any form of contemporaneous log in which he recorded the time spent in connection with either of the divisions. Taxpayer worked approximately 40 to 50 hours per week at ABS Glass. In addition to working at ABS Glass, in 2007 and 2008, Taxpayer owned four rental properties. On his Federal income tax returns, Taxpayer reported rental real estate losses attributed to the rental properties. The Service issued Taxpayer a notice of deficiency with respect to his 2007 and 2008 Federal income tax returns and determined that Taxpayer’s rental real estate activities were passive activities. Determining that Taxpayer was not a real estate professional under Section 469(c)(7), the Service disallowed the losses attributed to the rental real estate properties under the passive activity loss limitation rules. The Court agreed with the Service that Taxpayer did not qualify as a real estate professional under Section 469(c)(7). To qualify as a real estate professional, among other items, a taxpayer must perform more than 750 hours of services during the taxable years in real property trades or businesses in which the taxpayer materially participates. Section 469(c)(7) provides that a real property trade or business “means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” Taxpayer argued that the services he provided in connection with the residential division of ABS Glass were “construction” or “reconstruction” activities that qualified the residential division of ABS Glass as a real property trade or business. Although the Court “assumed without finding” that installing original or replacement windows in buildings constituted “construction” or “reconstruction” activities, it stated that the other activities of the residential division of ABS Glass (cutting and installing mirrors and tabletops, cutting and installing shower and bath glass enclosures, and replacing window panes) did not qualify. Because Taxpayer failed to provide evidence (i.e., contemporaneous logs showing how much time was spent on each activity) to prove that he spent more time in the real property trades or businesses than he did in other trades or businesses, the Court held that he failed to qualify as a real estate professional.
3-41 Tax Conference, 28th Annual, May 21, 2015
J. Cavallaro v. Comm’r, T.C. Memo 2014-189. William and Patricia Cavallaro incorporated Knight Tool Co., Inc. (“Knight”) in 1979, with Mr. Cavallaro owning 49% of Knight’s stock and Mrs. Cavallaro owning 51%.
Mr. Cavallaro’s principal work was making and selling the products of Knight, while Mrs. Cavallaro handled the paperwork. The Cavallaros’ three sons also worked as employees of Knight on a part-time basis while they were in school.
Knight’s primary operation began as a machine shop dedicated to manufacturing tools and parts that were used by other companies in the assembly of their own products. However, Mr. Cavallaro envisioned Knight developing its own product that could be sold regularly.
After visiting a customer, Mr. Cavallaro and his son, Ken Cavallaro, saw an opportunity for the production of computer circuit boards. As a result, in 1982, Knight began work on developing the first liquid-dispensing machine prototypes for use in through-hole mounting schemes. Knight began selling the machine under the name “CAM/ALOT”.
Knight was having trouble making a profit from the sales of CAM/ALOT, and, as a result, Mr. Cavallaro decided to “call it quits on CAM/ALOT”. However, Ken Cavallaro was not willing “to give up” on CAM/ALOT, and he approached his parents and asked if he and his brothers could work on developing a market for CAM/ALOT. Mr. and Mrs. Cavallaro assented.
The Cavallaros’ three sons formed Camelot Systems, Inc. (“Camelot”), with the help of their family attorney. Camelot had 150 shares, and each son owned 50 shares. The three sons jointly contributed $1,000 to start Camelot.
CAM/ALOT had no employees from 1987 to 1995. After incorporation of Camelot, Ken Cavallaro, who was paid as an employee of Knight, began exploring ways to improve the CAM/ALOT dispensing product. To implement his ideas, Ken Cavallaro used other Knight personnel. Camelot did not have its own bank accounts. Instead, intercompany accounts were created on Knight’s books so that Camelot could be billed for certain expenses. In general, Camelot’s bills were paid using Knight’s funds.
In 1992, Knight and Camelot engaged Ernst & Young for advice on various tax issues, including the availability of research and development (“R&D”) tax credits. Ernst and Young studied the financial statement of Knight and Camelot and determined that certain work performed by Knight’s engineers could be characterized as R&D costs eligible for the credit. As a result, Ernst and Young prepared amended tax returns for 1990-1994, claiming the R&D tax credits for Knight.
In 1994, unbeknownst to Ernst & Young, the Cavallaros had retained an estate planning attorney who advised them that they should claim that the value of CAM/ALOT technology inhered in Camelot and thus was owned by their three sons. This conclusion was not based on documentation of transfers but on the fact that Mr. Cavallaro had handed the Camelot minute book to Ken Cavallaro at the meeting where Camelot was incorporated. The attorney advised the Cavallaros that they should prepare affidavits and a confirmatory bill of sale attesting to the 1987 transfer, which they did.
3-42 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Although Ernst & Young initially objected to the attorney’s proposal that CAM/ALOT technology had been transferred in 1987, it eventually acquiesced and amended the returns (again) to shift the R&D tax credits from Knight to Camelot.
In order to circumvent the need for both companies to become CE certified (to be able to keep pace with the European Union manufacturing regulations), Knight and Camelot decided to merge in 1995. The Cavallaros engaged Ernst & Young to determine the prospective value of the companies. Using a market-based approached, Ernst & Young valued Camelot between $55 million and $57 million and Knight between $13 million and $15 million. These valuations were based on the assumption that Camelot owned CAM/ALOT technology.
On December 31, 1995, the companies merged in a tax-free merger, with Camelot as the surviving corporation. Mr. and Mrs. Cavallaro received 19% of Camelot’s shares and the remaining 81% was shared equally among the three sons.
On July 1, 1996, Camelot was purchased by a third party for $57 million in cash with a contingent additional amount. On the basis of stock ownership, Mr. and Mrs. Cavallaro received approximately $10 million in cash (19% of $57 million).
In 1998, the Service began to audit the merger and opened a gift tax examination. In 2005, Mr. and Mrs. Cavallaro each filed a gift tax return for 1995, reporting no taxable gifts and no gift tax liability. On November 18, 2010, the Service sent Mr. and Mrs. Cavallaro statutory notices of deficiency for 1995, determining (without having obtained an appraisal) that the pre-merger Camelot value was zero and that the Cavallaros had made taxable gifts of approximately $46 million to their sons when Knight merged with Camelot, resulting in a gift tax liability of approximately $26 million. The Service also asserted failure to file penalties and fraud penalties.
At trial, the Service stated that the taxable gifts amounted to approximately $29 million and asserted accuracy-related penalties as an alternative to the fraud penalties.
In determining the value of Knight and Camelot at the time of the merger, the Court focused on whether the merger transaction was made on an arm’s-length basis and found that it “was notably lacking in arm’s-length character” and was not in the ordinary course of business. The Court focused on the facts that there were no documents memorializing any transfer of CAM/ALOT technology from Knight to Camelot and that Camelot did not own the CAM/ALOT trademark registration.
The Court disregarded the Cavallaros’ experts’ valuations because they were based on the assumption that Camelot actually owned the CAM/ALOT technology. Because they had the burden of proof and neither of their experts’ valuations “comport[ed] with the [Court’s] fundamental finding that Knight owned the valuable CAM/ALOT technology before its merger with Camelot”, the Court determined that the Service’s valuation was not rebutted and held that the Cavallaros made gifts totaling approximately $30 million.
However, the Court held that the Cavallaros had satisfied the reasonable cause defense to the penalties asserted by the Service because the Cavallaros discussed all the relevant
3-43 Tax Conference, 28th Annual, May 21, 2015
facts regarding Knight and Camelot with their accountants and estate planning attorneys and followed their advice in good faith.
K. Chandler v. Comm’r, 142 T.C. No. 16 (2014). In 2003, Taxpayers purchased a home in Boston (the “Claremont Home”). In 2005, they purchased another home in Boston (“West Newton Home”). Both homes were located in Boston’s South End. The South End Landmark District Commission (“SELDC”) had jurisdiction over the homes. Taxpayers granted a façade easement on each of the properties to the National Architecture Trust (“NAT”). Taxpayers followed NAT’s recommendation and engaged George Rietholf and George Papulis, who valued the easement on the Claremont Home at $191,400 and that on the West Newton Home at $371,250. On their joint tax returns for 2004, 2005 and 2006, Taxpayers deducted $73,059, $89,939 and $296,251, respectively, for the donation of the façade easements. The Service determined that the easements had no value because they did not meaningfully restrict Taxpayers’ properties more than local law. Taxpayers abandoned their original appraisals, but presented new expert testimony by Michael Ehrmann, an appraiser, supporting the values they claimed on their returns. Mr. Ehrmann estimated that Taxpayers’ easements diminished their property value by 16% and, therefore, valued the easement on the Claremont Home at $220,000 and that on the West Newton Home at $470,000.
The Court agreed with the Service and determined that the façade easements did not decrease the value of Taxpayers’ property and, therefore, they were not entitled to a charitable deduction. The Court dismissed the appraisals of Mr. Ehrmann because of the seven comparable properties he used; three were located in New York City. In addition, the Court was concerned that Mr. Ehrmann failed to include a sufficient number of encumbered property sales in Taxpayers’ neighborhood. While the Court recognized some technical differences between the façade easement and the restriction enforced by the SELDC, the Court determined that the restrictions were practically the same. The façade easement was just slightly broader in the scope of its restriction on construction, had more regular monitoring of compliance and gave NAT a greater power to enforce the terms of the easement. These differences were not enough to convince the Court that the easement decreased the property value.
L. Chemtech Royalty Associates, LP v. United States, 114 AFTR 2d 2014-5940 (5th Cir. 2014). In the early 1990s, Goldman Sachs developed a financial product called “Special Limited Investment Partnerships” (“SLIPS”), which it promoted as a tax shelter. Following the steps outlined by Goldman Sachs, Dow Chemical Company (“Dow”) and certain subsidiaries formed Chemtech Royalty Associates, L.P. (“Chemtech”), a Delaware limited partnership with its principal place of business in Switzerland. Dow contributed 73 patents with a high value and a low basis to Chemtech. Five foreign banks decided to participate as limited partners in Chemtech, investing a total of $200 million in the partnership. There were several agreements to govern the transaction, including a partnership agreement, a patent license agreement and indemnity agreements. Dow continued to use the patents and the partnership received royalties for Dow’s right to use the patents.
The partnership operated from April 1993 through June 1998. Dow made royalty payments to the partnership of approximately $646 million. However, because the partnership claimed $476.1 million of book depreciation on the patents contributed to it, the partnership
3-44 Changes in Real Estate, Pass-Through Entities, and Estate Planning
reported book profits of only $61.7 million. From its profit, it paid a priority return to the foreign banks, a 1% return to Dow’s wholly owned foreign subsidiary, and a relatively small distribution to each partner to pay its Swiss tax obligation. Chemtech then contributed the remaining cash to a pre-existing shell corporation owned by Dow, which loaned the bulk of the cash to Dow. Chemtech allocated the overwhelmingly majority of its income to the foreign banks and only a fraction of the income to Dow.
Subsequently, Dow began a similar transaction with one of its Louisiana chemical plants.
The Service issued Chemtech a Final Partnership Administrative Adjustments (“FPAAs”) for tax years 1993 through 2006 and asserted accuracy-related penalties under Section 6662 for 1997 through 2006. After a five-day trial, the district court disregarded the partnership for tax purposes on three grounds: (1) the partnerships were shams; (2) the transaction lacked economic substance; and (3) the foreign banks’ interests in Chemtech were debt, not equity.
The Fifth Circuit began its analysis by focusing on whether the partnerships were shams. Relying on the holdings in Comm’r v. Tower, 327 U.S. 280 (1946), Comm’r v. Culbertson, 337 U.S. 733 (1940), and Southgate Master Fund L.L.C. ex rel. Montgomery Capital Advisors, L.L.C. v. U.S., 659 F.3d 466 (5th Cir. 2011), the Court stated that, for the parties to form a valid partnership, it had to have two separate intents: (1) the intent to act in good faith for some genuine business purpose and (2) the intent to be partners and to share in the “profits and losses”.
Dow argued that the Court first had to address whether an interest qualified as debt or equity before it could address whether there is a sham partnership under current case law. However, the Court limited its inquiry as to whether Dow possessed the intent to be partners with the foreign banks, focusing on whether Dow had the intent to share the profits and losses with the foreign banks.
Based on the facts—including that the transactions were structured to ensure that Dow paid the foreign banks a fixed annual return on their investment, that Dow agreed to bear all of the non-insignificant risks arising out of the Chemtech transactions, that there were “ironclad” assurances that Dow would not misappropriate or otherwise lose the banks’ initial investment, and that the foreign banks did not meaningfully share in any potential upside—the Court held that the district court did not clearly err in determining that Dow lacked the intent to share in the profits and losses of the Chemtech transactions with the foreign banks.
The Court remanded the case back to the district court to consider whether the valuation misstatement penalty could be imposed. The district court believed that it could not impose a valuation misstatement penalty when an entire transaction had been disregarded. However, the Court found that this belief was in error under the Supreme Court’s decision in U.S. v. Woods, 134 S. Ct. 557 (2013).
M. Copeland v. Comm’r, T.C. Memo 2014-226. Taxpayers purchased a residential property in California for $334,000. They financed the purchase with a $300,000 mortgage loan
3-45 Tax Conference, 28th Annual, May 21, 2015 secured by the property. In 2007, Taxpayers refinanced the California property with a $600,000 loan from Gateway Funding Diversified Mortgage Services, which was subsequently acquired by Bank of America.
In 2010, Taxpayers applied for and received a loan modification with Bank of America. The modification included a reduction of the interest rate, a change in the payment terms, and an increase in the loan balance.
Bank of America issued Taxpayers a Form 1098, “Mortgage Interest Statement”, reporting that it had received $9,253 of interest from Taxpayers during 2010. On their tax returns, Taxpayers claimed a home mortgage interest deduction of $48,078. The Service issued Taxpayers a notice of deficiency, disallowing the amount of the interest deduction which exceeded the interest that Bank of America had reported on the Form 1098. After conceding that approximately $8,000 of their deduction was properly disallowed, the Taxpayers contended that the “excess” amount represented the past-due interest that the Taxpayers capitalized into the principal of their modified mortgage loan.
Section 163(h)(2)(D) allows a deduction for “qualified residence interest”. The parties agreed that Taxpayers paid some “qualified residence interest”, but disagreed as to the deductible amount.
Because Taxpayers were cash basis taxpayers, the Court stated they are considered to pay interest only when they pay cash or their equivalent to their lender. Inasmuch as under the loan modification program, “no money changed hands”, the Court stated that the Taxpayers could not claim a deduction in 2010 for the amount of interest that was capitalized into the principal of their modified mortgage loan but not actually paid.
The Taxpayers asserted that, instead of treating their transaction as a loan modification, it should be treated as if they obtained a new loan from a different lender and used the proceeds of that loan to pay both the principal of the Bank of America loan and the past-due interest. However, the Court felt that the transaction the Taxpayers hypothesized was not economically equivalent to the transaction in which they engaged. The Court focused on the fact that the Taxpayers supplied no reason to believe that they could have obtained an approximately $600,000 loan from a different lender.
N. Cosentino v. Comm’r, T.C. Memo 2014-186. Taxpayers had adopted a plan to maximize and accumulate wealth during their lives in order to provide for their permanently disabled adult daughter. As part of their plan, Taxpayers engaged in the disposition of certain rental properties in Section 1031 like-kind exchanges without boot and intended to do so indefinitely.
In 2002, Taxpayers were advised by Fischer, Haley & Associates, P.C. (“Fischer”) that they could engage in certain transactions that would increase the basis in the rental property so that they could receive cash without paying income tax. During 2005, Taxpayers learned that the tax-avoidance plan set forth by Fischer constituted an abusive tax shelter. As a result, Taxpayers had to file amended returns and were required to recognize significant gain from the dispositions of the rental properties, resulting in $456,930 of Federal
3-46 Changes in Real Estate, Pass-Through Entities, and Estate Planning
and state taxes, approximately $98,000 in penalties and $30,000 in interest. Taxpayers paid the amounts due and sued Fischer for $640,750. They eventually settled and received $375,000 in satisfaction of the various claims against Fischer.
Taxpayers did not include in income the $375,000 payment. As stated by the Court, the general rule is that the taxability of the proceeds of a lawsuit or settlement depends upon the nature of the claim and the actual basis of recovery. If the recovery represents lost profits, it is taxable as ordinary income. If the recovery represents a replacement of capital destroyed or damaged, it generally does not constitute taxable income to the extent that it does not exceed the basis of the destroyed property.
Taxpayers argued that the $375,000 represented a replacement of capital. In support of their argument, they relied on Clark v. Comm’r, 40 B.T.A. 333 (1939), where a tax advisor advised a taxpayer and his spouse to file a joint return, instead of separate returns. This advice cost the taxpayer $19,941, and, as a result, the tax counsel reimbursed the taxpayer for this amount. The Service claimed that the payment was taxable. The Board of Tax Appeals rejected the Service’s position and held that the payment was not includible because it constituted “compensation for a loss which impaired…[the taxpayer’s] capital.”
The Court also reviewed Concord Control, Inc. v. Comm’r, 78 T.C. 742 (1982), where a taxpayer’s counsel failed timely to file a notice of appeals, so it paid deficiencies and interest of $666,230. The taxpayer filed a malpractice claim, which was settled by the insurance company by paying the taxpayer $125,000. The taxpayer excluded this amount from income. The Court held that the malpractice payment was to compensate the taxpayer for a loss similar to that in Clark and, therefore, was not taxable. However, the payment that reimbursed the taxpayer for the interest that it had deducted was taxable.
Finally, the Court reviewed Rev. Rul. 57-47, 1957-2 C.B. 23, where a taxpayer overpaid taxes because of a tax consultant’s error. The taxpayer discovered the error after the period of limitation for recovering any overpayment had expired. The taxpayer’s consultant made a settlement payment to the taxpayer. The Service ruled that no taxable income was derived from the part of the settlement payment, which was attributable to the excess tax the taxpayer paid because of the tax consultant’s error. However, the amount that represented a recovery of the fee that she had paid to her consultant was taxable because she previously deducted the fee.
Based on the cases and the Revenue Ruling, the Court held that the $375,000 payment was not includible in Taxpayers’ income, except for the amounts of such payment that they received for damages for which they had claimed deductions that the Service did not disallow and for damages which they were compensated but which they in fact did not incur (or incurred in amounts less than the alleged damages).
The Court then allocated the $375,000 payment ratably among the various claims. The Court determined whether each type of damage was includible in Taxpayers’ income. For example, the Taxpayers’ damage resulting from costs and losses incurred in connection with the sale and purchase of the Treasury Bonds was includible in income because the Taxpayers claimed a deduction on their tax returns for this amount, and the Service did not disallow such a
3-47 Tax Conference, 28th Annual, May 21, 2015 deduction. The Court also held that the portion of the damage attributed to state income taxes, for which the Taxpayers claimed a deduction and the Service did not disallow were includible in income.
O. Debough v. Comm’r, 142 T.C. No. 17 (2014). In 2006, Taxpayer sold his personal residence for $1.4 million pursuant to an installment sale agreement. The buyer’s indebtedness was secured by the residence. On his Form 1040, “U.S. Individual Tax Return”, for 2006, Taxpayer excluded $500,000 of the gain from the sale of his residence pursuant to Section 121 and reported the remaining gain
In 2009, the buyer failed to comply with the terms of the installment sale agreement, so Taxpayer reacquired the property in full satisfaction of the debt. Taxpayer acknowledged that he had to report the amount of unreported gain from the initial property sale. However, the Service asserted Taxpayer also had to report a gain of $500,000 because Taxpayer had to report the amount of gain he excluded under Section 121 in the original transaction. Taxpayer disagreed, claiming that under Section 1038 he was not required to recognize his previously excluded gain when he repossessed the real property.
The Court agreed with the Service and Taxpayer was required to recognize $500,000 of additional gain upon reacquisition of his personal residence.
As background, Section 1038(a) allows nonrecognition of gains and losses when a taxpayer reacquires a property in full or partial satisfaction of a debt secured by that property. Section 1038(b), however, requires recognition of a gain if the seller receives “money” prior to the reacquisition and, thereafter, occupies an improved position after acquisition. Because Taxpayer received $500,000 in cash before the reacquisition of his former principal residence, Taxpayer received “money” as defined within Section 1038(b) and, therefore, was required to recognize the entire amount in income. The Court further stated that Congress only created one exception to Section 1038(b), which was Section 1038(e) (which allows a taxpayer not to recognize a gain if he resells a reacquired personal residence within one year of reacquisition). The Court was “disinclined to carve out other exceptions to section 1038 where Congress ha[d] not expressly done so”. Therefore, because Section 1038(e) was not applicable in the instant case, the Taxpayer had to include the previously excluded income into income.
P. Estate of Elkins v. Comm’r, 114 AFTR 2d 2014-5985 (5th Cir. 2014). The Elkins purchased 64 works of art between 1970 and 1999, including works by Pablo Picasso, Henry Moore, Jackson Pollock and Paul Cezanne. In 1990, the Elkins each created a grantor retained income trust (“GRIT”) funded by each of their undivided 50% interests in three of the works in their collection—a large Henry Moore sculpture, a Pablo Picasso drawing and a Jackson Pollock painting (the “GRIT Art”). Each GRIT was for a 10-year period, and, at the conclusion of the 10-year period, each grantor’s interests in the GRIT Art were to go to their three children. Mrs. Elkins died before the expiration of the 10-year period of her GRIT and, as a result, her 50% undivided interest in the GRIT Art went to Mr. Elkins. Mr. Elkins survived the 10-year period and his children each received a 16.667% interest in the GRIT Art. Mr. Elkins and his children entered into a lease with respect to two pieces of the GRIT Art, whereby the children leased their 50% interest in the art to Mr. Elkins.
3-48 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Under Mrs. Elkins’ will, her 50% interests in the other 61 works of art passed outright to Mr. Elkins. Mr. Elkins disclaimed a portion of those interests equal in value to the unused unified credit against estate tax available to Mrs. Elkins’ estate so that the disclaimed portion could pass to their children free of estate tax. Pursuant to Mrs. Elkins’ will, those fractional interests passed equally to her children (one-third each). As a result, each child received an 8.98167% interest in each of the disclaimed works of art, and Decedent retained a 73.055% interest (the “Disclaimer Art”).
Shortly after Mr. Elkins executed his partial disclaimer, he and his children entered into a co-tenants’ agreement relating to the Disclaimer Art. The co-tenants’ agreement provided that an item of art could not be sold without the unanimous consent of the co-tenants. After Mr. Elkins’ GRIT terminated, he and his children amended the co-tenants’ agreement by incorporating one of the three works of the GRIT Art.
Mr. Elkins died on February 21, 2006. On Mr. Elkins’ estate tax return, his gross estate included his 73.055% interest in the Disclaimer Art that was subject to the co-tenants’ agreement, valued at $9,497,650, and the three works of GRIT Art (two of which were subject to the art lease), valued at $2,652,000. These amounts were derived by determining Mr. Elkins’ pro rata share of the fair market value of the art as determined by Sotheby’s, Inc. and, then, applying a 44.75% combined fractional interest discount (for lack of control and lack of marketability). The parties stipulated that the fair market value of the Disclaimer Art was $24,580,650 and of the GRIT Art was $10,600,000.
The Service issued the Estate a notice of deficiency, determining that no discount should be taken with respect to Mr. Elkins’ interest in the Disclaimer Art or GRIT Art or, in the alternative, that the restrictions on sale set forth in the co-tenants’ agreement and the art lease constituted an “option, agreement, or other right to acquire or use artwork at a price less than the fair market value”, so that, under Sections 2703(a)(1) and (2), Mr. Elkins’ interest in the Disclaimer Art and GRIT Art should be valued without regard to those restrictions.
With respect to the Section 2703 argument, the Estate argued that, because the co- tenants’ agreement restricted only the sale of the art (not Mr. Elkins’ fractional interest in the art), Section 2703(a)(2) was inapplicable. The Tax Court in Estate of Elkins v. Comm’r, held that, under the co-tenants’ agreement, Mr. Elkins waived his right to institute a partition action and, in doing so, relinquished an “important use of his fractional interests in the cotenant art”, and thus Section 2703(a)(2) was applicable to the restriction. With respect to the art subject to the lease, the Estate agreed that Section 2703 was applicable to restrictions in the lease.
For purposes of determining the value of Mr. Elkins’ interest in the Disclaimer Art and GRIT Art, the Tax Court did not agree with the Service that no discount was warranted because it should not be assumed that the Elkins children would agree to a sale of the art or to a division among the co-owners. However, the Tax Court found that the Estate’s appraisers failed to consider that the Elkins children, who had the financial wherewithal, would seek to purchase the hypothetical buyer’s interest in the art, thereby enabling them to continue to maintain absolute ownership and possession of the art. As a result, the Tax Court held that a 10% discount was appropriate to determine the value of Mr. Elkins’ interests in the Disclaimer Art and GRIT Art.
3-49 Tax Conference, 28th Annual, May 21, 2015
The Fifth Circuit affirmed the Tax Court’s ruling that percentages of fractional ownership discount were applicable. However, the Court found that the Tax Court failed to require the Service to bear the burden of proof, even though it was mandated to do so under Section 7491. The Court further found that it should have been “obvious” to the Tax Court that “in the absence of any evidentiary basis whatsoever, there [was] no viable factual or legal support for the court’s own nominal 10 percent discount”. The Court further stated that it found that the “discounts determined by the Estate's experts [were] not just the only ones proved in court; they [were] eminently correct”. As a result, the Court held that the “correct quantums of the fractional-ownership discounts applicable to the Decedent's pro rata share of the stipulated FMVs of the various works of art [were] those determined by the Estate's experts”. Thus, the Court ruled that the estate was entitled to a refund of taxes overpaid in the amount of $14,359,508.21, plus statutory interest.
Q. Frank Aragona Trust v. Comm’r, 142 T.C. No. 9 (2014). The issue in this case was whether a trust could qualify for the real estate professional exception to passive activities under Section 469(c)(7). The Trust was a complex residuary trust that owned rental real estate properties and was involved in other real estate business activities, such as holding and developing real estate. During 2005 and 2006, the Trust incurred losses from its rental real estate properties. On its tax returns, the Trust treated its rental real estate activities—in which it engaged both directly and through its ownership interests in a number of entities—as non- passive activities.
In its notice of deficiency, the Service determined that the Trust’s rental real estate activities were passive activities. The Service argued that the Trust could not qualify for the exception under Section 469(c)(7) because, for such exception to apply, there must be “personal services performed…by the taxpayer”. Because ‘[p]ersonal services” are defined by the Regulation as “work performed by an individual in connection with a trade or business”, the Service contended that a trust cannot perform personal service and, therefore, cannot qualify for the Section 469(c)(7) exception. The Court rejected the Service’s argument. First, the Court stated that, because a trust is managed by trustees (which are individuals), if such individuals “work on a trade or business as part of their duties, their work can be considered ‘work performed by an individual in connection with a trade or business’”. Second, the Court stated that, if Congress had wanted to exclude trusts from the Section 469(c)(7) exception, it could have explicitly limited the exception to “any natural person”, like Section 469(i). The Service then argued that, even if trusts could qualify for the Section 469(c)(7) exception, the Trust did not qualify because it did not materially participate in real property trades or businesses. The Service claimed that, in determining whether a trust is materially participating in an activity, only the activities of the trustees can be considered. Thus, the Service argued that the Court should ignore the activities of the employees of the Trust’s wholly- owned limited liability company (“Holiday Enterprises”), even if such employees were also Trustees. The Court held that the Trustees’ activities as employees of Holiday Enterprises should be considered in determining whether the Trust materially participated in its real estate operations. Based on the Trustees’ role as trustees and employees of Holiday Enterprises, the
3-50 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Court held that the Trust materially participated in real property trades or business. Moreover, because the Service did not argue whether the Trust met the requirements to satisfy the Section 469(c)(7) exception (i.e., that the Trust performed more than half of its services in a real property trade or business and performed more than 750 hours of service in a real property trade or business), the Court held that the Trust met the Section 469(c)(7) exception. R. Gateway Hotel Partners, LLC v. Comm’r, T.C. Memo 2014-5. GHP, a partnership for Federal income tax purposes, was organized to own, develop, construct and operate the rehabilitation portion of the former Statler and Lennox Hotels in downtown St. Louis, Missouri. GHP’s members were Washington Avenue Historic Developer (“WAHD”) and Housing Horizons, LLC (“HH”), each of which was also treated as a partnership for Federal income tax purposes. WAHD was majority owned and controlled by Historic Restoration, Inc. (“HRI”), a real estate developer. The hotel project was designed to receive tax credits; however, to include the tax credits as a source of funding at the beginning of the hotel project, bridge financing was required.
The Missouri Development Finance Board (“MDFB”) was approached about making an $18,455,000 bridge loan to HRI in connection with the hotel project. In December 2000, HRI entered into the bridge loan agreement with MDFB. Under an amendment to WAHD’s operating agreement, HRI agreed to make a capital contribution of the bridge loan proceeds to WAHD concurrent with the funding of the bridge loan. WAHD was required to contribute those proceeds to GHP. In return for the contribution, HRI was entitled to a 9.5% preferred return.
HRI anticipated that GHP would earn a certain amount of tax credits from the hotel project and distribute such credits as a preferred return of capital to WAHD, which HRI expected would make a further distribution of tax credits to it as a preferred return of capital. In anticipation of receiving the credits, HRI entered into a tax credit purchase agreement with First CDC, which agreed to purchase a certain amount of credits for $.82 per $1 of credit.
GHP qualified for and received the tax credits on two occasions in 2002. The Missouri Department of Economic Development (“MDED”) transferred $6,178,656 of tax credits to GHP on June 19, 2000, after completion of the Lenox hotel project. Per HRI’s instructions, the MDED transferred the tax credits first to HRI (as WAHD’s assignee) and then to Firstar CDC, in accordance with the tax credit purchase agreement.
In December of 2002, GHP completed its Statler Hotel project. This project incurred more tax credit eligible expenses than anticipated, resulting in additional tax credits. GHP initially believed that the amount of the additional credits was approximately $4 million and transferred such credits to Firstar CDC (“Statler 1”). However, in January of 2003, GHP’s accounting firm realized that the amount of unanticipated credits actually was $1.3 million. GHP notified MDED and requested that the Statler 1 transfer to Firstar CDC be voided and that MDEB transfer $1.3 million to Firstar CDC (“Statler 2”).
The bridge loan was repaid in 2002 with proceeds from the sale of certain tax credits to Firstar CDC.
3-51 Tax Conference, 28th Annual, May 21, 2015
The Service issued WAHD (as GHP’s tax matters partner) an FPAA covering 2002 and 2003, which determined that GHP failed to report $18,455,000 of income from its transfer for the Lennox tax credits and the Statler 1 and Statler 2 tax credits. The Service contended that GHP sold the Lennox tax credits and the Statler 1 and Statler 2 tax credits to Firstar CDC.
GHP contended that the MDFB made the bridge loan to HRI, that HRI contributed the bridge loan proceeds to WAHD in exchange for preferred-equity rights, and that WAHD contributed those same proceeds to GHP in exchange for preferred-equity rights. GHP also contended that GHP’s transfers of the tax credits to HRI were distributions in redemption of WAHD’s preferred equity and were not recognized under Section 731(b).
The Service argued that GHP’s transfers of the tax credits were not redemptions for two reasons. First, because the bridge loan was made directly to GHP, the Service concluded that WAHD was precluded from having made a capital contribution to GHP. However, the Court found that because HRI was obligated under its operating agreement to contribute the bridge loan proceeds to WAHD and WAHD was obligated under its operating agreement to contribute the proceeds to GHP, the fact that the lender dispensed the proceeds directly to GHP, instead of doing three separate transfers, was not conclusive that HRI was not the borrower in both form and substance.
The Service also argued that WAHD’s transfer of the bridge loan proceeds to GHP and GHP’s transfer of the relevant tax credits to WAHD should be recast as a disguised sale under Section 707. The Court reviewed Reg. §1.707-3(b), which provides that a disguised sale occurs if based on all the facts and circumstances two conditions are met: (1) the partnership would not have transferred the money or property to the partner but for the transfer of money or property to the partnership and (2) in cases of transfer that are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risk of the partnership operations.
The disguised sale regulations include a rebuttable presumption that a disguised sale of property has occurred if within a two-year period a partner transfers property to a partnership and the partnership transfers money or other consideration to the partner. Because the transfer of the Lenox tax credits was less than two years after the transfer of the bridge loan proceeds to GHP occurred, the presumption was that it was a disguised sale. However, because the transfer of the tax credits in Statler 1 was more than two years after the transfer of the bridge loan proceeds to GHP occurred, the presumption was that it was not a disguised sale.
With this as background, the Court then reviewed the ten factors discussed in Reg. § 1.707-3(b)(2) and held that eight of the factors weighed against disguised sale treatment for the Lenox tax credits and the Statler 1 tax credits.
With respect to the transfer of the unanticipated credits in Statler 2, the Court ruled in favor of the Service. The Service argued that GHP sold the Statler 2 credits to Firststar CDC and had to include all the proceeds from that sale in income. The partners of GHP argued that the form of the January 8, 2003 transfer controlled the transaction’s character. As a result, GHP transferred all of the Statler 2 credits to Firstar CDC on December 30, 2002. Then on January 8, 2003, GHP asked MDED to amend its transfer records to reflect that a portion of the
3-52 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Statler 2 credits represented a distribution to HRI. The Court found that the Statler 1 transfer controlled its analysis of the transaction. While GHP attempted to rescind the Statler 1 transfer, because the Statler 1 transfer occurred in a different year than the Statler 2 transfer, the Court held that rescission attempt was ineffective. As a result, the Court concluded that GHP had to include all the proceeds from the Statler 2 transfer in income.
S. Estate of Giustina v. Comm’r, 114 AFTR 2d 2014-6848 (9th Cir. 2014). Natale Giustina (“Giustina”) was the trustee of a revocable trust, which owned a limited partner interest in Giustina Land & Timber Co. Limited Partnership (the “LP”). In 1990, the LP was one of three new partnerships formed to which were contributed interests in the assets of two family businesses. The LP was owned by Giustina and his family, as well as his brother and his family and another relative. Giustina died in 2005, at which time he owned a 41.28% limited partner interest in the LP, which owned 47,939 acres of timberland in Oregon.
From the date of formation, the LP was governed by a written partnership agreement, which included a buy-sell agreement that barred a limited partner from transferring an interest in the LP, unless the transfer was to a member of the transferring partner’s “family group”. Giustina’s family group included him, his children and his grandchildren. The buy-sell agreement was in effect at the time of Giustina’s death.
On the Estate tax return, the value of the 41.28% limited partner interest was reported to be $12,678,117. The Service issued a notice of deficiency, claiming that the limited partner interest had a value of $35,710,000. In the Tax Court trial proceedings in Estate of Giustina v. Comm’r, T.C. Memo 2011-141, the Service contended that the value was $33,515,000, and the Estate contended that the value was $12,995,000.
In addition, in the Tax Court proceedings, both the Estate and the Service provided expert witnesses as to the value of the limited partner interest. The Court found two methods helpful – the cash flow method (which was based upon how much cash the partnership would be expected to earn if it had continued its ongoing forestry operations) and the asset method (which was based upon the value of the partnership’s assets if they were sold).
With respect to the cash flow method, the Service’s expert valued the total future cash flow, discounted to present value, at $65,760,000 and the Estate’s expert valued it at $33,800,000. In Estate of Giustina v. Comm’r, T.C. Memo 2011-141, the Tax Court found that the Service’s expert’s valuation had internal inconsistencies and therefore disregarded it. With regard to the Estate’s expert’s valuation, the Tax Court found problems with the application of the cash flow method, but adjusted the computation to arrive at the correct value. Specifically, the Court eliminated a 25% reduction for taxes because the cash flow was based on a pre-tax rate of return (not a post-tax rate of return), and it reduced a 3.5% discount for partnership-specific risks by half. As a result, under the cash flow method, the Court calculated that the value of the LP was $51,702,857. Regarding the discount for lack of marketability, because the Estate’s expert did not rebut the Service’s expert’s testimony that he used studies which overstated the discount for lack of marketability, the Tax Court adopted the Service’s expert’s discount of 25%.
With respect to the asset method, the Service’s expert claimed that the total value of the assets of the LP was $150,680,000. Because this valuation was essentially unchallenged
3-53 Tax Conference, 28th Annual, May 21, 2015 by the Estate, the Court accepted this valuation. The Court did not feel it was appropriate to apply a discount for lack of control or marketability to the asset method, even though the Service’s expert applied such a discount. Instead, it reflected the “lack of control to cause a sale” in the weighing of the two methods. In addition, the Court reasoned that there was a 75% probability that the LP would continue its operations rather than liquidate its assets. For this reason and because the Giustina family had a long history of acquiring and retaining timberlands, it gave a 75% weight to the cash flow method and a 25% weight to the asset method. As a result, the Tax Court held that the value of the limited partner interest was $27,454,115.
The Estate appealed the Tax Court’s decision. The Ninth Circuit reversed the Tax Court’s decision and remanded the case back to the Tax Court to recalculate its valuation. The Ninth Circuit stated that the Court’s underlying conclusion that there was a 25% probability that the LP would liquidate was “clearly erroneous” as it was based on hypothetical events and was contrary to the evidence in the record. In addition, the Ninth Circuit found that Tax Court did not adequately explain its basis for cutting in half the Estate’s expert’s partnership-specific risk premium. However, the Ninth Circuit affirmed the Tax Court’s disregard of tax-effecting and the 25% discount for lack of marketability.
T. Gragg v. United States, et al, 113 AFTR 2d 2014-1647 (DC CA 2014). Charles and Delores Gragg owned two rental real estate properties, which incurred losses in 2006 and 2007. The Graggs sought to deduct those losses from their otherwise taxable income, claiming that Ms. Gragg satisfied the real estate professional exception under Section 469, as she was a qualified real estate agent. Based on an interview and a review of the documents provided, the Service noted that Ms. Gragg would not be able to pass the material participation test of Section 469. The Graggs argued that, because Ms. Gragg was a real estate professional (which the Service did not dispute), she was exempted from having to establish her material participation in each of her separate real estate activities. The Service argued that, notwithstanding Ms. Gragg’s occupation, the Graggs had to separately establish material participation with respect to their two rental real estate properties for 2006 and 2007. Because the Graggs did not make an election to treat all their interests in rental real estate as one activity, the Court stated that Section 469 applied as if each of the Graggs’ interests in rental real estate were a separate activity.
Although the Graggs contended that Ms. Gragg’s real estate rental activities were encompassed within her profession as a rental real estate agent, so that she satisfied the material participation standard set forth in Section 469, the Court disagreed. First, the Court focused on the fact that Reg. §1.469-9 specifically foreclosed the Graggs’ position, as it stated that “only the participation of the taxpayer with respect to the rental real estate may be used to determine if the taxpayer materially participates in the rental real estate activity”. Second, the Court focused on the fact that, in Perez v Comm’r, T.C. Memo 2010-232, the Court specifically rejected the same contention as was made by the Graggs. The Court also held that the Graggs did not establish their material participation in their real estate activities. First, the Graggs specifically stated that they did not contend that Ms. Gragg met the material participation standard set forth in Reg. §1.469-5T. However, they then set out to demonstrate that Ms. Gragg materially participated in the rental real estate activities. The Court concluded that the documents provided by Ms. Gragg that addressed her rental real estate activities amounted to “unreliable post hoc reconstructions of time spent”.
3-54 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Therefore, the Court granted the Service’s motion for summary judgment, denying the Graggs’ deduction based on the losses from their rental real estate properties. U. Herwig v. Comm’r, T.C. Memo 2014-95. Taxpayers purchased two condominium units in Clearwater, Florida (the “Properties”) in 2005. In that same year, they transferred the ownership interests in the Properties to AJH Resources, LLC (“AJH”) in exchange for a 99% interest. The remaining 1% interest in AJH was held by Zander Solutions, Inc. AJH acted as landlord on the property and leased the Properties from 2005 to 2008.
In 2008, the mortgage company filed a lawsuit against Taxpayers to foreclose on the mortgages on the Properties and to recover deficiencies from them. The Circuit Court entered final judgments of foreclosure in favor of the mortgage company. The Properties were sold at foreclosure sales on December 19, 2008. However, the foreclosure litigation was not fully settled until 2011. In the interim, the mortgage company issued to Taxpayers Form 1099-A, “Acquisition or Abandonment of Secured Property”, for 2008 reporting that the balance due on one of the Properties was $574,100 and it had a fair market value of $100,000 and that the balance due on the other of the Properties was $471,000 and the fair market value was $102,000. On their tax return for 2008, Taxpayers reported a loss of $893,394 in connection with the foreclosures of the Properties. The loss was reported on Form 4797, “Sale of Business Property”. Taxpayers initially argued that the losses they claimed in connection with AJH’s rental real estate activities were passive losses under Section 469, but decided not to pursue this argument. However, Taxpayers did argue that they disposed of their interests in the passive activities when the mortgage company foreclosed on the Properties in 2008 or, in the alternative, when AJH filed its final return in 2010. As a result, under Section 469(g), Taxpayers argued they were entitled to deduct the full loss because they disposed of their entire interest in the passive activity. The Court did not agree with Taxpayers and listed several factors weighing against a determination that Taxpayers had fully disposed of the real estate by 2008. First, although the mortgage lender had foreclosed on the properties, the Taxpayers offered no explanation as to why AJH continued to list the properties as assets on Schedules L attached to its Forms 1065 for 2008 and 2009. Second, the parties agreed at trial that, in light of the settlement agreement with the mortgage company, the Taxpayers recognized income from the cancellation of indebtedness in 2011 (as opposed to 2008). Third, the fact that AJH filed a final return for 2010 was not proof “of the statements contained therein”. The Taxpayers offered no testimony and did not call any witnesses to address the accuracy of AJH’s Form 1065 for 2010. The Service also imposed a 20% accuracy-related penalty under Section 6662. Although there is a reasonable cause exception to the penalty, Taxpayers did not testify at trial and did not offer any other evidence in support of the proposition that they had reasonable cause for, and they acted in good faith with respect to, the underpayments for the year at issue. Therefore, the Court sustained the Service’s imposition of the accuracy-related penalty. V. Howard Hughes Company, LLC v. Comm’r, 142 T.C. No. 20 (2014). The issue in this case was whether a real estate developer’s contracts were eligible for the completed
3-55 Tax Conference, 28th Annual, May 21, 2015
contract method of accounting under Section 460(e). Taxpayers were in the residential land development business and generated revenue primarily by selling property to builders, who would then construct and sell homes. Sometimes, they would sell the property to individual buyers who would then construct single-family residential homes. The land Taxpayers sold was part of a large master-planned community in the Las Vegas Valley, which was segregated into “villages”.
The Service alleged that, with respect to most of Taxpayers’ contracts, Taxpayers needed to use the percentage of completion method of accounting, instead of the completed contract method of accounting. Taxpayers argued that, because their contracts qualified as home construction contracts within the meaning of Section 460(e), they properly reported income on the completion contract method. Section 460(e) provides that taxpayers must determine taxable income for long- term contracts under the percentage of completion method of accounting, whereby taxpayers recognize gain or loss throughout the duration of the contract. However, Section 460(e) provides an exception for home construction contracts, which allows taxpayers to use the completed contract method of accounting. In order to determine whether the contracts fit within Section 460(e), the Court first reviewed whether the contracts were long-term construction contracts. The parties agreed that the building development agreements with homebuilders that were executed with respect to pad sales and finished lot sales were long-term construction contracts. However, the Service argued that agreements with respect to custom lot sales, where the Taxpayers sold the lots to individuals who were contractually bound to build a residential dwelling unit, were not long-term construction contracts, because many of the contracts were entered into and closed within the same tax year. Because the Court was convinced that the subject matter of the contracts encompassed more than just the sale of the lots, it held that final completion and acceptance occurred when financial completion and acceptance of the subject matter of the contracts (which included improvements whose costs were allocable to the custom lot contracts) occurred. As a result, the Court held that the custom lot sale contracts were considered long-term construction contracts. The Service also argued that bulk sale contracts, whereby the Taxpayers sold entire villages to a homebuilder, were not long-term construction contracts because the Taxpayers did not establish that they were obligated to construct anything under such contracts. However, the Court found that the bulk sale contracts were similar to certain building development agreements under which the Taxpayers were obligated to build certain common improvements. Therefore, the Court held that these contracts were long-term construction contracts. The Court then reviewed whether the contracts were home construction contracts. The parties disagreed over whether Taxpayers’ contracts qualified as home construction contracts, because the Taxpayers did not build the houses or any improvements on the lots. Section 460(e) defines a home construction contract as any construction contract if 80 percent or more of the estimated total contract costs are reasonably expected to be attributable to activities with respect to dwelling units and improvements to real property. The Service contended that
3-56 Changes in Real Estate, Pass-Through Entities, and Estate Planning
the home construction contract exception requires the taxpayer to build dwelling units or to build improvements to real property. Because the Taxpayers closed the contracts and received revenue without having to building a single home, the Service stated that the contracts did not fit the definition of “home construction contracts”. The Taxpayers asserted that, because the costs under the contract at issue benefit the property sold to the homebuilders and ultimately to individual buyers, the costs are attributable to construction activities with respect to dwelling units or real property improvements. Although the Court recognized that without Taxpayers’ development work, the pads and lots would be “mere patches of land in a desert”, it concluded that this fact did not mean that the contract costs were necessarily incurred with respect to qualifying dwelling units. After reviewing the legislative history of Section 460(e), the Court held that Taxpayers’ contracts and agreements did not qualify as home construction contracts. Specifically, the Court stated that a “taxpayer’s contract can qualify as a home construction contract only if the taxpayer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units or real property improvements directly related to and located on the site of such dwelling units”. The Court also distinguished its decision in Shea Homes v. Comm’r, 142 T.C. No. 3 (2014), where the Court held that the subject matter of the home construction contracts of the taxpayer developers who developed land and built homes included the home, the lot and the common improvements and amenities. The Court stated that the starting point in Shea Homes was that the taxpayers’ contracts were for the construction of dwelling units, but in this case Taxpayers were not homebuilders. W. Estate of Kessel v. Comm’r, T.C. Memo 2014-97. Decedent had a personal pension plan that he had invested with Bernard Madoff. Decedent’s Madoff investment account ostensibly had assets appraised at more than $4.8 million. Decedent died in 2006. His estate filed a Federal estate tax return in 2007 and reported the Madoff account as a $4.8 million asset of the estate. The estate paid the full amount of tax due on that value. By reason of Decedent’s death, the Madoff account became payable to Decedent’s fiancée and son, who withdrew $2.8 from the Madoff account.
After Mr. Madoff’s arrest in late 2008 for perpetrating a Ponzi scheme, the pension plan tried to recover $3,221,057 in securities positions reflected on the Madoff account statement for the month immediately before Mr. Madoff’s arrest, but the trustee appointed by the Securities Investor Protection Corporation (the “Madoff Trustee”) denied the plan’s claim. After the Madoff Trustee denied the claim, the estate submitted a Form 843, “Claim for Refund and Request for Abatement”, requesting a $1.9 million refund. The estate also submitted a supplemental Form 706, which reported the date of death value of the Madoff account as zero. The Service denied the estate’s request for refund and determined the value of Decedent’s taxable estate was greater than the estate had reported. The estate timely filed a petition alleging, among other items, that the fair market value of the Madoff account was zero rather than $4.8 million when Decedent died. The Service filed a motion for partial summary judgment.
3-57 Tax Conference, 28th Annual, May 21, 2015
First, the Service requested the Court to rule that the investment account existed on the date of Decedent’s death and that the account itself, rather than the securities in the account, should be valued for Federal estate tax purposes. The Court held, to the contrary, that it could not determine whether the account itself could constitute a property interest includable in the gross estate separate from the securities contained in the account. Rather, the Court determined that this question would be better answered after the parties had an opportunity to develop the relevant facts. Second, the Service requested that the Court hold that a hypothetical willing buyer and seller of the investment account at the time of Decedent’s death would not reasonably know or foresee that Mr. Madoff was running a Ponzi scheme. Once again, the Court held to the contrary and stated that years before Mr. Madoff’s arrest, some people suspected that his investment record was too good to be true. The Court determined that this was a disputed material fact that would be better answered at trial and therefore declined to grant either motion for summary judgment. X. Long v. Comm’r, 114 AFTR 2d 2014-6657 (11th Cir. 2014). From 1994 to 2006, Taxpayer, as sole proprietor, owned and operated Las Olas Tower Company, Inc. (“LOTC”), which was created to design and build a luxury high-rise condominium named the Las Olas Tower on property owned by the Las Olas Riverside Hotel (“LORH”). LOTC never filed a corporate income tax return and did not have a valid Federal employer identification number. Instead, Taxpayer reported LOTC’s income on Schedule C, “Profit or Loss From Business (Sole Proprietorship)”, on his individual income tax return.
In 1995, Steelervest, a company owned by a Henry Langesenkamp, III, entered into a contract to loan funds to LOTC for the development of Las Olas Tower. In November 2001, Steelervest purchased Taxpayer’s interest in a joint venture for the development of a different condominium. As part of the deal, Taxpayer agreed to pay Steelervest $600,000 in the event that Taxpayer sold his interest in the Las Olas Tower Project.
In 2002, Taxpayer, on behalf of LOTC, entered into an agreement with LORH (the “Riverside Agreement”), whereby LOTC agreed to buy land owned by LOTC for approximately $8 million. LORH subsequently terminated the contract, and LOTC filed suit in Florida state court against LORH for specific performance of the contract and other damages. LOTC won at trial. LORH appealed the judgment.
On September 13 2006, Taxpayer entered into an agreement with Louis Ferris, Jr. (the “Assignment Agreement”), whereby he sold his position as plaintiff in the Riverside Agreement lawsuit to Mr. Ferris for $5,750,000.
On his 2006 tax return, Taxpayer reported a taxable income of $0 and reported the income from the Assignment Agreement as capital gains. The Service issued Taxpayer a notice of deficiency, claiming, among other items, that the income from the Assignment Agreement was ordinary income. Taxpayer challenged the Service’s determination in Tax Court.
In Long v. Comm’r, T.C. Memo 2013-233, the Service argued that the $5,750,000 received by Taxpayer from the Assignment Agreement was in lieu of future ordinary income payments and, therefore, that the sale proceeds should be counted as ordinary income under the
3-58 Changes in Real Estate, Pass-Through Entities, and Estate Planning
“substitution for ordinary income doctrine”. The Tax Court treated LORH’s land as a putative capital asset. As such, it stated that the determination of whether Taxpayer was entitled to capital gains treatment turned on whether Taxpayer intended to sell the land to customers in the ordinary course of his business. Because it believed that Taxpayer had such an intention, the Tax Court concluded that the $5,750,000 payment constituted ordinary income.
Taxpayer appealed. In this case, Taxpayer argued that the $5,750,000 he received from the Assignment Agreement should be taxed as capital gains income because he only had the option to purchase LORH’s land, and the only asset he ever had in the Las Olas Tower project was the Riverside Agreement.
The Service (again) argued that Taxpayer’s proceeds from the Assignment Agreement were a lump sum substitute for the ordinary income he would have earned from developing the Las Olas Tower Project and, thus, under the “substitute for ordinary income doctrine”, the $5,750,000 payment was taxable as ordinary income.
The Eleventh Circuit reversed the Tax Court and held that the income from the Assignment Agreement was capital gain rather than ordinary income. The Court found that the Tax Court erred in analyzing the capital gains issue as if the land subject to the Riverside Agreement was the “property” that Long disposed of in return for $5,750,000. This Court held that Taxpayer never actually owned the land and, instead, sold a judgment giving the exclusive right to purchase LORH’s land.
The Court further explained that this distinction was “material”. Because the property subject to the capital gains analysis was Taxpayer’s exclusive right to purchase the property pursuant to the Florida court judgment, the Court stated that the question is not whether Taxpayer intended to sell the land to customers in the ordinary course of business (as the Tax Court held), but whether Taxpayer held the exclusive right to purchase the property primarily for sales to customers in the ordinary course of his trade or business. The Court found that there was no evidence that Taxpayer entered into the Riverside Agreement with the intent to assign his contractual rights in the ordinary course of his business.
The Court specifically rejected the Service’s “substitute for ordinary income doctrine” because, in this instance, the Court stated that it “cannot be said that the profit [Taxpayer] received from selling the right to attempt to finish developing a large residential project that was far from complete was a substitute for what he would have received had he completed the project himself.” As a result, the Court held that the $5,750,000 Taxpayer received in the sale of his position in the Riverside Agreement lawsuit was properly characterized as capital gains.
Y. Mountanos v. Comm’r, T.C. Memo 2014-38. Taxpayer, through his living trust, owned 882 acres of land in Lake County, California, which was known as Blue Lakes Ranch. The access roads to the Blue Lakes Ranch traversed neighboring properties, whose owners granted Taxpayer easements to pass over their land for purposes of accessing the ranch. The easement granted by the Bureau of Land Management limited access to the Blue Lakes Ranch for single-family use. The ranch was also under a contract with Lake County (the “Williamson Act Contract”), which limited the ranch’s use and development. Finally, a creek traversed the
3-59 Tax Conference, 28th Annual, May 21, 2015
Blue Lakes Ranch, and a permit was required to divert water for private use. Taxpayer did not have the required permit.
In 2005, Taxpayer conveyed a conservation easement on the ranch to Golden State Land Conservancy, a California non-profit corporation, claiming a $4,691,500 charitable contribution deduction. Taxpayer could use only $1,343,704 of the deduction in 2005 and claimed a carryover deduction regarding the unused portion for 2006, 2007 and 2008. The Service issued Taxpayer a notice of deficiency disallowing the carryover deductions, claiming that the value of the easement was overstated.
In Mountanos v. Comm’r, T.C. Memo 2013-138 (“Mountanos I”), the issue of this case was focused on the value of the conservation easement. Taxpayer presented reports and testimony of three expert witnesses who provided that the “highest and best use” of the Blue Lakes Ranch was for vineyard use. However, because Taxpayer failed to show that the Bureau of Land Management would modify the easement to allow access to the Blue Lakes Ranch for vineyard use, that the Blue Lakes Ranch possessed an adequate water supply, and that there was demand for a vineyard, the Court held that the Taxpayer had failed to establish that the vineyard use was reasonably probable in the near future, so as to affect the value of the Blue Lakes Ranch when the conservation easement was placed on it.
In addition, although one of the experts stated that the Blue Lakes Ranch’s highest and best use was in part residential development, the Court held that the Taxpayer failed to establish that this was a probable use of the ranch, because of restrictions set forth in the Williamson Act Contract. As a result, the Court held that the Taxpayer had failed to demonstrate that the conservation easement had any value.
The Service also imposed a 40% gross valuation misstatement penalty for each year at issue, which the Court upheld because the reasonable cause exception does not apply to the gross valuation misstatement penalty.
The Taxpayer moved to reconsider the Court’s opinion and to vacate its earlier decision in Mountanos I. The Court held that there was no valid basis on which to reconsider or vacate its earlier decision.
Taxpayer argued that, under Keller v. Comm’r, 556 F.3d 1056 (9th Cir. 2009), and Gainer v. Comm’r, 893 F.2d 225 (9th Cir. 1990), the Court had to address the alternative grounds the Service raised in Mountanos I because it would allow him to avoid the accuracy- related penalty. However, the Court found that both Keller and Gainer involved taxpayers’ stipulating that deductions were unlawful on a ground other than valuation, which the Taxpayer did not stipulate. In addition, the Taxpayer contended that the Court had to address the alternative grounds to save the Court from having to revisit the issue should the Ninth Circuit remand Mountanos I. Agreeing with the Service, the Court held that the principles of judicial administration guide the courts not to gratuitously decide complex issues that cannot affect the disposition of a case. Because the Court held dispositively in Mountanos I that Taxpayer failed to prove the conservation easement had value, it declined “the invitation” to issue an advisory opinion and found that there was no basis on which to reconsider or vacate its opinion in Mountanos I.
3-60 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Z. Mylander v. Comm’r, T.C. Memo 2014-191. In the 1980s, Dr. Howard and Jacquelyn Mylander were involved in real estate development projects in Idaho. The Mylanders invited Glen Koch, a friend of Dr. Mylander, to invest $400,000 to help finance the construction of a golf course in the development project. Mr. Koch agreed to invest, provided that the Mylanders personally guaranteed his investment. The Mylanders promised to pay Mr. Koch $400,000 if the development project “went under”, and Mr. Koch invested the $400,000. The project subsequently failed. Mr. Koch did not receive any returns on his $400,000 investment and sought payment from the Mylanders.
Around the same time, the Mylanders met Rodney and Katherine Ledbetter. In an unrelated deal, the Ledbetters entered into a business venture with Hershell Murray. The business venture failed and the Ledbetters owed Mr. Murray $500,000. Mr. Ledbetter convinced the Mylanders to guarantee the $300,000 of the $500,000 debt by promising to pay the off the debt they owed Mr. Koch by delivering to Mr. Koch a title to a convenience store that Mr. Ledbetter owned. Mr. Ledbetter transferred his ownership interest in the convenience store to Mr. Koch, but neither the Mylanders nor Mr. Koch knew that Mr. Ledbetter had “leveraged…[the store] to the hilt”, leaving it with no equity. Mr. Koch sold the convenience store and ended up breaking even on the transaction. However, because no part of the debt owed to Mr. Koch by the Mylanders was satisfied by the transfer and the sale of the convenience store, the Mylanders remained obligated to pay the full $400,000 to Mr. Koch, which they eventually did.
However, the Ledbetters did not make any payments on their promissory note to Mr. Murray. As a result, Mr. Murray obtained a judgment against the Mylanders for $310,000 in 1994. In 2001, Mr. Murray entered into a covenant not to execute with the Mylanders in which Mr. Murray agreed not to execute on the State court judgment, as long as the Mylanders made regular payments to him. The Mylanders began making payments to Mr. Murray and continued through 2009.
In 2010, Dr. Mylander sold his dental practice and offered to pay Mr. Murray a lump sum of $100,000 if he would forgive the remaining $102,000 on the debt. Mr. Murray accepted the offer and forgave the remaining debt by the end of 2010.
The Service contended that the Mylanders had cancellation of debt (“COD”) income based on Mr. Murray’s forgiveness. The Mylanders argued that they were acting as guarantors, and under Hunt v. Comm’r, T.C. Memo 1990-248, and Landreth v. Comm’r, 50 T.C. 803 (1968), a guarantor does not realize COD income upon release of a contingent liability. The Service argued that the case at hand was different from Hunt and Landreth because the Mylanders received consideration in exchange for the guaranty (the convenience store). The Mylanders argued that the transfer of the convenience store did not result in their receiving any taxable COD income because the store had no value, and under Hunt and Landreth, any taxable consideration received by the guarantor in exchange for his guaranty is recognized for the year in which it is received and, consequently, had no effect on the existence or treatment of the COD income. The Court agreed with the Mylanders that they received no valuable consideration in exchange for the guaranty.
3-61 Tax Conference, 28th Annual, May 21, 2015
The Service also argued that the Mylanders had to recognize COD income because they became primary obligors on the debt owed to Mr. Murray, when the Ledbetters defaulted. However, the Court agreed with the Mylanders that, even if the Mylanders became primary obligors because of the State court judgment against them, they did not realize any COD income when the remaining debt was forgiven because they “did not receive the benefit of the non-taxable proceeds from the loan obligation”. As a result, the Court held that the Mylanders did not have an accession to wealth and did not realize any COD income when the remaining debt was forgiven by Mr. Murray in 2010.
AA. Oderio v. Comm’r, T.C. Memo 2014-39. In 2008, Julia Oderio worked full-time at a real estate investment company (“RREEF”) and owned a rental property in San Jose, California. On her 2008 tax return, she claimed a status of married filing separately. She also claimed a deduction for a rental loss of approximately $30,000 based on her rental property. The Service issued Ms. Oderio a notice of deficiency, disallowing the claimed rental loss deduction.
Although Ms. Oderio contended that she did not separately satisfy the requirements of Section 469(c)(7), she stated that she and her husband did satisfy them and that her husband’s efforts were attributable to her for purposes of satisfying the Section 469(c)(7) requirements, regardless of whether she and her husband filed a joint return. The Court disagreed. The Court based its decision on Reg. §1.469-9(c)(4), which provides that “[i]n determining the real property trades or business in which a married taxpayer materially participates (but not for any other purpose under this paragraph (c)), work performed by the taxpayer’s spouse in a trade or business is treated as work performed by the taxpayer under §1.469-5T(f)(3), regardless of whether the spouses file a joint return for the year”. Because Reg. §1.469-9(c)(4) only allows for spousal attribution for purposes of satisfying the material participation standard, the Court held the spousal attribution rules could not be used to satisfy any other requirements—namely, that a taxpayer performs more than half of his or her personal services and more than 750 hours in real estate trades or businesses. Although Section 469(c)(7) has an exception to the general rule that a taxpayer must separately satisfy the Section 469 requirements, the flush language to this exception provides it applies “[i]n the case of a joint return”. Based on the statutory canon of construction “expression unius est exclusion alterius” (i.e., that if a statute provides specific exclusion to a general rule, one may infer that Congress intended to exclude any further exceptions in the absence of contrary legislative intent), the Court held that a married taxpayer filing separately must separately satisfy the requirements of Section 469(c)(7) to avoid per se passive activity loss treatment. BB. Ohana v. Comm’r, T.C. Memo 2014-83. Issachar Ohana grew up in Israel and worked as a senior executive for CEVA, Inc. (a firm that developed and licensed digital-signal processor patents to computer-chip manufacturers). In 2003, Mr. Ohana and his wife moved from Israel to Northern California. In 2005, the Ohanas purchased a house in Saratoga, California, where they lived. In 2006, Mr. Ohana sold one of his properties in Israel in order to purchase a house in Palo Alto, California. The Palo Alto property was rented out for two years, but Mr. Ohana repeatedly expressed his plan to build his family a new home on the Palo Alto
3-62 Changes in Real Estate, Pass-Through Entities, and Estate Planning
property. By 2008, Mr. Ohana had evicted the Palo Alto renter and began to build a home for his family on the property.
In 2007, 2008 and 2009, the Ohanas claimed deductions for nonrental business expenses and real estate activity losses. The Service issued the Ohanas notices of deficiency for those years claiming (1) Taxpayers’ rental activity constituted a passive activity and therefore related expenses could be only deducted to the extent of income from passive activities and (2) nonrental real estate expenses were not incurred in connection with a trade or business and therefore most of these expenses were not deductible.
With respect to the tax treatment of the Ohanas’ rental expenses, Mr. Ohana conceded at trial that he was not a real estate professional for the years at issue and that “rental [was] not [his] main source of business”. Therefore, the Court agreed with the Service and held that his rental expenses were deductible only to the extent of his passive income under Section 469.
With respect to the tax treatment of the Ohanas’ nonrental activities, the Court once again agreed with the Service. The deductibility of the nonrental real estate expenses turned “on whether they were personal or incurred in connection with a trade or business”. Based on Comm’r v. Groetzinger, 480 U.S. 23, 25 (1987), the Court stated that for Mr. Ohana to be engaged in a trade or business, he had to be involved in an activity with continuity and regularity. The Court determined Taxpayer was not continuously or regularly involved in the business of buying and selling real estate because he did not buy or sell any real estate other than the real estate in question during 2007, 2008 or 2009. The Court also determined Taxpayer did not engage in his activity for the primary purpose of generating income. He never attempted to sell either of his houses in order to make a profit, and he always clearly intended for the Palo Alto house in particular to be his family’s home. He obtained personal mortgage loans for it, enrolled his children in the Palo Alto school system before construction was completed and personalized the décor in the home in ways that made it less marketable.
Additionally, the Court noted that many of the contested deductions were personal expenses unrelated to either house and were poorly documented and lacked corroboration, so the Court did not allow such deductions.
CC. Palmer Ranch Holdings Ltd v. Comm’r, T.C. Memo 2014-79. Taxpayer owned two parcels of land: Parcel 9 and Parcel 10. Parcel 10 was the subject property of this valuation dispute. Parcel 10 was an irregularly shaped, undeveloped parcel of land consisting of 82.19 acres. The parcel’s general topography included upland developable acreage as well as wetland, ponds, and a bald eagle nest.
Hugh Culverhouse, who owned about 98% of Taxpayer, wished to preserve a portion of his undeveloped property for public use, conservation and open space, so he encumbered it with a conservation easement and donated it to Sarasota County, Florida. Prior to donation, he hired an attorney to advise him on how to donate the easement in compliance with the Internal Revenue Code. His attorney retained an appraiser who appraised the land at $23,940,000 on December 19, 2006, based upon recently sold comparable properties. Taxpayer donated the property and claimed a $23,940,000 deduction for the donated easement on its Form
3-63 Tax Conference, 28th Annual, May 21, 2015
1065, “U.S. Return of Partnership Income”. The Service claimed Taxpayer overstated the fair market value of the property he donated, disallowed $16,965,000 of the deduction and assessed an accuracy-related penalty. The issue before the Court was whether Taxpayer overestimated the fair market value of its donated property. Because both the Taxpayer’s appraiser and the Service’s appraiser used the comparable sales method to determine the fair market value of the easement and the Service’s appraiser used four of the eight comparables used by the Taxpayer’s appraiser, the dispute hinged upon the highest and best use of the parcel 10. Taxpayer claimed that it was reasonably probable that 360 multifamily dwelling units could have been developed on Parcel 10 around December 2006. The Service disagreed based upon (1) previous failed attempts at rezoning, (2) environmental concerns and likely restrictions, (3) the limited access to outside roads, and (4) neighborhood opposition. On all four points, the Court disagreed with the Service holding that it was reasonably probable that the parcel would have been successfully rezoned to allow for the development of multifamily dwellings. In addressing the Service’s argument, the Court explained (1) previous failed attempts at rezoning did not consider the eagle nest zone, wetlands and wildlife corridor as Taxpayer’s proposed plan does, (2) Taxpayer’s plan leaves open space for the protected eagle nest zone, (3) Taxpayer could have easily given the parcel necessary road access, and (4) neighborhood opposition alone would not preclude development. Accordingly, under the before-and-after method, the Court held that the easement’s fair market value was $19,955,014. DD. Phan v. Comm’r, T.C. Summary Opinion 2015-1. In 2008, Taxpayer moved into a house in California to help his mother, who was unable to care for the property, and who was in the process of divorcing his father. In 2010, Taxpayer was still living on the property and claimed a home mortgage interest deduction with respect to such property on his Form 1040, “U.S. Individual Income Tax Return”. At that time, legal title to the property was held by Taxpayer’s mother, brother and father, but his brother and father were not living at the property. Taxpayer was unable to buy the property in 2010 because of his financial condition. However, he entered into an oral agreement with his mother and siblings providing that he would pay the mortgage loan and the property taxes. In 2013, Taxpayer’s name was added to the legal title to the property. The Service issued Taxpayer a notice of deficiency disallowing his claimed home mortgage interest deduction for 2010.
In determining whether Taxpayer was eligible to claim the home mortgage interest deduction, the Court looked to California law to determine if Taxpayer was considered the equitable owner of the property. California law provides that an individual may overcome the presumption that the legal owner is also the equitable owner by showing that there exists an agreement or understanding between the parties evidencing an intent contrary to that which is reflected in the deed. Based on the facts that the Taxpayer credibly testified that his family had granted him an interest in the property and would allow him to add his name to the title at any time if he paid the property expenses, that his name was in fact added to the title in 2013, and
3-64 Changes in Real Estate, Pass-Through Entities, and Estate Planning
that his name was not added earlier because of his financial status, the Court held that Taxpayer showed, pursuant to his family’s agreement, that he was the beneficial owner of the property. The Court then examined whether Taxpayer was the equitable owner of the property by determining whether he assumed the benefits and burdens of ownership. Based on the facts that Taxpayer resided at the property in 2010, made the mortgage payments before, during and after 2010, and testified credibly that he made the property tax and insurance payments and that his mother could not take care of the property, the Court held that he was the equitable owner of the property and did not sustain the Service’s deficiency determination. EE. Pilgrim’s Pride Corp. v. Comm’r, 115 AFTR 2d 2015-930 (5th Cir. 2015). Pilgrim’s Pride Corporation (“Pilgrim’s Pride”) is the successor-in-interest to Gold Kist, Inc. (“Gold Kist’’). In 1998, Gold Kist purchased certain securities from Southern States Cooperative, Inc. (“Southern States”) for $98.6 million. In early 2004, Gold Kist and Southern States negotiated a price at which Southern States would redeem the securities. Gold Kist suggested a price of $31.5 million, but Southern States offered only $20 million. Gold Kist’s board of directors decided not to accept the $20 million offer, and, instead, abandoned the securities for no consideration. Gold Kist’s board of directors reasoned that the $98.6 million ordinary loss would produce more than $20 million in tax savings. Consequently, Gold Kist sent letters to Southern States and other appropriate parties, stating that it had irrevocably abandoned all of its rights, title and interest in the securities and, on its Form 990-C for the 2004 tax year, reported a $98.6 million ordinary loss deduction.
Five years later, while Pilgrim’s Pride was in bankruptcy, the Service issued it a deficiency notice with respect to Gold Kist’s 2004 tax years. The deficiency notice asserted that Gold Kist’s loss from the abandonment of the securities was a capital loss, rather than an ordinary loss, creating a tax deficiency of approximately $30 million. Pilgrim’s Pride timely filed a petition in Tax Court. In Tax Court, Pilgrim’s Pride argued that the abandonment caused the securities to become worthless, making the loss an ordinary loss under Section 165. However, the Tax Court issued a sua sponte order, requesting a brief on whether Section 1234A(1) applied to Pilgrim Pride’s abandonment of the securities. In general, Section 165 requires the “sale or exchange” of a capital asset to be treated as a capital gain or loss. However, prior to 2008, the abandonment of a security was not subject to Section 165(g) (which requires capital gains/loss treatment for worthless securities). As a result, Pilgrim’s Pride argued it was entitled to ordinary loss treatment. However, the Service argued that Section 1234A applied to the abandonment of the securities and, as a result, was subject to capital loss treatment. Section 1234A requires capital loss treatment for any loss “attributable to the cancellation, lapse, expiration, or other termination of…a right or obligation…with respect to property which is (or on the acquisition would be) a capital asset in the hands of the taxpayer”. Agreeing with the Service, the Tax Court held that Section 1234A applied to the abandonment of the securities, and, therefore, it was subject to capital loss treatment. The Fifth Circuit reversed the Tax Court and concluded that Section 1234A(1) applies only to the termination of contractual or derivative rights and not to the abandonment of capital assets.
3-65 Tax Conference, 28th Annual, May 21, 2015
The Service attempted to argue that Section 1234A applied to the abandonment of a capital asset because the abandonment involved the termination of certain rights and obligations “inherent” in such assets. It argued that the abandonment of the securities terminated the inherent rights with respect to the securities (such as rights in managements and profits) and thus was subject to Section 1234A. After reviewing the legislative history of Section 1234A, which was intended to address tax straddles (i.e., transactions in which taxpayers acquire offsetting contractual positions to obtain tax benefits would any economic risk), and finding that the Service’s interpretation would render other provisions in Section 1234 superfluous, the Fifth Court held that Section 1234A(1) did not apply to Pilgrim’s Pride abandonment loss. The Court also addressed the Service’s other argument—namely, that Section 165(g) required Pilgrim’s Pride abandonment loss to be treated as capital. Section 165(g) (prior to 2008) provided that, if a security becomes worthless during the taxable year, the loss resulting therefrom was to be treated as a capital loss. Although the parties stipulated that the securities were worth at least $20 million when Pilgrim’s Pride abandoned them, the Service argued that the securities were “worthless” because they had no value to Pilgrim’s Pride. The Court found that the Service failed to offer how this argument was in alignment with its precedent under Echols v. Comm’r, 935 F.2d 703 (5th Cir. 1991), that the test for worthlessness was a mixed question of objective and subjective indicia. FF. Pool v. Comm’r, T.C. Memo 2014-3. Taxpayers organized a limited liability company treated as a partnership for Federal income tax purposes (the “Company”). The Company purchased 300 undeveloped acres in Montana for $1.4 million, which was to be developed in four phases. The Company entered into an agreement with Elk Grove Development Co. (which has been formed by the Taxpayers and one other individual) that gave Elk Grove Development Co. the exclusive right to purchase the first three phases of the new development.
The Company reported approximately $500,000 of long-term capital gain on its 2005 Federal income tax return. This gain resulted from the taxable portions of two installments it received on certain land sales.
The issue of this case was whether the gain from the sale of the real property resulted in ordinary income or capital gain. The Service contended that the Company’s land sale produced ordinary income, while Taxpayers argued that the sale produced capital gain because they held the land for investment.
Section 1221 provides that a capital asset does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. The Court stated that the determination of whether Taxpayers held the lots primarily for sale to customers in the ordinary course of their trade or business was a factual inquiry. The Court identified five factors for evaluating a taxpayer’s motive: (1) the nature of the acquisition of the property; (2) the frequency and continuity of sales over an extended period of time; (3) the nature and extent of the taxpayer’s business, (4) the activity of the seller about the property; and (5) the extent and substantiality of the transactions.
Because the Company’s tax return identified its principal business activity as “development”, the Company did not present evidence demonstrating how many sales of the lots
3-66 Changes in Real Estate, Pass-Through Entities, and Estate Planning
in the development were made and to whom they were made, and the Company did not present evidence to support the sales prices they calculated for the first three phases of development, the Court found that the Taxpayers failed to carry the burden of proving that the Service’s determinations were erroneous.
GG. Puentes v. Comm’r, T.C. Memo 2014-224. In 2002, Taxpayer’s brother (the “Brother”) bought a house in San Francisco. Taxpayer started living in the house in 2002. Brother made all required mortgage payments on the property until he became unemployed in 2009. At that point and during 2010, Taxpayer began making mortgage payments. In addition, Taxpayer paid the homeowners’ insurance and the property taxes. In 2010, Taxpayer (rather than Brother) claimed the mortgage interest deduction. The Service issued Taxpayer a notice of deficiency, disallowing the deduction.
Taxpayer conceded that she was not the legal owner of the property, but she contended that she was an equitable owner of the property and thus was entitled to the mortgage interest deduction for 2010. Because the record established that Brother was the sole legal owner of the property, the Court stated that California law presumes him to be the full beneficial and equitable owner as well. Taxpayer offered no evidence that she had any agreement with Brother entitling her to an ownership interest in the property. The Court stated that the fact that Taxpayer paid the mortgage, home insurance and property taxes was not sufficient to make her an equitable owner of the property. Therefore, the Court held that she was not entitled to a mortgage interest deduction for 2010. HH. RERI Holdings I v. Comm’r, T.C. Memo 2014-99. This case involved a partnership-level action brought in response to a notice of final partnership administrative adjustment. Taxpayer, a limited liability company, engaged in a series of transactions that resulted in it claiming a $33,019,000 charitable contribution in 2003 for 100% of the remainder estate in the membership interest in H.W. Hawthorne Holdings, LLC (“Holdings”). The Service asserted that Taxpayer overstated the value of the contribution by $29,119,000, claiming that the transaction giving rise to Taxpayer’s charitable contribution deduction was a “sham for tax purposes or lack[ed] economic substance” and, therefore, should be disregarded for Federal tax purposes.
Taxpayer moved for partial summary judgment, claiming “that the doctrines ‘sham’ and ‘lack of economic substance’ [were] not applicable to the determination of whether a taxpayer’s contribution to charity is allowable under I.R.C. §170”. The Court denied the motion. Taxpayer relied principally on Skripak v. Comm’r, 84 T.C. 285 (1985), where the taxpayers participated in a book contribution program under which high-tax-bracket individuals purchased a part of a book publisher’s excess inventory, and after holding the books for more than six months (i.e., the then-existing long-term capital gains holding period), contributed them to rural public libraries. In that case, the Service argued that the taxpayers had “no chance of realizing an economic profit” under the program. However, the Court in Skripak denied that argument, stating that “doctrines such as business purpose and an objective of economic profit are of little, if any significance in determining whether petitioners have made charitable gifts”. The Service relied principally on the analysis in Ford v. Comm’r, T.C. Memo 1983-556, where the taxpayer was a limited partner in a partnership that decided to transfer an
3-67 Tax Conference, 28th Annual, May 21, 2015
underwater habitat to the University of Hawaii. To that end, the partnership transferred the underwater habitat to a newly formed corporation, and then the partnership donated its shares in the corporation to the University of Hawaii. If the corporation had not been formed, the taxpayer (as a partner in the partnership) would have received a zero charitable contribution deduction under Section 170(e)(1)(A) because the underwater habitat had been fully depreciated. However, because the partnership contributed stock, the taxpayer received a $600,000 charitable deduction. The Court held the newly formed corporation was formed for the sole purpose of tax avoidance and was without substance and, therefore, the partnership was considered to have donated the underwater habitat to the University. The Court ruled that Skripak was distinguishable from Ford. Skripak involved the fair market value of property where taxpayers directly purchased and contributed property, while Ford focused on whether the formation of the corporate shell should be respected. In addition, the Court focused on the decision in Torney v. Comm’r, T.C. Memo 1993-385, where the Court ruled that, where a related party transferred stock to a charitable organization that never benefited from ownership of the stock, donation of the stock lacked economic substance and therefore was not deductible as a charitable contribution. Based upon these cases and the fact that the Service stated it intended to present evidence that Taxpayer’s acquisition and donation of the success member interest lacked economic substance, the Court concluded that it could not assert, as Taxpayer had requested it to, that the doctrines of sham and lack of economic substance were irrelevant to the determination of whether the charitable contribution was deductible under Section 170. II. Estate of Richmond v. Comm’r, T.C. Memo 2014-26. Decedent died in December of 2005. At that time, she owned a 23.44% interest in PHC, a family-owned investment holding company. PHC was a C corporation, the purpose of which was to maximize dividend income. In order to defer tax liability, PHC preferred to hold its securities, rather than to sell them.
The parties agreed that as of December 2005 PHC had a portfolio value of $52,159,430, of which $45,576,677 consisted of unrealized appreciation. The parties further agreed that the capital gain tax liability “built in” to that appreciation (but not yet due) was $18,113,083. On September 20, 2006, the co-executors of Decedent’s estate filed a Form 706. Before doing so, the Estate retained a law firm to prepare the Form 706 and an accounting firm to value the PHC stock. Peter Winnington, an accountant and appraiser, prepared a draft report valuing Decedent’s interest in PHC at $3,149,767, which the Estate used on its Form 706. On June 12, 2009, the Service issued a statutory notice of deficiency to the Estate, determining an upward valuation of Decedent’s interest in PHC to $9,223,658. At trial, the Estate offered an expert in valuation who stated that the correct fair market value of Decedent’s interest in PHC was $5,046,500. The Estate conceded to this higher valuation. In determining the value of the PHC stock, the Court reviewed the different approaches used by the experts. The Service’s expert used the net asset value approach and the Estate’s expert used the capitalization of dividends approach. The Court believed that the net asset value approach better determined the value of PHC. Specifically, it felt that the dividend
3-68 Changes in Real Estate, Pass-Through Entities, and Estate Planning capitalization method was appropriate where a company’s assets were difficult to value, but, here, because there was concrete and reliable data of value available (i.e., the actual market prices of the publicly traded securities that constituted PHC’s portfolio income), the Court felt that “valuing the holding company…by the income approach would essentially overlook [the] fact” that the “assets themselves [were] easily valued”. Having determined that the net asset value approach was the appropriate valuation methodology, the Court then determined the appropriate discount for the built-in capital gains (“BICG”) tax attributable to PHC’s unrealized appreciation. In its notice of deficiency, the Service did not provide a discount for the BICG tax, but the Service’s expert proposed a 15% discount for BICG tax (or $7.8 million). The Estate contended that PHC’s value should be discounted by 100% of the $18,113,083 BICG tax liability. In supporting its contention, the Estate relied on Estate of Jelke v. Comm’r, 507 F.3d 1317 (11th Cir. 2007), Estate of Dunn v. Comm’r, 301 F.3d 339 (5th Cir. 2002) and Estate of Jameson v. Comm’r, 267 F.3d 366 (5th Cir. 2001), where the Courts held that the built-in gain would give rise to a current liability reducing value. However, the Court considered the 100% discount approach “plainly wrong in a case like the present one” because it did not reflect the economic reality that the BICG tax is a potential liability that is susceptible to indefinite postponement. Although the Court did not agree with the Service’s expert’s approach, which was based on the assumption that an investor would be indifferent to the tax implications of built-in gain that constituted up to 50% of the stock’s net asset value, the Court did find the $7.8 million BICG discount reasonable. In determining the range for the BICG discount, the Court used a present value approach based on different discount rates and either a 20 or 30 year holding period (which was based on the Service’s expert testimony that a potential investor would expect that a portfolio like PHC’s would turn over within a period of 20 to 30 years). With respect to the discount for lack of control, both experts used a data set consisting of the net asset values and trading prices of 59 closed-end funds for the week ending December 9, 2005 and then analyzed the percentage difference between the net asset value and trading price. The Service’s expert found the mean of the premiums and discount for all 59 date points was 6.7%, but, without explanation, chose a 0.7% discount. The Estate’s expert used the median of the data set to support an 8% discount. The Court found that among the 59 funds, there were 3 outliers which skewed the mean. Removing these outliers, the Court found that the appropriate discount was 7.75%. With respect to the discount for lack of marketability, the Service’s expert examined seven studies of restricted stock and found that the range of lack-of-marketability discounts ranged from 26.4% to 35.6%. The Service chose the bottom of the range. The Estate’s expert accepted the Service’s expert’s general approach but chose the top of the range. Unconvinced by either expert’s rationale, the Court found the marketability discount to be 32.1%—the average of the data sets. Based on these determinations, the Court found the value of Decedent’s interest in PHC to be $6,503,804.
3-69 Tax Conference, 28th Annual, May 21, 2015
The Court upheld the Service’s imposition of the accuracy-related penalty under Section 6662. Because the Estate (i) used an unsigned draft appraisal report for reporting the value of Decedent’s interest in PHC on the Form 706; (ii) relied on Mr. Winnington’s valuation on the Form 706 although he was not a certified appraiser; (iii) never demonstrated or discussed how Mr. Winnington arrived at the value reported on the Form 706 except to say that two prior estate transactions involving PHC stock used the capitalization of dividend method of valuation; and (iv) did not explain why they abandoned Mr. Winnington’s valuation at trial, the Court held that the Estate did not demonstrate why it should be excused from the penalty. JJ. Estate of Sanders v. Comm’r, T.C. Memo 2014-100. Decedent died on April 5, 2008. She was the widow of the late James Sanders, founder of Jimmy Sanders, Inc. (“JSI”). Decedent owned 41,073 shares of JSI common stock when she died.
Decedent made gifts of stock to her family members every year from 1999 through 2008. Decedent timely filed Forms 709, “United States Gift (and Generation-Skipping Transfer) Tax Return”, each year in which she gifted stock to her family members. In 2012, the Service issued deficiency notices for Federal gift taxes for 9 of the 10 years in which Decedent gifted stock. The gift tax notices were sent to the coexecutors’ last known addresses. The estate did not challenge the gift tax notices. The estate reported the fair market value of the JSI shares to be approximately $3.9 million on its Form 706, “United States Estate (and Generation-Skipping Transfer) Tax Return”. The Service issued a deficiency notice for Federal estate tax to the estate, increasing the value of the taxable gifts the estate reported on its Form 706 by approximately $3.2 million to reflect the determinations in the gift tax notices. The estate filed a petition to challenge the Service’s increase on its Form 706. As part of those proceedings, the estate filed a motion for partial summary judgment asking the Court to determine that the Service was barred from assessing deficiencies on the gifts in question because the statute of limitations had expired. The Court determined that there was a genuine dispute as to whether Decedent adequately disclosed the gifts to the Service so as to trigger the running of the period of limitations on assessment, and therefore the Court denied the estate’s motion for partial summary judgment. Taxpayers making transfers by gift are typically required to file Form 709. The Service must assess gift taxes within three years after a taxpayer discloses a gift on Form 709 or on a statement attached to Form 709. In order properly to disclose a gift on Form 709, a taxpayer must disclose in a manner that is adequate to apprise the Secretary of the nature of the gift. Adequate disclosure requires a taxpayer to provide, among other things, a detailed description of the method used to determine the fair market value of the property transferred, including any financial data. In this case, the estate argued Decedent adequately disclosed the gifts and the statute of limitations expired, so the Service could no longer assess a deficiency. The Service argued that Decedent’s Form 709 disclosure was not adequate because, among other things, JSI owned another closely held entity that was never disclosed. Since the Court was unable to determine whether there was adequate disclosure and whether the statute of limitations had expired without more facts, the Court denied the estate’s motion.
3-70 Changes in Real Estate, Pass-Through Entities, and Estate Planning
KK. Schmidt v. Comm’r, T.C. Memo 2014-159. Taxpayer was a McDonald’s restaurant franchisee who entertained the notion of becoming a builder. On May 5, 2000, Taxpayer purchased a 40 acre parcel of vacant land in Colorado for $525,000 with the intention of subdividing and developing it.
In June 2000, Taxpayer retained a land planning consultant who informed Taxpayer of the possibility of developing his property with the adjacent property. The land planning consultant began the entitlement process and submitted a petition for rezoning the properties. However, in 2002, the adjacent property owner abandoned the development of his property. In 2003, Taxpayer executed a $1.25 million purchase agreement for the adjacent property but terminated it a few months later. Sometime later, Taxpayer decided to build a single family residence on his property. During the development process of the property, Taxpayer considered granting a conservation easement and engaged the services of W&D Park to value the proposed easement. In 2003, Mr. Park notified Taxpayer that his firm had concluded that the value of the proposed conservation easement would be $1.6 million based on a discounted cashflow analysis using the proposed development costs set forth by the land planning consultant. On August 1, 2003, Taxpayer granted a conservation easement on the property to El Paso County. The conservation easement permitted one homesite on the property. Taxpayer and his wife timely filed their Form 1040, “U.S. Individual Income Tax Return”, for 2003 and claimed a charitable contribution deduction of $1.6 million related to the conservation easement. Because of certain limitations, they carried over the remainder of the charitable contribution deduction and claimed portion of it on their 2004, 2005 and 2006 returns. On November 28, 2011, the Service issued Taxpayer and his wife a notice of deficiency with respect to their 2003 through 2006 tax years. The Service determined that Taxpayer failed to meet the requirements of Section 170 in claiming a charitable contribution deduction for the conservation easement or, in the alternative, that the correct value of the conservation easement was $195,000. The Court then discussed each party’s expert report and testimony. Taxpayer introduced the expert report and testimony of Mr. Park whose report was substantially derived from his 2003 appraisal valuing the easement at $1.6 million. The Service introduced the expert report and testimony of Thomas Fellows. Similar to Mr. Park, Mr. Fellows used the before and after method to determine the value of the conservation easement. He determined that the value of the easement was $480,000, based on a determination that the highest and best use of the property before the granting of the easement was a residential subdivision and after the granting of the easement was a 40-acre homesite. After largely rejecting the Service’s arguments to discredit Mr. Park and Mr. Schmidt’s testimony, the Court set out to value the subject property using the before and after method. The Court acknowledged that both parties agreed that the market and subdivision methods were appropriate to determine the before value of the property. The market method was used by Mr. Fellows. As a basis for determining the value of the property before the easement, Mr. Fellows identified four sales of raw law that he determined to be comparable to a
3-71 Tax Conference, 28th Annual, May 21, 2015 hypothetical sale of the subject property before the granting of the conservation easement. Taxpayer argued that the comparables were not sufficiently similar because the comparables did not have any development entitlements. The Court agreed with the Taxpayer and held that the market method was not an appropriate method to use to determine the before value of the properties. The Court then determined the value of the property under the subdivision method. Although both Mr. Park and Mr. Fellows used the subdivision method, the Court found that both experts’ reports were inadequate and, therefore, drew its own conclusions based on its examination of the evidence in the record. The Court recalculated the before value of the subject property, using a discounted cashflow analysis which was based on the factors both experts’ used in their analysis. The Court determined that the before value of the property was $1,422,445. Then, the Court set out to determine the after value of the properties. Both experts agreed that the after value should be based on sales of comparable properties with restrictions similar to those impose by the conservation at issue. Because Mr. Fellows selected sales of properties that were platted for use as a 35-40 acre residential building site, the Court used Mr. Fellow’s conclusion that the after value of the property was $270,000. Thus, the Court held that the value of the easement was $1,152,445 ($1,422,445-$270,000). In its answer (not in the notice of deficiency), the Service asserted penalties. The Service conceded that it had the burden of proof with respect to the penalties, but contended that Taxpayer had the burden of proof with respect to any affirmative defenses to the penalties. Agreeing with the Taxpayer, the Court held, because the penalties were pleaded in the answer, the Service bore the burden of proof with respect to the penalties, both as to the production of evidence and as to persuasion. First, the Court concluded that substantial valuation misstatement penalties were not applicable because the amounts Taxpayers claimed on their return was less than 200% (and 150%) of the amount the Court determined was the correct amount. Then, assuming that Taxpayer could be liable for the substantial understatement penalty, the Court considered whether Taxpayer had reasonable cause for the understatement. Because he relied on Mr. Park’s 2003 appraisal, Mr. Park had the requisite credentials, and the Service conceded that it was a qualified appraisal, the Court held that Taxpayer had reasonable cause for the underpayment and acted in good faith. The Service tried to point to certain facts that it believed showed that Taxpayer did not in “good faith” accept Mr. Park’s appraisal (namely, that Taxpayer did not decide to purchase the adjacent land), but the Court rejected these arguments. LL. Seismic Support Services, LLC v. Comm’r, T.C. Memo 2014-78. Taxpayer was employed as a seismic design consultant. He formulated an arrangement to alter his status as an employee to reduce his tax obligation. After his employer refused to treat him as an independent contractor, he resigned from his job and formed a limited liability company, Seismic Support Services, LLC (“Seismic”), through which he provided consultation services as an independent contractor. Taxpayer owned 95 percent of Seismic and took distributions in 2007, 2008 and 2009. In each of those same years, Seismic filed Form 1065, “U.S. Return of Partnership Income”, and claimed management fee deductions for similar amounts as his distributions.
3-72 Changes in Real Estate, Pass-Through Entities, and Estate Planning
Seismic did not have any employees or file employment tax returns in any of those years. The Service issued notices of final partnership administrative adjustments (“FPAAs”) and claimed that the management fees were actually guaranteed payments for services the Taxpayer performed. Seismic contended that the payments were capital expenditures. Agreeing with the Service, the Court determined that the management fees were guaranteed payments for services performed by Taxpayer. In general, a guaranteed payment is a payment from a partnership to a partner for services or use of capital that does not represent a distribution and is determined without regard to the partnership’s income. The Court determined that the payments Taxpayer received were for services he provided and were determined without regard to Seismic’ s income. Therefore, they were guaranteed payments. The Service also asserted an accuracy-related penalty for negligence under Section 6662(a), which the Court sustained. Because partnerships do not pay taxes, penalties for underpayments are imposed at the partner level. However, TEFRA requires that the applicability of some penalties must be determined in the partnership-level proceedings. Because guaranteed payments are a partnership-level items, the applicability of the penalty is determined at the partnership-level proceeding, even though the imposition of the penalty occurs at the partner- level proceeding. Relying on Higbee v. Comm’r, 116 T.C. 438 (2001), the Court determined that the Service met its burden of production. Because Seismic knew the payments were made for services Taxpayer provided, yet it mischaracterized them as management fees, the Court held that Seismic was negligent. Taxpayer did not advance any argument or articulate any reasons as to why the accuracy-related penalties were not warranted. MM. Shea Homes, Inc. v. Comm’r, 142 T.C. No. 3 (2014). The issue in this case was whether Taxpayers properly reported income and loss from the sale of homes in their planned developments using the completed contract method of accounting provided for in Section 460.
Taxpayers were builders/developers of large, planned residential communities. They developed the land and constructed homes and common improvements, including amenities. Specifically, they acquired the land, designed the developments, posted bonds to secure their performance with respect to the completion of the common improvements in their developments, constructed the developments, marketed the developments and sold the homes to prospective buyers. Section 460 governs how taxpayers report income from long-term contracts. In general, it provides that taxpayers who receive income from long-term contracts must account for that income through the percentage of completion method, which requires a taxpayer to recognize income and expenses throughout the duration of a contract. However, under Section 460(e), home construction contracts are exempted from the percentage of completion method, and instead are accounted for under the completed contract method. A home construction contract is defined as any construction contract if 80% of the estimated total contract costs are reasonably expected to be attributable to certain activities with
3-73 Tax Conference, 28th Annual, May 21, 2015
respect to certain dwelling units and improvements to the dwelling units which are located on the site of such units. For the years at issue, Taxpayers reported income from their contracts for the sales of homes using the completed contract method of accounting. Taxpayers were of the opinion that the term “contracts” was broad and encompassed the entire development phase of which the home was a part. As a result, they contended that their contracts were complete when they met the test under Reg. §1.460-1(c)(3) and incurred 95% of the costs of the development, which did not occur until the final road was paved and the final bond was released. The Service argued that the subject matter of Taxpayer’s contracts was the home and its lot and, therefore, each contract was completed, within the meaning of Section 460, in the year in which the escrow closed as to that home. At trial, Taxpayers emphasized that they budgeted and incurred significant indirect costs when compared to the direct costs of building the homes. They further claimed that purchasers of homes in their developments were conscious of the “elaborate amenities” and would have understood that the price they paid for the homes included the amenities of the development. In addition, the Court noted that the Taxpayers were obligated to their lot purchasers for much more than the purchase and sale agreement less amenities as evidenced in the “hefty” performance bonds required by the State and municipal law in order to secure their performance with respect to the completion of the common improvements in each development. The Court agreed with the Taxpayers that, in construing the contracts under Section 460, the purchase and sale agreement was not the exclusive embodiment of that understanding but included the other related documents. The Court then addressed the subject matter of the contract. Agreeing with the Taxpayer, the Count held that the contracts included the costs of common improvements for the purposes of testing their completion date. As a result, Taxpayers were entitled to defer income from their contracts until 95% of the total contract costs, allocable to the subject matter of the contract, were incurred or the development was completed and accepted. Even though the Court had determined the Taxpayers used a permissible method of accounting, it still needed to address whether such method clearly reflected income. Because the completed contract method was specifically contemplated by Congress and was “a permissible, congressionally sanctioned clear reflection of income”, the Court concluded that the Service could not change the Taxpayers’ method of accounting even if its proposed method more clearly reflected income. NN. SI Boo, LLC, et al. v. Comm’r, T.C. Memo 2015-19 . S.I. Securities, Sabre, and SI Boo were organized in Illinois as limited liability companies and treated as partnerships for Federal income tax purposes.
S.I. Securities and Sabre bid on and acquired certificates of purchase of tax lien at Illinois tax lien public auctions. At various times during the years at issue, Sabre assigned some of the certificates of purchase of tax lien that it had acquired during public auctions to SI Boo. After the assignment concluded, Sabre recorded in its accounting records a “sale” at book value or cost, and SI Boo recorded in its accounting records the acquisition of an asset at cost.
3-74 Changes in Real Estate, Pass-Through Entities, and Estate Planning
If the lien had not been redeemed during the statutory redemption period, S.I. Securities, Sabre and SI Boo followed the legal procedures necessary under Illinois law to acquire deeds on those properties. After acquiring tax deeds on the properties, the entities attempted to sell them to third parties by quitclaim deed or contract for deed.
For the years at issue, S.I. Securities and Sabre reported income they received from the certificates of purchase of tax lien penalty percentage rates as ordinary income and reported income they received from sales of real properties to third parties as capital gains.
On December 3, 2010 the Service issued Final Partnership Administrative Adjustments to the tax matters partner of S.I. Securities for S.I. Securities’ 2007 and 2008 taxable years, to the tax matters partner of Sabre for Sabre’s 2008 taxable year and to the tax matters partner of SI Boo for SI Boo’s 2007 and 2008 taxable years. The Service determined that because the entities held the real estate properties acquired by tax deeds primarily for sale to customers in the ordinary course of their trades or businesses, the proceeds from sales of these real properties should be classified as ordinary income. The taxpayer entities disagreed.
The Court stated that whether property is held primarily for sale to customers in the ordinary course of a taxpayer’s trade or business is a question of fact which must be determined by consideration of all the surrounding circumstances. The Court considered various factors and concluded that the real properties the entities acquired from certificates of purchase of tax lien and converted into tax deeds were properties held by them primarily for sale to customers in the ordinary course of their trades or businesses and the sale proceeds were ordinary income.
More specifically, the Court examined the frequency and regularity of the sales of real properties and focused on the facts that: (i) in 2007 and 2008, S.I. Securities sold 29 and 14 parcels of real estate, respectively, by quitclaim deed; (ii) in 2008, Sabre sold 86 parcels of real estate by quitclaim deed; and (iii) in 2007 and 2008, SI Boo sold 52 parcels and 20 parcels of real estate, respectively, by quitclaim deed. The Court gave little weight to the fact that the entities acquired more certificates of purchase of tax lien than tax deeds.
The Court also focused on the fact that the entities’ sales of real property were substantial during the years at issue, especially with respect to the total amounts of income each entity earned during the year. In addition, the Court stated that fact that the entities had employed persons or had employees from other entities acting for and on behalf of their businesses in acquiring deeds, preparing the properties for sale, and maintaining accounting and other records in the course of their trades or businesses supported the Court’s finding that the real properties were not capital assets under Section 1221(a)(1) and the sale proceeds were ordinary income.
In its FPAAs, the Service also determined that the entities were prohibited from using the installment method of accounting because the sales were dealer dispositions under Section 453(l). Because the Court concluded that the entities disposed of real properties held for sale to customers in the ordinary course of their trades or businesses, it further concluded that the entities could not use the installment method to account for their sales of real properties made by contract for deed. For the same reason, the Court also concluded that the entities should have
3-75 Tax Conference, 28th Annual, May 21, 2015
included the income earned from the proceeds of sales of real property in their reported net earnings from self-employment.
OO. Stine v. Comm’r, 115 AFTR 2d 2015-637. Taxpayer claimed a bonus depreciation deduction for two buildings constructed in Louisiana, which were located in the Gulf Opportunity Zone, under Section 1400N. The Service disallowed Taxpayer’s bonus depreciation deduction. To qualify for the bonus depreciation deduction, the property had to be placed in service by the taxpayer on or before December 31, 2008. Each party filed a motion for summary judgment. The parties’ only dispute in the motions was when the property was “placed in service”.
Taxpayer maintained that, when the buildings were substantially complete and had certificates of completion and occupancy, they were placed in service. The Service took the position that the buildings had to be open for business to satisfy the placed-in-service requirements. The Service argued that, if Taxpayer were allowed to claim the depreciation allowance, it would offend the “matching principle” because the revenue Taxpayer would receive from the buildings would not match the depreciation deduction taken within a taxable year. However, the Court found this argument “totally without merit”, and stated that the bonus depreciation deduction, by its nature, allowed the mismatching of expenses and corresponding revenue. The Service attempted to support its position by providing case law on the issue, but all of the cases involved equipment, and the Court found that there was a “marked difference” between equipment and buildings for purposes of determining when it is placed in service. The Court concluded that a building is placed in service “when it is substantially complete” and that the buildings at issue were complete before December 31, 2008 and, thus, Taxpayer was able to qualify for the bonus depreciation deduction under Section 1400N. PP. Tolin v. Comm’r, T.C. Memo 2014-65. Taxpayer was a lawyer who devoted significant time to breeding a stallion he owned named “Choosing Choice”. The sole issue in this case was whether losses Taxpayer sustained in the operation of a thoroughbred horse breeding and racing activity were passive activity losses. Specifically, at trial, the focus was on the amount of time Taxpayer devoted to the thoroughbred activity in 2002, 2003 and 2004.
Choosing Choice was foaled by Taxpayer’s mare in 1993 and his racing career began in 1995. Choosing Choice became injured in 1996 and 1998, which prematurely ended his racing career. Taxpayer believed Choosing Choice could become a profitable stud horse because of his racing ability. In 2000 and 2001, Taxpayer had problems with the horse breeding farms in New Mexico and Texas where he sent Choosing Choice. After doing some research, he decided to breed Choosing Choice in Louisiana. Taxpayer realized that the ultimate success of the thoroughbred activity depended on the racing success of Choosing Choice’s progeny. To overcome any difficulties Taxpayer might face because he was new to thorough breeding in Louisiana, in the contract with the
3-76 Changes in Real Estate, Pass-Through Entities, and Estate Planning
breeding farm, he reserved for himself the task of heavily promoting Choosing Choice. The bulk of Taxpayer’s promotional efforts involved his personal solicitation of individuals to breed their mares to Choosing Choice. In addition, Taxpayer designed full-page print advertisements for Choosing Choice’s breeding services. Taxpayer monitored activities at the breeding farm by having telephone conversations with the breeders. Taxpayer initiated the great majority of these calls. Taxpayer reported the results of the thoroughbred activity on Schedule C, “Profits or Loss from Business”, that he attached to his tax returns for the years at issue. He claimed deductions for, among other items, advertising, board and care, mortality insurance, nomination and registration fees, veterinary expenses and travel. Taxpayer claimed losses from the thoroughbred activity for all of the years at issue which the Service disallowed in a notice of deficiency, determining that the losses were passive activity losses. Because the Service’s disallowance was based solely on Section 469, the Court deemed that the Service had conceded that Taxpayer operated the activity with a profit motive, that the expenses were ordinary and necessary, and that he maintained records to substantiate the deductions. At trial, Taxpayer introduced a narrative summary in which he described the work he performed in connection with the thoroughbred activity, using telephone records, credit card invoices, and other materials. Taxpayer contended that he participated in the thoroughbred activity for 891 hours in 2002, 862 hours in 2003 and 937.5 hours in 2004. The Service primarily disputed the time Taxpayer claimed he spent performing the activities described in his narrative summary because it was prepared for purposes of litigation. In addition, the Service argued that a substantial amount of Taxpayer’s work was undertaken in his capacity as an investor in the thoroughbred activity and did not qualify as participation under Temp. Treas. Reg. §1.469-5T(f)(2)(ii). In make its decision whether Taxpayer materially participated in the thoroughbred activity, the Court thoroughly examined the detailed evidence (including phone records), Taxpayer’s testimony, and third-party witness testimony. On that basis, the Court held that Taxpayer performed more than 500 hours of qualifying work in connection with the thoroughbred activity in each of 2002, 2003 and 2004. Therefore, the Court held that Taxpayer materially participated in the thoroughbred activity and Section 469 did not prohibit Taxpayer’s deduction of the loss therefrom for any of the years at issue. QQ. VisionMonitor Software, LLC v. Comm’r, T.C. Memo 2014-182. Torgeir Mantor and Alan Smith started VisionMonitor Software, LLC (“VM Software”) in 2002. For the first several years, VM Software lost money. American Metallurgical Coal Company (“AMC”) was willing to put money into VM Software if Mantor and Smith put some additional “skin in the game”. However, Mantor and Smith did not have the liquidity to contribute cash so they discussed with their attorney the tax implications of contributing promissory notes. Their attorney stated that he told Mantor and Smith that the notes were appropriate capital contributions and “would create partnership basis”. The attorney did not issue a written legal opinion and did not review any company documents before providing this advice. As a result, Mantor and Smith agreed to a “Resolution of the Managing Members” of VM Software, whereby they agreed to freeze their salaries, to provide personal credit to the Company vendors
3-77 Tax Conference, 28th Annual, May 21, 2015 and “to indebt themselves through notes payable to the Company to improve the Company’s financial position”. The Resolution was adopted in 2007. Their 2007 notes were for $50,000 and $95,000; and their 2008 notes were for $25,000 and $43,000. AMC provided VM Software an additional $900,000 to sustain operations—and received in exchange $450,000 in equity and $450,000 in convertible debt. The execution of the notes was not perfect (i.e., not notarized, amounts stated incorrectly, and incorrectly dated). All the notes were unsecured. Mantor and Smith could not make the interest payments on the notes and, therefore, had VM Software report unpaid accrued interest on the unpaid promissory notes.
The Service audited Mantor’s and VM Software’s returns for 2007 and 2008 and issued a notice of deficiency to Mantor and a notice of final partnership administrative adjustment to Mantor, as tax matters partner of VM Software. The only issue in this case was whether Mantor and Smith obtained bases in their partnership interests when they contributed their personal promissory notes. VM Software argued that the contribution of the promissory notes increased Mantor’s and Smith’s outside bases in amounts equivalent to their face value. The Service argued that VM Software’s basis in the notes was zero because Mantor’s and Smith’s bases in them were each zero. The Court agreed with the Service. Based on case law, the Court stated that it has “long held that the contribution of a partner’s own notes to his partnership isn’t the equivalent of a contribution of cash, and without more, it will not increase his basis in his partnership interest”. VM Software argued that under Gefen v. Comm’r, 87 T.C. 1471 (1986) (where a limited partner was entitled to an increase in basis by the amount of the partnership’s recourse debt that she personally assumed under a guaranty), Mantor and Smith were entitled to an increase in basis. However, the Court found that VM Software’s reliance was misplaced because neither Mantor nor Smith was guaranteeing a preexisting partnership debt to a third party. The Court acknowledged that Mantor did sign a resolution in 2007 that included a promise to provide personal credit to VM Software’s vendors. However, the Court stated that there was no evidence that either Mantor or Smith actually provided that credit or were personally obligated under the VM Software partnership agreement to contribute a fixed amount for a specific, preexisting partnership liability. The Service also asserted a Section 6662 accuracy-related penalty at the partnership level. First, the Court stated it had jurisdiction to determine the applicability of any penalty in this case and to rule on any partnership-level defense but the partners had to take their partner-level defenses to a refund forum. The Court acknowledged that the determination of the underpayment cannot happen at the partnership level because partnerships do not pay taxes. However, it stated that it can determine the applicability of the understatement penalty at the partnership level. VM Software’s only defense to the penalty was that it relied on professional advice. The Court stated that under Neonatology Associates, P.A. v. Comm’r, 115 T.C. 43, 99 (2000), aff’d 299 F.3d 221 (3rd Cir. 2002) it had to demonstrate that: (1) its advisor was a competent professional who had sufficient expertise to justify reliance; (2) it provided necessary and accurate
3-78 Changes in Real Estate, Pass-Through Entities, and Estate Planning
information to the advisor; and (3) it relied in good faith on the advisor’s judgments. VM Software’s key advisor was its attorney. The Court had no issue with the attorney’s competence and that VM Software relied on the attorney’s advice. It had a little difficulty with the prong focused on whether VM Software provided necessary and accurate information to the advisor, but, in the end, found both Mantor and his attorney credible in saying that the attorney had access to all the records he needed when he prepared the returns. Therefore, the Court did not sustain the Service’s imposition of the accuracy-related penalty. RR. Wachter v. Comm’r, 142 T.C. No. 7 (2014). The issue in this case was whether a State law that limited the duration of an easement to not more than 99 years precluded the Taxpayers’ conservation easement from qualifying as granted “in perpetuity” under Section 170(h)(2)(C). During the years at issue, Taxpayers held varying interests in WW Ranch. On its tax returns, WW Ranch reported bargain sales of conservation easement as charitable contributions. For each year, the parties to the transaction obtained two appraisals of the property. Taxpayers reported their interests in the charitable contributions on their personal income tax returns.
The Service issued the Taxpayers notices of deficiency, disallowing their charitable contribution deductions. The Taxpayers timely filed a petition disputing the notices of deficiency. The Service moved for partial summary judgment. The parties agreed that the State law at issue was unique and, by operation of State law, the easements at issue would expire 99 years after they were conveyed. The Service asserted that the State law restriction prevented the easements from being granted in perpetuity, which prevented them from being qualified real property interests under Section 170(h)(2) and contributions exclusively for conservation purposes under Section 170(h)(5). Taxpayers asserted that the 99-year limitation should be considered the equivalent of a remote future event or the retention of a negligible interest because the remainder interest was essentially valueless. Based on the definition of “remote event” in case law and Regulations as a “chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction” (citing 885 Investment Co. v. Comm’r, 95 T.C. 156 (1990)), the Court found that the event at issue was not remote. Instead, on the date of the donation, the Court found that it was not only possible but it was inevitable that the donee organization would be divested of its interests in the easements by operation of North Dakota law. Therefore, the Court concluded that the easements were not restrictions granted in perpetuity, and thus were not qualified conservation contributions. Accordingly, it granted partial summary judgment in favor of the Service, disallowing the charitable contribution deductions for the bargain sales of the conservation easements. SS. Wade v. Comm’r, T.C. Memo 2014-169. Charles and Betty Wade owned stock in two corporations, TSI and Paragon. Mr. Wade founded TSI in 1980. TSI’s business involved acquiring plastic waste and converting it into usable product. Paragon received the raw materials from TSI and used them to make building and construction materials. Mr. Wade developed the manufacturing processes used by both TSI and Paragon. The Wades’ son, Ashley, began helping Mr. Wade manage TSI and Paragon in 1994. Because Ashley handled the day-to-day management, Mr. Wade became more focused on product and consumer development. Because he did not need to live near the business operations, he moved to Florida but regularly visited the
3-79 Tax Conference, 28th Annual, May 21, 2015
facilities in Louisiana. In 2008, TSI and Paragon began struggling. To boost employee morale, Mr. Wade made three trips to the companies’ facility and redoubled his research and development efforts. The Court stated that “[w]ithout Mr. Wade’s involvement in the companies, TSI and Paragon likely would not have survived”.
In 2008, Ashley received stock in each company, thereby owning 30% of the stock in TSI and 70% of the stock in Paragon. The remaining stock of TSI and Paragon was held jointly by Mr. and Mrs. Wade. On their Form 1040, “U.S. Individual Income Tax Return”, for 2008, the Wades claimed a deduction for nonpassive losses from TSI and Paragon totaling approximately $3.8 million. In 2009, the Wades requested a refund for tax years 2006 and 2007, resulting from their carryback of the 2008 losses. In 2010, the Wades amended their 2006 and 2007 Form 1040s to reflect the carryback. The Service determined that approximately $3.4 million of the losses the Wades reported was passive and, therefore, issued a notice of deficiency disallowing a portion of the deduction the Wades claimed for the losses. Section 469 limits a taxpayer’s ability to claim deductions related to passive activities. A passive activity is any activity involving the conduct of any trade or business in which the taxpayer does not materially participate. Under Temp. Reg. §1.469-5T, a taxpayer materially participates in an activity for a given year if, “[b]ased on all of the facts and circumstances…the individual participates in the activity on a regular, continuous, and substantial basis during such year.” The Court stated that the record showed that Mr. Wade spent over 100 hours participating in TSI and Paragon during 2008, and his participation consisted primarily of nonmanagement and noninvestment activities. Although his son, Ashley, managed the day-to- day operations of the companies, the Court found that Mr. Wade focused more on product development and customer retention and “still played a major role in their 2008 activities”. Therefore, the Court held that Mr. Wade materially participated in TSI and Paragon in 2008. The Service further argued that the Wades did not prove that Mrs. Wade actively participated in TSI and Paragon. However, the Court found that this argument was “irrelevant” because for purposes of the passive loss limitation, taxpayers who file a joint return are treated as a single taxpayer. Therefore, the Court stated that Mr. Wade's material participation in the companies was sufficient to establish material participation for both him and his wife. TT. Williams v. Comm’r, T.C. Memo 2014-158. Scott Williams owned WPP, a telephone skills training business. In 2007, in addition to spending more than 2,000 hours running WPP, Mr. Williams operated a law practice out of the same office as WPP and actively participated in the rental of five properties that he owned.
Mr. Williams had an interest in aviation and received his private pilot’s license in 1987 and his commercial pilot’s license in 1990. In December of 2006, Mr. Williams caused WPP to purchase an airplane. WPP signed an aircraft marketing agreement with Sky Blue Flight School to market and rent WPP’s airplane to prospective fliers. Sky Blue closed in November
3-80 Changes in Real Estate, Pass-Through Entities, and Estate Planning
2007 due to financial difficulties. In November 2007, WPP signed an aircraft marketing agreement with a new flight school, Mach 1 Aviation. Mr. Williams performed a variety of tasks relating to WPP’s ownership of the airplane, including updating the navigation system, coordinating maintenance, hiring people to wash and wax the airplane, and assisting Sky Blue Flight School and Mach 1 Aviation in marketing the airplane. Mr. Williams estimated that he spent approximately 150 hours solely on airplane activity in 2007, but he failed to provide the Court with a log of his hours. In addition, he did not provide the Court with any documents corroborating what maintenance was performed on the plane in 2007 or invoices for any work related to washing or waxing the plane. Additionally, Mr. Williams claimed to have dinner meetings with Sky Blue Flight School to discuss how to better market WPP’s airplanes, but he did not provide any contemporaneous records to corroborate the dinner meetings, other than a one-page flyer to market the airplane. Mr. Williams and his wife filed a Form 1040, “U.S. Individual Income Tax Return”, for 2007, where they reported the airplane income and expenses on Schedule C, “Profit or Loss from Business”. The Service determined that the airplane activity was a passive activity that was not properly include as part of the Schedule C for WPP. The Service moved the airplane activity to Schedule E for rental property. The Court, upholding the Service’s characterization of the airplane activity as passive, determined Mr. Williams did not materially participate in the airplane activity and, therefore, could not deduct losses for that activity in excess of the income from that activity. In reaching its decision, the Court reviewed whether Mr. Williams materially participated in the airplane activity under the Regulations. Temporary Reg. §1.469-5T(a) sets forth seven tests in which an individual will be treated as materially participating in an activity. Mr. Williams asserted that he met the first, third and seventh of these tests. The first test states that he participated in the activity more than 500 hours during the year. In counting his hours, Mr. Williams included all of his time working at WPP. However, the Court found that WPP and the airplane activity did not constitute an appropriate economic unit for the passive activity loss rules. Therefore, Mr. Williams failed the first test. The Court also found that Mr. Williams failed the third and seventh tests because he failed to show that he spent more than 100 hours on the airplane activity, exclusive of his time as an investor. Mr. Williams asserted he was involved in the activity almost daily, primarily because he would argue about the maintenance bills. However, the Court found that the review of the bills was work done in the capacity of an investor. After removing that time, the Court found that there were very few hours Mr. Williams could corroborate that he actually spent on airplane activity in 2007. As a result, the Court sustained the Service’s determination that Mr. Williams could not deduct losses with respect to the airplane activity in excess of the activity’s income. The Service also asserted a 20% accuracy-related penalty under Section 6662(a). In determining whether Mr. Williams was liable for the penalty, it reviewed whether he acted with reasonable cause and in good faith. Although the Williamses had a return preparer prepare their 2007 return, Mr. Williams did not allege he relied on the return preparer. Instead, he made a statement that he did his own research to determine the proper characterization of the airplane and its expenses. However, the Court stated that Mr. Williams, as an attorney, should have discerned from his research that he needed to keep records of the time he was spending on the
3-81 Tax Conference, 28th Annual, May 21, 2015 airplane activity. Because he made no attempt to keep contemporaneous records and did not provide any appointment book or narrative summaries corroborating such time, the Court held that the Williamses were liable for the Section 6662(a) penalty for 2007.
3-82 Round-Up of Select Recent State and Local Tax Cases
by Joanne B. Faycurry Schiff Hardin LLP Ann Arbor
Round-Up of Select Recent State and Local Tax Cases
Joanne B. Faycurry Schiff Hardin LLP Ann Arbor I. Recent Decisions of Michigan Supreme Court and Court of Appeals on Sales/Use Tax Issues...... 4-1 II. Recent Decisions of Michigan Supreme Court and Court of Appeals on Apportionment - MTC Election ...... 4-13 III. Recent Decisions of Michigan Court of Appeals on Approach to Valuing Properties of “Big-Box” Retailers for Property Tax Assessment Purposes . . . . 4-17
I. Recent Decisions of Michigan Supreme Court and Court of Appeals on Sales/Use Tax Issues A. Imposition of Use Tax - What Constitutes a Taxable “Use” Under the Use Tax Act (“UTA”)? NACG Leasing v Dept of Treasury, 495 Mich 959 (2014)
1. Imposition Section—MCL 205.93(1): “There is levied upon and there shall be collected from every person in this state a specific tax…for the privilege of using, storing, or consuming tangible personal property in this state at a…rate equal to 6% of the price of the property or services specified in sec- tion 3a or 3b….” 2. Definition of “Use”—MCL 205.92(b): “[T]he exercise of a right or power over tangible personal property incident to the ownership of that property including transfer of the property in a transaction where possession is given….” 3. Procedural Background and Facts: • Plaintiff was formed as an LLC for the purpose of engaging in activity of aircraft leasing and operations. The LLC had 2 Members, Murray Aviation, Inc and HBJ Leasing, LLC. Each member had a 50% ownership in Plaintiff. In 2005, Plaintiff purchased a DC-8 aircraft and simultaneously entered into a lease agreement with Murray. • The Department assessed NACG use tax of $414,000, plus penalty of $103,500. NACG disputed the use tax assessment arguing that it did not use the aircraft under the UTA’s definition of “use.” • Tax Tribunal first granted summary disposition in Plaintiff’s favor. • On the Department’s motion for reconsideration, the Tribunal reversed and granted the Department’s motion for summary disposition. Tax Tribunal believed reversal was required because of Court of Appeals then recently
4-1 Tax Conference, 28th Annual, May 21, 2015
issued decision in Fisher & Co v Dept of Treasury, 282 Mich App 207 (2009), wherein one sentence in the opinion stated: “Entering into a con- tract to give up some of one’s right to possession or control is, itself, an exer- cise of those rights.” • Court of Appeals reversed (unpublished decision, dec’d October 16, 2012). Persuaded by the following facts, the Court of Appeals distinguished Fisher: • Undisputed that the lease executed contemporaneously with Plaintiff’s pur- chase of aircraft ceded total control/possession of aircraft to Murray. • Murray was responsible for maintenance, insurance, taxes and bore the risk of loss. • The aircraft was in Murray’s possession prior to Plaintiff’s purchase and that possession was not interrupted. • The Court of Appeals held: Plaintiff did not “use” the aircraft as that term is defined in UTA, MCL 205.92(b), “the exercise of a right or power over tan- gible personal property incident to the ownership of that property including transfer of the property in a transaction where possession is given.” 4. Michigan Supreme Court. • On May 22, 2013, Supreme Court granted Department’s Application for Leave to Appeal and directed the parties to address applicability of use tax to a transaction where tangible personal property is purchased by one party and leased to another party when the purchaser/lessor does not obtain actual possession of the property. • The Supreme Court reversed the Court of Appeals. • Looking to definition of “use” in MCL 205.92(b), “The exercise of a right or power over tangible personal property incident to the ownership of that property including transfer of the property in a transaction where possession is given.” • Basic precept of property law: property owner has the right to the use and enjoyment of his or her personality. This includes the property owner’s right to allow others to use his or her property in exchange for consideration. • One way in which property owner exercises this right is by executing a lease. “Therefore, because the right to allow others to use one’s property is a right incident to ownership, and a lease is an instrument by which an owner exercises that right, it follows that the execution of a lease is an ‘exercise of a right or power over tangible personal property incident to the ownership of that property.” • Execution of lease in Michigan falls squarely within statutory definition of “use.”
4-2 Round-Up of Select Recent State and Local Tax Cases
B. Exemption from Use Tax Where Transaction Subject to Sales Tax— Andrie, Inc v Dept of Treasury, 496 Mich 161 (2014)
1. The UTA exempts from use tax property that was sold in this state on which transaction a sales tax was paid. MCL 205.94(1)(a) (No pyramiding of sales and use taxes.) 2. Court of Appeals Opinion in Andrie, Inc v Dep’t of Treasury, 296 Mich App 355 (2012) (dec’d April 26, 2012) The Court of Appeals held in Andrie v Dept of Treasury, that if a transaction is a sales-taxable transaction, the purchaser does not have the burden of proving that the sales tax was paid in defending against a Department of Treasury assessment of use tax on the purchaser and the Department is obligated to pursue the seller for sales tax. The Court held:
Our Supreme Court and this Court have held on multiple occasions that the mere fact that a transaction is subject to sales tax necessarily means that the transaction is not subject to use tax. See, e.g., Elias Bros Restaurants v Dept of Treasury, 452 Mich 144, 146 n1; 549 NW2d 837 (1996) (“The Use Tax Act is complementary to the Michigan General Sales Tax Act…and is designed to cover those transactions not subject to the sales tax.”). In the present case, there is no dispute that the transactions in question involved Michigan retailers and transfers of title within the state of Michigan. Because the retailer has the ultimate responsibility to pay any sales tax, it is erroneous to place a duty on a purchaser to show that the sales tax was indeed paid to the state. Combustion Eng’g, 216 Mich App at 469. Thus, the transac- tions are not subject to use tax, and the trial court properly held in favor of plaintiff on this issue.
3. The Supreme Court granted the Department’s application for leave to appeal, instructing the parties to address: a. Whether the Court of Appeals correctly determined that a retail transaction in Michigan subject to the sales tax, MCL 205.51 et seq., is not subject to the use tax, MCL 205.91 et seq.; b. Whether a retail purchaser is entitled to a presumption that sales tax is paid on retail transactions in Michigan; and c. Whether the exemption in MCL 205.94(1)(a) applies in this case. 4. The Supreme Court issued its decision on June 23, 2014, reversing Court of Appeals. The Supreme Court held: a. The Court of Appeals incorrectly determined that a retail transaction in Michigan subject to sales tax is not subject to use tax. • The sales and use tax are complementary and supplementary, and their potential applications are not mutually exclusive. Absent exemption, TPP sold and used in Michigan is subject to both sales and use tax.
4-3 Tax Conference, 28th Annual, May 21, 2015
• UTA imposes 6% tax on use, storage and consumption of all TPP prop- erty in this State. Legal responsibility for use tax falls solely on the con- sumer. • STA imposes 6% tax on sale of all TPP in Michigan. Legal responsibil- ity for sales tax falls on the retail seller. Seller is permitted to pass on the sales tax to the consumer. • Regardless of whether the retail seller collects sales tax from consumer or pays from another source, seller is responsible for remitting the sales tax to the Dept. • Absent an exception, TPP sold and used in Michigan is subject to both use and sales tax. • Under MCL 205.94(1)(a), property sold in Michigan on which sales tax was paid is exempt from use tax If the sales tax was due and paid on the retail sale. This exemption provision requires payment of sales tax before use tax exemption applies. • Because Andrie failed to submit evidence proving sales tax was actu- ally paid on in-state purchases at time of sale, it was not entitled to use tax exemption. b. Taxpayers/retail purchasers are NOT entitled to presumption that sales tax was included in the prices paid to retailers when their receipts do not list sales tax as a separate line item. • Taxpayer entitled to use tax exemption when it proves that it paid sales tax to the retail seller, even if the retail seller, who bears the legal responsibility for payment of sales tax, did not remit the tax to the Department. • Burden of proving exemption rests on party asserting right to exemp- tion. Presumption of sales tax payment would shift this burden to Department. • A presumption that sales tax is always included in an item’s purchase price would entitle purchaser to exemption whenever sales tax is merely due without having to meet second requirement of §4(1)(a) that tax was actually paid. Use tax exemption provision requires proof of both: tax due and tax paid. c. The exemption in MCL 205.94(1)(a) does NOT apply in this case. • MCL 205.73(1), which states that a retail seller may not state or imply that an item’s purchase price does not include sales tax, did not relieve Andrie of its duty to prove that sales tax was paid. • MCL 205.73(1), as an advertising statute, was only a restriction on retail seller’s representations to the public. It did not purport to define the actual components of an item’s purchase price. • The Opinion was not unanimous. 5 Justices concurred in reasoning and result; 1 Justice concurred in result only; and 1 Justice, Zahra, dissented
4-4 Round-Up of Select Recent State and Local Tax Cases
(Because GSTA places burden of paying sales tax only on retailers and not on consumers, Court should have afforded consumers presumption that retailers had actually paid sales tax if it was evident that sales tax was due. The Dept would then be permitted to rebut presumption by producing evidence that tax was not paid.) 5. Post Andrie: STA Levy/Imposition Provision (MCL 205.52(1))—MANDATES that sales tax be collected from all persons engaged in the business of making sales at retail.
[T]here is levied upon and there shall be collected from all persons engaged in the business of making sales at retail, by which ownership of tangible personal property is transferred for consideration, an annual tax for the privilege of engaging in that business equal to 6% of the gross proceeds of the business…
• §52(1) requires the Department to collect sales tax on all non-exempt retail sales. • No question that the items involved in Andrie were purchased in a retail sale. And, per the MSC’s Opinion, no proof that sales tax was paid on the sales- taxable purchases. • Has the Department violated §52(1) of the STA by failing to collect sales tax from the retail sellers involved in Andrie? • Has the Department unlawfully compromised sales taxes due to the State in violation of MCL 205.28(1)(e)? • Violating §28(1)(e) is a felony, “punishable by a fine of not more than $5000, or imprisonment for not more than 5 years, or both, together with the costs of prosecution.” In addition, employee shall be dismissed from office or discharged from employment upon conviction. C. Industrial Processing Exemption - DTE v Dept of Treasury, 303 Mich App 612 (2014) (dec’d January 9, 2014)
1. For the tax period involved, 2003–2006, “industrial processing” was defined as,
the activity of converting or conditioning tangible personal property by chang- ing the form, composition, quality, combination, or character of the property for ultimate sale at retail or for use in manufacturing of a product to be ulti- mately sold at retail. Industrial processing begins when tangible personal prop- erty begins movement from raw materials storage to begin industrial processing and ends when finished goods first come to rest in finished goods inventory storage.
2. “Industrial processor” was defined as,
4-5 Tax Conference, 28th Annual, May 21, 2015
a person who performs the activity of converting or conditioning tangible per- sonal property for ultimate sail at retail or use in the manufacturing of a prod- uct to be ultimately sold at retail.
• DTE’s operations include production and generation of electricity at its gen- eration plants, along with the transmission and distribution of electricity. • The transmission and distribution system, or electrical system, is an inte- grated, interconnected, and interrelated network of machinery and equip- ment, including, substations, transformers, high-voltage towers, cables and poles. 3. Issue: whether industrial processing of electricity continues to occur once the electricity leaves a generation plant for purposes of transmission and distri- bution. • Findings: Electricity is continuing to be processed up until the point where it reaches the customers’ meter, because the voltage and current levels are drastically changed multiple times at set points, the last being at or near the customer’s meter, and in between these changes the voltage and current lev- els are constantly being adjusted to keep them constant. • Court of Appeals Holding: DTE’s machinery and equipment located out- side its generation plants are used in the activity of converting and condi- tioning electricity by changing the quality, form, character, and/or composition of the electricity for ultimate sale at retail up until the time the electricity reaches its customers’ meters, at which point it becomes a fin- ished good. • The Dept filed an application for leave to appeal to the Michigan Supreme Court which was granted on October 1, 2014, so stay tuned 4. Consumers Energy v Dep’t of Treasury (October 16, 2014 COA unpublished decision) • Followed DTE Decision • Electrical and natural gas distribution equipment exempt as industrial pro- cessing. D. Cloud Computing Transactions - Taxable as Tangible Personal Property or Non-Taxable Services?
1. Michigan’s Treatment of Cloud Computing • Michigan’s sales and use tax acts do not address whether cloud computing is subject to tax. • In 2007, the Department issued a private letter ruling determining that a Michigan user’s subscription to an on-demand customer relationship man- agement application service provided online that was powered by out-of- state servers was not subject to sales or use tax, because there is no retail sale of TPP.
4-6 Round-Up of Select Recent State and Local Tax Cases
• In 2009 the Department issued a private letter ruling determining that a Michigan user’s subscription to Software as a Service (Saas), in this case, application software that allows the user to manage employee metrics that was powered by out-of-state servers was subject to sales or use tax. The Department determined that a right to access/use prewritten computer soft- ware is analogous to a taxable license to use prewritten computer software. • In general, services are not subject to Michigan sales and use tax. There should be no distinction between services provided in person and services powered by software provided online. • Only TPP is subject to sales or use tax. • TPP includes “prewritten computer software.” MCL 205.92(k). “Computer software” is defined as “a set of coded instructions designed to cause a com- puter or automatic data processing equipment to perform a task” MCL 205.92b(c) • TPP is only taxable if it is used, stored, or consumed. MCL 205.93(1) • “Use” is “the exercise of a right or power over tangible personal property incident to the ownership of that property including transfer of the property in a transaction where possession is given …” MCL 205.92(b) 2. Thomson Reuters v. Dep’t of Treasury, Unpublished COA Docket No. 313825 (Dec’d May 13, 2014), lv app filed on 8/12/14, Sup Ct Docket No. 149902. • At issue is a Michigan user’s subscription to the online information service, www.riacheckpoint.com, and whether that constitutes a use tax taxable use. •Facts: • The servers housing the hardware and software that powered the online service were owned by Thomson and located in Minnesota • The user in Michigan accessed the information provided online by log- ging into the website with a user name and password. • The user did not have access to the software such that the user could transfer it, manipulate it, or modify it. • Court of Claims Holding • Determined that the intangible information transferred to the user was tangible personal property and subject to use tax and that there was no difference between the product provided online and the taxable CD- ROM. • Since Javascript was required to run any of the tools included in RIA Checkpoint, then it had to be software. • The mechanism of how Checkpoint is powered remotely by hardware and software located in Minnesota and how information is accessed by subscribers is “not relevant”. • A subscription to an online information service is a service and not a taxable delivery of prewritten computer software.
4-7 Tax Conference, 28th Annual, May 21, 2015
• Delivery of intangible information is not subject to tax. This has been conceded by the Department and resolved by the Michigan Supreme Court in Catalina. • Services are not subject to use tax. • No computer software is “delivered” to subscribers using the online information service. • A de minimus use of user-side JavaScript to access some informa- tion provided through the service does not constitute a “delivery” of TPP. • If a small component of a subscription to an online information service is prewritten computer software delivered to subscribers in Michigan, the software is incidental to the service provided, and that subscription is not subject to Michigan use tax under the Cat- alina Incidental to Service Test • Courts utilize the Catalina test in sales and use tax cases for determin- ing whether a mixed transaction involving sale of tangible person prop- erty and services is a sale of services or a sale of TPP. If the transaction is a sale of services, it is not subject to sales or use tax. Under the “inci- dental to service” test, the whole transaction should be looked at objec- tively to determine the principal component, considering the following six factors: • What the buyer sought as the object of the transaction; • What the seller or service provider is in the business of doing; • Whether the goods were provided as a retail enterprise with a profit-making motive; • Whether the tangible goods were available for sale without the service; • The extent to which intangible services have contributed to the value of the physical item that is transferred; and • Any other factors relevant to the particular transaction • Court of Appeals Holding • “[A]ny transfer of tangible personal property was incidental to the ser- vice provided”. • There is no evidence that any de minimis amount of software trans- ferred was the object of the transaction, or that customers sought to own or otherwise have responsibility for the prewritten software. • Further, the fact that the license agreement allowed the user to access and use Checkpoint does not establish that users primarily sought the physical software. 3. Auto-Owners Insurance Company v. Dep’t of Treasury, Court of Claims Case No. 12-000082-MT (Dec’d March 20, 2014)
4-8 Round-Up of Select Recent State and Local Tax Cases
• The issue is whether a Michigan user’s remote access to a third party’s tech- nology infrastructure is subject to Michigan use tax. • Facts: • Insurance provider in Michigan represented by numerous independent agents. • Taxpayer used an outside service provider to supply their computer infrastructure. • A third party hosted Auto-owners network, servers, data storage, and software applications. • Issues: • Was tangible personal property provided? • If so, was the TPP “used: within the meaning of the Use Tax Act? • If TPP used, was it purchased with services requiring Catalina Market- ing to be considered? • Court of Claims Holding: • There was no “use” of TPP. “Use” requires the exercise of a right or power over tangible personal property with a right or power over the property “incident to ownership”. (NACG Leasing) • Mere access to software does not equate to “use” • Catalina Marketing Tests supports that a service was received, so not taxable. 4. Rehmann Robson & Co v Dep’t of Treasury, Court of Claims Case No. 12-98- MT (Dec’d November 26, 2014) • The issue in general is whether Rehmann’s subscription to Checkpoint is properly subject to use tax. • Facts: • Large accounting firm that provides tax and auditing services to clients. • Rehmann subscribes to Thomson Reuters’s online information data- base product, Checkpoint, to research and obtain access to tax materi- als. • Access is obtained by locating Checkpoint’s main website through a web browser and inputting a user name and password. • No special Checkpoint software is downloaded by Rehmann employees to access the database. • Dep’t assessed use tax based on its determination that Rehmann’s use of Checkpoint constituted the sale of TPP in the form of “prewritten computer software.”
4-9 Tax Conference, 28th Annual, May 21, 2015
• Specific Issues: • Was the software involved in the Checkpoint transactions “tangible per- sonal property” within the meaning of the UTA? • If so, did Rehmann “use” the prewritten computer software within the meaning of the UTA? • Was Rehmann’s use of prewritten computer software incidental to the services provided? • Court of Claims Holding: • First Issue: Looking to the definition of “prewritten computer soft- ware”: “defined as “computer software, including prewritten upgrades, that is delivered by any means and that is not designed and developed by the author or other creator to the specifications of a specific pur- chaser.” MCL 205.92b(o). • “Delivered by any means” not defined in UTA. Look to dictionary def- initions for common and ordinary meaning: Given the context of §92b(o), “deliver” is “to take and handover to or leave to another; CONVEY; to hand over, surrender.”…“the formal act of transferring something; the giving or yielding possession or control of something to another.” • Definition of “prewritten computer software” indicates that the UTA applies only to those transactions in which the person takes ‘delivery’ of the software.” • No evidence in record that Rehmann took “delivery” of prewritten computer software from Thomson Reuters or BNA. • Second Issue: Even if prewritten computer software was “delivered” to Rehmann, the requisite “use” of software was not made. • There was no “use” of TPP. “Use” requires the exercise of a right or power over tangible personal property with a right or power over the property “incident to ownership”. (NACG Leasing) • Mere access to software does not equate to “use” • Third Issue: Even if prewritten computer software was somehow deliv- ered and used by Rehmann within the meaning of the UTA, any such use was merely incidental to the services rendered through Checkpoint, and under Catalina Marketing test, a service was received, so not tax- able. 5. GXS, Inc v Dep’t of Treasury, Court of Claims Case No. 13-000181-MT (Dec’d March 4, 2015) • The case concerns use tax treatment of certain remote transactions engaged in over the internet between an out-of-state “e-commerce” business (Inovis USA, prior to merger with GXS), and its Michigan customers. • Facts:
4-10 Round-Up of Select Recent State and Local Tax Cases
• Inovis engaged in various online transactions with its Michigan customers. Transactions at issue involved those related to 3 of Inovis’s customer offer- ings: a. electronic data interchanges (EDI) conducted over public and private value added networks (VANS), b. “Managed Services” involving the translation and transformation of business documents into an appropriate format for EDI transmission, and c. “Catalogue Services” involving data synchronization, storage and retrieval allowing suppliers to exchange data with their retail custom- ers. • Taxpayer and Department agree (or do not dispute) that: a. no underlying software or software code was installed or downloaded to Michigan customers’ computers or servers in connection with the transactions. b. the underlying software used in these transactions was at all times housed on Inovis’ servers located outside Michigan. c. transactions did not involve the mixed use of both services and sale of TPP. (Thus Court did not apply “incidental to services” test under Cat- alina.) • Taxpayer characterized the transactions as purely services provided to Mich- igan’s customers through Inovis’ internal use of its own software—making 3 arguments: a. There was no “delivery” of prewritten computer software to Michigan customers as required under the UTA. Inovis’s Michigan customers were provided with electronic document processing and delivery ser- vices, but not software. b. No “use” of prewritten computer software was made by Inovis’s Mich- igan customers as required by UTA. (GXS rejects Dept’s theory that by “accessing the functionality” of Inovis’s internally-used software, req- uisite “use” was made under the UTA by Inovis’s Michigan customers. c. Dept’s assessment violates the Internet Tax Freedom Act. • Issues: a. Whether Inovis’s Michigan customers engaged in the taxable use of prewritten computer software as TPP under the UTA. b. Whether the transactions were taxable communications services under the UTA.
4-11 Tax Conference, 28th Annual, May 21, 2015
c. Whether application of the use tax to the transactions violated the ITFA, and d. Whether GSX’s claims are barred by the 90-day statute of limitations. • Court of Claims Holding: • First Issue: Looking to the definition of “prewritten computer soft- ware”: “defined as “computer software, including prewritten upgrades, that is delivered by any means and that is not designed and developed by the author or other creator to the specifications of a specific pur- chaser.” MCL 205.92b(o). • “Delivered by any means” not defined in UTA. Look to dictionary def- initions for common and ordinary meaning: Given the context of §92b(o), “deliver” is “to take and handover to or leave to another; CONVEY; to hand over, surrender.”…“the formal act of transferring something; the giving or yielding possession or control of something to another.” • Definition of “prewritten computer software” indicates that the UTA applies only to those transactions in which the person takes ‘delivery’ of the software.” • No evidence that Inovis’s Michigan customers took “delivery” of pre- written computer software from Inovis. • “Access” to Inovis’s software applications does not equate to “deliv- ery.” • Even if prewritten computer software was “delivered” to Inovis’s Michigan’s customers, requisite “use” of software was not made. • There was no “use” of TPP. “Use” requires the exercise of a right or power over tangible personal property with a right or power over the property “incident to ownership”. (NACG Leasing) • Rejected Dept’s argument that Michigan customers “accessed the func- tionality” of Inovis’s software and therefore made requisite use of soft- ware. • Court noted that provisions of the UTA have not kept pace with “rapid technological changes occurring in an increasingly ‘virtual’ world, and that Michigan sales and use tax laws as they stand today do not allow for the easy application to facts such as those presented in this case.” • Second Issue: Transactions are not taxable “telecommunications ser- vices” under MCL 205.93a(5)(s)(i) because transactions fit squarely within the definitional exclusion of “[d]ata processing information ser- vices that allow data to be generated, acquired, stored, processed, or retrieved and delivered by an electronic transmission to a purchaser
4-12 Round-Up of Select Recent State and Local Tax Cases
where the purchaser’s primary purpose for the underlying transaction is the processed data or information.” • Third Issue (violation of ITFA) and Fourth Issue (claim barred by 90- day statute of limitations) not addressed because the transactions prop- erly characterized as non-taxable services and thus not subject to use tax. II. Recent Decisions of Michigan Supreme Court and Court of Appeals on Apportionment - MTC Election A. IBM v Dept of Treasury, Unpublished CoA Opinion (dec’d November 20, 2012), lv gtd.
• The Multistate Tax Compact (MTC) was adopted by Michigan effective on July 1, 1970. 1969 PA 343 • IBM’s Position: MBT apportionment formula was optional. The Compact was a contract. (Gillette in California has prevailed on this argument.) • Dept’s Position: MBT apportionment formula was mandatory. • Court of Appeals Holding: • Affirmed the lower court and held that IBM was required to use the MBT apportionment formula (100% sales) and that the taxpayer was not permitted to elect to use the Multistate Tax Compact’s 3-factor apportionment formula (equally-weighted property, payroll and sales.) • Noted that the MBT statute allowed taxpayers to request permission to use an alternative apportionment method so that unusual situations where the default formula caused distortion would not occur. • However, the MTC allowed an election of right, presumably exercised in order to obtain a lower tax liability. • Examining the statutory language, the court noted that the applicable provi- sion in the MBT (MCL 208.1301) absolutely precluded any other apportion- ment formula except by petition. • Court noted that statutes were not deemed to be contracts in the absence of an exceedingly clearly-expressed intent by the Legislature. Legislature would have had to use the word “contract” or “covenant,” or otherwise explicitly “surrender its power to make changes.” • Compact language did not specify that it was a contract. • The Court reasoned that enacting a conflicting statute might be an improper way to repeal the Compact, but not necessarily impermissible. • Holding in favor of Dep’t: MBT law repealed by implication the MTC apportionment election provision. • Supreme Court Grants Leave to Appeal Parties instructed to include among the issues to be briefed:
4-13 Tax Conference, 28th Annual, May 21, 2015
1. whether IBM could elect to use the apportionment formula provided in the Multistate Tax Compact, MCL 205.581, in calculating its 2008 tax liability to the State, or whether it was required to use the apportionment formula provided in the MBTA, MCL 208.1101 et seq.; 2. whether §301 of the MBTA, MCL 208.1301, repealed by implication Article III(1) of the Multistate Tax Compact; 3. whether the Multistate Tax Compact constitutes a contract that cannot be unilaterally altered or amended by a member state; and 4. whether the modified gross receipts tax component of the MBTA constitutes an income tax under the Multistate Tax Compact. B. Supreme Court Decision: IBM Corp v Dep’t of Treasury, 496 Mich 642 (2014)
• In lead Opinion by Justice Viviano, joined by Justices Cavanaugh and Markman; and a separate concurring opinion by Justice Zahra, the Supreme Court reversed the opinion of the Court of Appeals granting summary disposition in favor of the Dep’t and remanded the case to Court of Claims for entry of order consistent with Opinion (entry of order granting summary disposition in favor of IBM.) The Supreme Court held: • Modified Gross Receipts component of the MBT is an “income tax” for pur- poses of the MTC; • IBM entitled to use the MTC’s elective 3-factor apportionment formula to calculate IBM’s MBT taxes for 2008; • The 3 Justices in lead Opinion held that the MBT Act’s modified gross receipts tax fits within the MTC’s broad definition of an “income tax. • Court of Appeals erred by holding that MBTA had repealed the MTC’s elec- tion provision by implication because the two statutes could be reconciled when read in pari materia. • Justice Zahra, in a concurring opinion, agreed that IBM was entitled to use the MTC’s 3-factor elective apportionment formula in calculating MBT taxes for 2008, and also that the tax bases were “income taxes” within the meaning of the MTC Act. • However, Justice Zahra would not have reached the question of whether the Legislature had repealed by implication the MTC’s 3-factor election when it enacted the MBTA because the Legislature made clear that taxpayers were entitled to use the MTC’s 3-factor election for the 2008, 2009 and 2010 tax years by enactment of 2011 PA 40:
The BTA’s exclusive apportionment method remains in conflict with the election provision of the Compact. This conflict, in my view, is easily resolved because the Legislature in 2011 also expressly supplemented the Compact. This new provision is not “the same as those of prior laws” and is a “new enactment,” which expressly provides that a taxpayer could
4-14 Round-Up of Select Recent State and Local Tax Cases
elect to apportion its income under article IV of the Compact except that beginning January 1, 2011 any taxpayer subject to the Michigan business tax act, 2007 PA 36, MCL 208.1101 to 208.1601, or the income tax act of 1967, 1967 PA 281, MCL 206.1 to 206.697, shall, for purposes of that act, apportion and allocate in accordance with the provisions of that act and shall not apportion or allocate in accordance with article IV. There can be no dispute given this language that the Legislature specifically intended to retroactively repeal the Compact’s election provision begin- ning January 1, 2011. Further, I conclude that this language contemplates that any taxpayer could avail itself of the Compact’s election provision for tax years 2008 through 2010. This is because the Legislature, either under the original enactment of the Compact (assuming the Legislature did not repeal the Compact’s election provision by implication when it enacted the BTA) or under the above re-enactment and supplementation of the Compact (assuming the Legislature repealed the Compact’s elec- tion provision by implication when it enacted the BTA), chose to com- mence its express repeal of the Compact’s election provision on January 1, 2011, even though the conflict between the BTA and the Compact had existed from the 2008 tax year. Simply put, the contrapositive of the Compact’s supplemental provision must mean that before January 1, 2011, a taxpayer could, “for purposes of the act [the ITA or BTA], appor- tion or allocate in accordance with article IV” of the Compact. That is, in my opinion, the most reasonable understanding of this legislation.” In sum, the Legislature in 2011 created a window in which it intended the Compact’s election provision to apply. In this case, IBM sought to “apportion and allocate” its taxes under the BTA well before January 1, 2011, and therefore may apportion or allocate its taxes in accordance with article IV of the Compact. For this reason, I concur in the result reached in the lead opinion.
• Justice McCormack, joined by Chief Justice Young and Justice Kelly, dis- sented. They would have affirmed the Court of Appeals opinion. Justices concluded that allowing taxpayers to apportion their multistate income in accordance with the MTC’s 3-factor formula violated the Legislature’s unambiguous directive that taxes established under the MBTA must be in accordance with the MBTA’s single sales factor apportionment formula. The dissenting Justices further concluded that there was no constitutional imped- iment that prevented the Legislature from making the MTC’s alternative 3- factor election provision unavailable to taxpayers. • On August 4, 2014, the Dept filed motion for rehearing and motion to stay, argu- ing that the cost to the State of paying tax refunds to other taxpayers for 2008, 2009 and 2010, would exceed $1 Billion. • On September 12, 2014, Governor Snyder signed into law 2014 PA 282, which retroactively “reversed” the Supreme Court’s July 14, 2014 Opinion in IBM, and retroactively repealed Michigan’s adoption of the MTC to tax years beginning on or after 1/1/2010. • Enacting Section 1 of PA 282 states: “1969 PA 343, MCL 205.581 to 205.589, is repealed retroactively and effective beginning January 1, 2008. It is the intent of the legislature that the repeal of 1969 PA 343, MCL 205.581
4-15 Tax Conference, 28th Annual, May 21, 2015
to 205.589, is to express the original intent of the legislature regarding the application of section 301 of the Michigan business tax act, 2007 PA 36, MCL 208.1301, and the intended effect of that section to eliminate the elec- tion provision included within section 1 of 1969 PA 343, MCL 205.581, and that the 2011 amendatory act that amended section 1 of 1969 PA 343, MCL 205.581, is not available under the income tax act of 1967, 1967 PA 281, MCL 206.1 to 206.713. • Enacting Section 2 adds: “This amendatory act is retroactive and is effective for tax years beginning on and after January 1, 2010.” • Supreme Court denied the Dept’s motion for rehearing and its motion to stay enforcement of the IBM decision on November 14, 2014. • On remand to the Court of Claims: • On November 19, 2014, in compliance with the Supreme Court’s July 14, 2014 decision, the Court of Claims entered an order in favor of IBM. • The Dept filed a motion for reconsideration of the November 19 Order asserting that the retroactive change in the law as a result of 2014 PA 282 applies to and controls the outcome of the case. • On April 28, 2015, the Court of Claims granted the Dept’s motion for recon- sideration and effectively reversed the Supreme Court’s July 14, 2014 deci- sion in favor of IBM, ruling that 2014 PA 282 retroactively repealing the Compact effective January 1,2008, applies to IBM and therefore IBM not entitled to the approximately $6 Million in MBT refunds it claimed. C. Court of Claims Rules that Retroactive Repeal of Compact Precludes MBT and SBT Tax Refunds in Cases that Were Pending Decision in IBM
• Anheuser-Busch v Dept of Treasury (Court of Claims Case No. 11-85-MT; Dec’d April 7, 2015); • Ingram Micro, Inc v Dept of Treasury (Court of Claims Case No. 11-000033-MT; Dec’d December 19, 2014); • Yaskawa America Inc. v Dept of Treasury (Court of Claims Case No. 11-000077- MT; Dec’d Decmeber 19, 2014); • EMCO Enterprises v Dept of Treasury (Court of Claims Case No. 12-000152- MT; Dec’d April 21, 2015)—SBT Refund Claim; • 22 Other SBT Refund Cases also Dismissed on April 21, 2015.
4-16 Round-Up of Select Recent State and Local Tax Cases
III. Recent Decisions of Michigan Court of Appeals on Approach to Valuing Properties of “Big-Box” Retailers for Property Tax Assessment Purposes A. Lowe’s Home Centers, Inc v Township of Marquette and Home Depot USA, Inc v Township of Breitung (Consolidated Appeals), Court of Appeals, Unpublished Decision (Case Nos. 314111 and 314301; Dec’d April 22, 2014), and Lowe’s Home Centers, Inc v City of Grandville, Court of Appeals, Unpublished Deci- sion (Case No. 317986; Dec’d December 31, 2014).
• Court of Appeals upholds Tax Tribunal’s use of the sales-comparison approach in valuing “big-box” stores. • Categorized properties’ Highest and Best Use as “improved commercial retail rather than as a continuously-occupied, successful home improvement store.” • Court of Appeals held: “Highest and best use ‘recognizes that the use to which a prospective buyer would put the property will influence the price which the buyer would be willing to pay.’… Respondent’s contention that the property’s HBU is to continue its existing use as an operating home improvement store is another attempt to incorporate value-in-use, or use-value, into the calculation of the sub- ject property’s value, contrary to Michigan law. The HBU is informed by the existing use, but not by the specific use of a particular existing user.” • Query: Is current owner not a potential prospective purchaser?
4-17
Current Developments in Michigan Tax Litigation, Legislation, and Administrative Guidance - State and Local Tax Committee/Practice and Procedure Committee
by Thomas J. Kenny Varnum LLP Novi Wayne D. Roberts Varnum LLP Grand Rapids Nichole Shultz Michigan Department of Treasury Lansing
Current Developments in Michigan Tax Litigation, Legislation, and Administrative Guidance - State and Local Tax Committee/Practice and Procedure Committee
Wayne D. Roberts Varnum LLP Grand Rapids Thomas J. Kenny Varnum LLP Novi Nichole Shultz Michigan Department of Treasury Lansing
I. Court of Claims Jurisdiction: Payment of Tax, Penalty and Interest ...... 5-1 II. Tax Tribunal Jurisdiction: Payment of “Uncontested Portion of an Assessment, Order, or Decision” ...... 5-2 III. Statute of Limitations: Completion of an Audit ...... 5-2 IV. Property Tax Appeals: Real Party in Interest ...... 5-3 V. Revenue Act: Requirements of a “Notice of Intent to Assess”...... 5-4 VI. Update on Corporate Officer Liability: SB 64; PA 3 of 2014 - Revised MCL 205.271(5)...... 5-4 VII. HB 4003 Created an Offer-In-Compromise (“OIC”) Program for the State of Michigan that Would Apply to All Michigan Taxes ...... 5-8 VIII. Industrial vs. Commercial Classification Disputes...... 5-9 IX. CVS Caremark and Iron Mountain - Standard of Review from STC Decision ...... 5-10
I. Court of Claims Jurisdiction: Payment of Tax, Penalty and Interest A. Coventry Health Care Inc. v Department of Treasury (Michigan Court of Appeals (Docket 31789) October 16, 2014) Procedural Background: The Department of Treasury issued a Notice of Additional Tax Due to the taxpayer on March 30, 2012. The notice provided that if additional tax, penalty and interest totaling $721,198.00 was not paid within 30 days then a Notice of Intent to Assess would be issued.
5-1 Tax Conference, 28th Annual, May 21, 2015
The Department of Treasury later issued a Notice of Intent to Assess which updated the interest bringing the total due to $746,952.07. The taxpayer paid the amount of $721,198.00 on June 28, 2012 which was 90 days after the issuance of the Notice of Additional tax Due. Coventry Health Care also filed a suit for tax refund in the Court of Claims on June 28, 2012. The Department of Treasury moved for summary disposition arguing the court lacked jurisdiction based on the failure of the tax payer to pay the entire amount of tax, penalty and interest that had accrued. The Court of Claims ruled in favor of the Department of Treasury. Court of Appeals Affirms Trial Court: Coventry Health Care did not “pay the tax, including any applicable penalties and interest” before it brought its appeal. The Court of Claims, therefore, did not have jurisdiction. Practice Note:
1. The Department accepts mailed payments as made on the date they are post- marked. 2. To comply with MCL 205.22(2), a taxpayer simply needs to determine the addi- tional interest accrued from the date of the notice to the date of payment. The Department provides multiple ways to assist taxpayers in making these calcula- tions including: (1) direct contact with the Department; (2) website interest calcu- lator; and (3) publication of interest rates. B. SB 100 (Brandenburg) Would eliminate the requirement that, in an appeal of a tax case to the Court of Claims, a taxpayer must first pay the full amount of tax, penalty and interest at issue and seek a refund. II. Tax Tribunal Jurisdiction: Payment of “Uncontested Portion of an Assessment, Order, or Decision” A. Buddy’s I-94 Mart, Inc. v Department of Treasury (MTT No. 449144, March 10, 2014) Failure to pay the uncontested portion of an assessment resulted in jurisdictional defi- ciency and appeal was dismissed. B. Toaz v Department of Treasury, 760 NW2d 325; 280 Mich App 457 (2008)
III. Statute of Limitations: Completion of an Audit A. Statute of Limitations MCL 205.21
(6) For audits commenced after September 30, 2014 the department must complete fieldwork and provide a written preliminary audit determination for any period no later than one year after the period provided for in section 27a(2) without regard to the exten- sion provided for in section 27a(3).
5-2 Current Developments in Michigan Tax Litigation, Legislation, and Administrative Guidance
B. Tolling Provision: Prior to 2014 Amendment MCL 205.27a(3)
(3) The running of the statute of limitations is suspended for the following: (a) The period pending a final determination of tax, including audit, conference, hearing and litigation of the liability for federal income tax or a tax administered by the Department and for 1 year after that period. C. Current Tolling Provision MCL 205.27a(3)
(3) The running of the statute of limitations is suspended for the following if that period exceeds that described in subsection (2): (a) The period pending a final determination of tax through audit, conference, hear- ing and litigation of liability for federal income tax and 1 year after that period. (b) The period for which the taxpayer and the State Treasurer have consented to in writing that the period be extended. D. Amendments to Revenue Act Sections 21, 27a, and 30 2014 PA 3 The amendments were approved January 30, 2014 and took immediate effect on Feb- ruary 6, 2014. (See Shotwell v Department of Treasury, 305 Mich App 360 (2014).) Practice Note: It appears Treasury employs a three phase approach:
1. Audits commenced prior to February 6, 2014 Treasury follows the old (repealed) statutory provision in which the statute is tolled upon commencement of the audit 2. Audits commenced during the period February 6, 2014–September 30, 2014 There is no automatic tolling of the statute. Therefore, a portion of the 4 year audit period may have expired (shortened exposure period for taxpayer). 3. Audits commenced after September 30, 2014 The audit period is limited to 4 years from filing of the tax return, plus 1 addi- tional year. Comment: No Legal Basis for approach No. 1. IV. Property Tax Appeals: Real Party in Interest A. Spartan Stores, Inc. and Family Fare, LLC v. City of Grand Rapids, 307 Mich App 565 (2014), Sup. Ct. Application Pending Factual Background: Spartan Stores owns the petitioner Family Fare, LLC, which operated a grocery store that leased space in a shopping center. Both businesses claimed to be a “party in interest” under MCL 205.735a(6) and, therefore, may challenge the property
5-3 Tax Conference, 28th Annual, May 21, 2015 tax assessment. The City argued only the property owner or its agent, not lease holders, may be considered a “party in interest.” Court of Appeals Rules in Favor of Lessee Only: A “party in interest” under MCL 205.735a(6) includes persons or entities with a property interest in the property being assessed. Family Fare is a “party in interest” under MCL 205.735a(6) because it has a leasehold in the shopping center, and thus possesses a property interest in the property being assessed. However, Spartan Stores is not a “party in interest” because it does not have a property interest in the property being assessed. V. Revenue Act: Requirements of a “Notice of Intent to Assess” A. Section 21
…The notice (of intent to assess) shall include the amount of the tax the Department believes the taxpayer owes, the reason for that deficiency, and a statement advising the taxpayer of a right to an informal conference, the requirement of a written request by the taxpayer for the informal conference that includes the taxpayer’s statement of the con- tested amounts and an explanation of the dispute, and the 60 day limit for that request.
Practice Point: The Notice of Intent to Assess requires a statement of the “reason for that deficiency.” Are statements such as “per previous communication” or “returns received without sufficient payment” in compliance with the statutory requirement? Under Fradco v Department of Treasury, 495 Mich 104 (2014), the Department’s failure to comply with the mandatory notice requirements relating to the intent to assess means the final notice was never validly issued and is void. Without an adequate statement of the “reason for the deficiency” the taxpayer cannot comply with its duty to “remit the uncontested portion of the liability” and “provide a statement of the contested amounts and an explanation of the dispute” as required by MCL 205.21(2)(c). VI. Update on Corporate Officer Liability: SB 64; PA 3 of 2014 - Revised MCL 205.271(5) A. Prior Law Livingstone v Department of Treasury, 434 Mich 771 (1990) Signed a Tax Return or Check to Pay a Tax—“tax-specific” authority (generally). Officer in title or role Deena Shotwell v Dep’t of Treasury, Mich Ct App No 314860 (May 27, 2014) (For Publication) Two Primary Issues
5-4 Current Developments in Michigan Tax Litigation, Legislation, and Administrative Guidance
1. Facts resulted in taxpayer being held NOT liable as a responsible officer Widow of prior business owner assessed for Michigan Tobacco Product Tax Act Taxes that allegedly were owed by the former husband’s business. Sole shareholder was husband; husband named widow and daughter as co- administrators of his estate. Taxpayer signed a single 2007 tobacco tax return and marked “all taxes paid.” Listed herself as “co-owner” and as “president” on forms. Department determined $694,732.82 in taxes were due. Pursued widow as an “officer” responsible for taxes as she signed the return and a later partial payment of taxes. MTT Held widow not liable as not an officer and not responsible when taxes were due. Court of Appeals Affirmed. Court of Appeals rejected de jure officer—Legislature must expressly state that it is imposing a tax on a de jure officer. 2. Retroactivity Applied Officer Liability standards set forth in MCL 205.27a(5), as amended, apply to “all taxes” administered under the Revenue Act for assessments made before Jan- uary 1, 2014. Retroactively applied by the Michigan Tax Tribunal, and upheld by the Michigan Court of Appeals. B. Officer Liability Reform Enacted - Summary of Key Revisions to MCL 205.27a(5) Timing—Assessment Before January 1, 2014 -versus- Assessment After December 31, 2013 Threshold Issue: Business must not pay or file return
“if a business liable for taxes administered under this act fails, for any reason after assessment, to file the required returns or to pay the tax due” the dissolution of a busi- ness does not discharge a responsible person’s liability for a prior failure of the business to file a return or pay the tax due.
Practice Note: Officers, members, managers or partners can be held responsible
any of [non-filing or non-paying entity’s] officers, members, managers of a manager- managed limited liability company, or partners
Department must determine responsibility based on audit or investigation
[applies to person] who the department determines, based on either an audit or an inves- tigation, is a responsible person is personally liable for the failure for the taxes described in subsection (14)[i.e., trust fund taxes].
Personal liability limited to “trust fund” taxes. Similar to other states and the federal government. Officer liability applies to:
5-5 Tax Conference, 28th Annual, May 21, 2015
For ASSESSMENTS issued to responsible persons before January 1, 2014, officer liability applies to all taxes administered under the Revenue Act. MCL 205.27a(5), (14). For ASSESSMENTS issued to responsible persons after December 31, 2013, the fol- lowing:
•Sales Tax •Use Tax • Tobacco Tax • Motor Fuel Tax • Motor Carrier Fuel Tax • Withholding and remittance of income taxes • Other tax administered under the Revenue Act that a person is required to collect from or on behalf of a third person, to truthfully account for and to pay over to Michigan. MCL 205.27a(14)(a)–(b).
Practice Note: COMPARE this limited, trust fund tax exposure to prior law assessments of general business taxes against controllers, accountants and others without ownership interests or control. Responsible AND Willful: Personal liability limited to a person who had been responsible for collecting the tax or filing returns during the time period of default, and willfully failed to pay the collected tax. Very different standard than prior law. “Responsible person” means an officer, member, manager of a manager-managed limited liability company, or partner for the business who:
• controlled, supervised, or was responsible for the filing of returns or payment of any of the taxes described in subsection (14) (i.e., trust fund taxes); • during the time period of default [temporal requirement now statutory] and • who, during the time period of default, willfully failed to file a return or pay the tax due for any of the taxes at issue. MCL 205.27a(15).
“Time period of default” means the tax period for which the business failed to file the return or pay the tax due under subsection (5) and through the later of the date set for the filing of the tax return or making the required payment. MCL205.27a(15)(c). “Willful” or “willfully” means the person knew or had reason to know of the obliga- tion to file a return or pay the tax, but intentionally or recklessly failed to file the return or pay the tax. MCL 205.27a(15)(d). Prime Facie Evidence. The signature, including electronic signature, of any officer, member, manager of a manager-managed limited liability company, or partner on returns or negotiable instruments submitted in payment of taxes of the business during the time period of default, is prima facie evidence that the person is a responsible person. A signa- ture, including electronic signature, on a return or negotiable instrument submitted in pay-
5-6 Current Developments in Michigan Tax Litigation, Legislation, and Administrative Guidance ment of taxes after the time period of default alone is NOT prima facie evidence that the person is a responsible person for the time period of default but may be considered along with other evidence to make a prima facie case that the person is a responsible per- son. With respect to a return or negotiable instrument submitted in payment of taxes before the time period of default, the signature, including electronic signature, on that doc- ument along with evidence, other than that document, sufficient to demonstrate that the signatory was an officer, member, manager of a manager-managed limited liability com- pany, or partner during the time period of default is prima facie evidence that the person is a responsible person. Burden: The department has the burden to first produce prima facie evidence as described in subsection (15) or establish a prima facie case that the person is the responsi- ble person under this subsection through establishment of all elements of a responsible person as defined in subsection (15). No assessment after 4 years past the assessment of the business.
The department shall not assess a responsible person under this section more than 4 years after the date of the assessment issued to the business.
Personal liability of a responsible person limited to his or her proportionate share of the tax assessed—if more than one responsible person. Responsible person can challenge the underlying assessment. MCL 205.27a(5).
A responsible person may challenge the validity of an assessment to the same extent that the business could have challenged that assessment under sections 21 and 22 when orig- inally issued.
Department must first collect from purchaser under successor liability provisions— before pursuing officers.
Before assessing a responsible person as liable under this subsection for the tax assessed to the business, the department shall first assess a purchaser or succeeding purchaser of the business personally liable under subsection (1) if the department has information that clearly identifies a purchaser or succeeding purchaser under subsection (1) and estab- lishes that the assessment of the purchaser or succeeding purchaser would permit the department to collect the entire amount of the tax assessment of the business. The department may assess a responsible person under this subsection notwithstanding the liability of a purchaser or succeeding purchaser under subsection (1) if the purchaser or succeeding purchaser fails to pay the assessment.
In a separate proceeding in Circuit Court, a responsible person is allowed to recover amounts from other responsible persons based on their proportional share of responsibil- ity. Id.
In a separate proceeding before the circuit court, a responsible person found to be liable for the assessment under this section may recover from other responsible persons an amount equal to the assessment or portion of the assessment based on that person’s pro- portionate liability for the assessment as determined in that proceeding.
5-7 Tax Conference, 28th Annual, May 21, 2015
(5) If a The sum due for a liability may be assessed and collected under the related sections of this act. The department shall provide a responsible person assessed under this section with notice of any amount collected by the department from any other responsible person determined to be liable under this subsection or purchaser determined to be liable under subsection (1) that is attributable to the assessment. Michigan Offer- in-Compromise. HB 4003; PA 240 of 2014. VII. HB 4003 Created an Offer-In-Compromise (“OIC”) Program for the State of Michigan that Would Apply to All Michigan Taxes Department of Treasury—Offer in Compromise Program www.michigan.gov/ oic Pursuant to 2014 PA 240: Treasury is providing an “offer-in-compromise” program beginning January 1, 2015. This program will allow taxpayers to submit an offer to compromise a tax debt for less than the amount due based on one or more of these specific criteria:
1. A doubt exists as to the liability based on evidence provided by the taxpayer. 2. A doubt exists as to the collectability of the tax due based on the taxpayer’s finan- cial condition. 3. A federal offer-in-compromise has been given for the same tax year(s).
To submit an Offer in Compromise, all of the following must be true:
• The taxpayer must have filed returns for all tax periods. • The taxpayer must have been assessed and the time period for all appeals must have expired. • The taxpayer must have no open bankruptcy proceedings.
When submitting an offer in compromise: Taxpayers must submit a non-refundable initial offer payment of $100.00 or 20% of the offer, whichever is greater, and use the official Department of Treasury forms and schedules:
• Form 5181—Michigan Offer in Compromise • Form 5182—Federal Offer in Compromise from the Internal Revenue Service (IRS) • Form 5183—Doubt exists as to the Collectability (Individuals) • Form 5184—Doubt exists as to the Collectability (Business) • Form 5185—Doubt exists as to the Liability A. PA 240 of 2014 - Practice Notes and Brief History Compromise allowed based on well-developed bases:
5-8 Current Developments in Michigan Tax Litigation, Legislation, and Administrative Guidance
• Doubt as to Liability—tax is not owed; Department concludes, based on the evidence provided by the taxpayer, that the taxpayer would have prevailed in a contested case if the taxpayer’s appeal rights had not expired. • Doubt as to Collectability—taxpayer cannot pay; Department is compromising for the most that can be expected to be paid or collected from the taxpayer’s present assets or income; and Taxpayer does not have reasonable prospects of acquiring increased income or assets that would enable the taxpayer to satisfy a greater amount of the liability within a reasonable period of time.
Federal Compromise Was Allowed—Section 7122 of the Internal Revenue Code of 1986, as amended (the “Code”). Compromise purely in the interest of fair administration of taxes—although this basis for compromise would further confidence in the tax system through fair and efficient administration—e.g., standard settlement percentage for movie credit claims, it was not retained as a separate, stand-alone statutory basis for compromise. However, decisions and actions that are in the interest of the fair administration of taxes should be a major require- ment of the Department in connection with compromise analysis. Michigan tax policy and law are now much more consistent with the tax policy and law in more than 40 states and the federal government. IMPORTANTLY, this law eliminated Michigan’s prior, longstanding policy that there could NEVER be ANY compromise of a final tax liability. This amendment had been identified by some as the single most needed tax reform in the State of Michigan. IMPLEMENTATION AND CASH FLOW IMPACT Based on experience in other states and the federal government, a Michigan OIC pro- gram would result in a large inflow of cash in the first year, and an annuity of otherwise uncollectible cash from compromised taxes in future years (compromise of taxes that oth- erwise would not be paid at all). VIII. Industrial vs. Commercial Classification Disputes A. Midland Cogeneration Venture Ltd Partnership v Naftaly, 489 Mich 83; 780 NW2d 923 (2009 STC upheld assessor’s determination that large electrical equipment was properly classified as other than industrial personal property. On appeal, the Circuit Court in Wayne County reversed STC and ordered that the property be reclassified as industrial personal property. Michigan Court of Appeals reversed Circuit Court finding that it had no jurisdiction based on the statute, MCL 211.34c(6), which provides that “An appeal may not be taken from the decision of the [STC] regarding classification complaint petitions and the [STC’s] determination is final and binding for the year of the petition.”
5-9 Tax Conference, 28th Annual, May 21, 2015
Michigan Supreme Court reversed and held the statute to be invalid as unconstitu- tional as Const 1963, Art 6, Sec. 28 provides a guarantee of Circuit Court review for judi- cial or quasi-judicial final decisions of administrative officers or agencies. Result: classification decisions are appealable to Circuit Court; but the standard of review was not addressed. IX. CVS Caremark and Iron Mountain - Standard of Review from STC Decision A. CVS Casemark v Michigan State Tax Commission and City of Novi, Mich Ct App No. 312119 (July 1, 2014)(For Publication) Classification appeal—Circuit Court reversed a STC decision that denied request to classify personal property from commercial to industrial for 2011. Court of Appeals reversed Circuit Court—result: property classified as commercial and not industrial by STC—upheld STC. Standard of Review of Circuit Court: For all STC decisions, review shall include, as a minimum, the determination whether such final decisions, findings, rulings and orders are authorized by law. For cases in which a hearing is required, whether the decision is supported by compe- tent, material and substantial evidence on the whole record. Reversal by Court of Appeals Reversal: Because the review procedure in MCL 211.34c(6)(the reclassification request pro- cess) does not qualify as a hearing, the standard is limited to whether the decision was authorized by law. The Court of Appeals found that the Circuit Court applied the proper standard. However, the Court of Appeals also found that the petitioner has the burden to prove that the assessor improperly classified the property, and because petitioner did not submit evidence establishing the manner in which it used the property, it failed to meet its burden. The STC properly denied the reclassification appeal. B. Iron Mountain Information Management, Inc. v City of Livonia and State Tax Commission, Mich Ct App No 312753 (August 19, 2014)(Unpublished) STC upheld City’s denial of Iron Mountain’s request to reclassify property from com- mercial to industrial. Wayne Circuit Court determined that STC decision was not “supported by competent, material, substantive evidence on the record” and ordered the property to be reclassified as industrial. Court of Appeals held that the Circuit Court applied the incorrect standard, vacated and remanded the decision to the Circuit Court for reconsideration under the proper stan- dard, i.e., whether the STC decision was “authorized by law.” Appeal of classification under MCL 211.34c(6) involves an appeal to the STC in which “the STC shall arbitrate the petition based on the written petition and the written recommendations of the assessor and the STC staff.” The Court of Appeals determined
5-10 Current Developments in Michigan Tax Litigation, Legislation, and Administrative Guidance that this appeal process is not a “hearing” and, as such, the standard of review is “autho- rized by law” and not whether the “supported by competent, material, substantive evi- dence on the record.” The Court of Appeals noted that Iron Mountain raised arguments that could establish that the STC decision was not authorized by law, but the Circuit Court did not consider those arguments under the correct standard—and remanded for such a review.
5-11
Red Flags when Buying or Selling a Business - Federal Income Tax Committee
by Aaron Seth Feinberg General Motors Detroit Juliana G. Rolecki KPMG LLP Detroit
Nosson C. Stoll KPMG LLP Detroit
Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Aaron Seth Feinberg General Motors Detroit Juliana G. Rolecki KPMG LLP Detroit Nosson C. Stoll KPMG LLP Detroit
Exhibit Exhibit A PowerPoint Presentation ...... 6-3
6-1
Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Exhibit A PowerPoint Presentation
Red Flags of Buying and Selling a Business
State Bar of Michigan: 28th Annual Tax Conference
May 21, 2015
Notice
This information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.
Any advice in this presentation is based on the facts as stated and on authorities that are subject to change, retroactively and/or prospectively. The advice or other information in this document was prepared for the sole benefit of KPMG’s client and may not be relied upon by any other person or organization. KPMG accepts no responsibility or liability in respect of this document to any person or organization other than KPMG’s client.
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 1
6-3 Tax Conference, 28th Annual, May 21, 2015
Today’s Presenters
Aaron Feinberg Juliana Rolecki Nosson Stoll Senior Tax Counsel Senior Associate Manager General Motors KPMG LLP KPMG LLP
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 2
Agenda
• Introduction - Overview of Target and Transaction Types • Analysis of Target’s Federal Income Tax Position • Key State and Local Tax Issues • Adding Value – including Structuring the Transaction • Questions
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 3
6-4 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Introduction: Overview of Target and Transaction Types
Introduction: Tax risk mitigation process
Types of tax Tax risk Tax risk Target Transaction risk identification mitigation
Know the target Know the deal Don’t forget the small Due diligence Protect your stuff ■ Legal entity ■ Legal deal ■ Management company ■ Federal, state, and ■ Federal tax ■ Business deal ■ Income and non- ■ Change the treatment foreign income taxes structure ■ Stock vs. asset income tax filings ■ State and foreign ■ State tax treatment ■ Income tax provision ■ Purchase price ■ Know the seller non-income taxes adjustments ■ Foreign tax ■ Consideration ■ Financial statements treatment ■ Revenue-related ■ Escrows – Cash taxes ■ Legal documents ■ Partnership ■ Indemnities ■ Offering memo considerations – Shares – Sales/use ■ Quantify, quantify, ■ History of entity – Equity Rollover – Gross receipts quantify structure – VAT ■ Elections affecting ■ Real/personal target property ■ Employment taxes ■ Unclaimed property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 5
6-5 Tax Conference, 28th Annual, May 21, 2015
Introduction: What creates tax risk in a target?
Target’s materiality threshold
Limitations of Lack of accounting knowledge of systems law
Reasons for historical risk
Aggressive Prior planning Transactions
Errors in filings
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 6
Introduction: What are you buying?
Stock of corporation • Acquiring all historical risks Corporation • Public v. Private • Reg. section 1.1502-6 • Elections under IRC section 338(h)(10)
Stock of S corporation • Acquiring all historical risks S corporation • C corporation history • Quality of election and status • Elections under IRC section 338(h)(10)
Interests in partnership • Check entity status • If pass-through, acquiring mostly state/non-income tax risks P'Ship • Pay attention to tax treatment of transaction (e.g., Rev. Ruls. 99-5 and 99-6)
Stock or interests in a disregarded entity • Depending on the structure of transaction, historical tax liability could carry over DRE • QSUB fiction • Potential carryover of corporate liability when sub is checked or merged into DRE
Foreign entity treated as a branch in the U.S. Foreign • Carryover of local country tax • Verify treatment in foreign jurisdiction Branch
Real, Tangible and intangible assets • Generally limited carry over of historical income tax liabilities • Sales/use taxes, Property taxes and, in some cases, employment taxes • Some states impose successor liability for all taxes, including income/franchise taxes, when assets of trade or business are acquired
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 7
6-6 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Introduction: Comparison of Targets
Limited Liability Company (LLC) Treated as: Entity: Corporation Partnership S Corp. Partnership Corporation Disregarded
Taxpayer Entity Partner Shareholder Member LLC
Flow-through of Tax Attributes/ No Yes Yes Yes No Losses Avoid Double Tax No Yes Yes Yes No Inefficiency Build Basis in No Yes Yes Yes No Operations Tax Treatment Deliver Step-up at No Yes No (338) Yes No Looks to Owner Exit Consolidation Yes No No (QSSS) No Yes Available
Limited Liability Yes No Yes Yes Yes
Flexibility of Inflexible Flexible Inflexible Flexible Inflexible Income Allocations
Type of Owners Unrestricted Unrestricted Restricted Unrestricted Unrestricted
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 8
Introduction: Stock Acquisition – Business Issues
■ Business Issues – All Target (T) liabilities acquired/T liabilities isolated – Must move unwanted assets out of T (or wanted assets into T) – Minimal asset transfer issues – Tax rules generally don’t limit the type of consideration ■ All-voting-stock consideration may be a reorganization – Tax rules generally don’t limit post-acquisition planning ■ Post-purchase liquidation/merger can cause acquisition to be a reorganization; see Rev. Rul. 2001- 46, 2001-2 C.B. 321 ■ General Rules – Shareholders recognize gain or loss on each share of stock sold ■ Difference between amount realized on the share and the basis in the share – Acquiring gets a cost basis in each share – T survives the stock sale intact ■ No change to inside asset basis ■ No change to tax attributes, though the future use of the attributes to offset income or tax liability may be limited (e.g., Section 382) ■ No change in tax history (e.g., ability to carryback future losses to pre-acquisition taxable years)
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 9
6-7 Tax Conference, 28th Annual, May 21, 2015
Introduction: Direct Stock Acquisition
$ S P S P T stock $
T T
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 10
Introduction: Indirect Stock Acquisition – Reverse Subsidiary Cash Merger
$ S P S P $
Merger
P owns all T Newco T of T stock
T shares convert to $
** See Rev. Rul. 90-95, 1990-2 C.B. 67.
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 11
6-8 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Introduction: Stock Acquisition – Tax Effects
$100 Cost basis of $80 gain S P $100 T stock
$20 basis
T T
$10 basis and $10 basis and tax attributes tax attributes subject to limitation
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 12
Introduction: Asset Purchase
■ Business Issues – Significant title transfer issues – Need not assume liabilities (unless merger) – Only need sell/buy wanted assets – Tax rules don’t limit type of consideration ■ But if more than 38% stock, may be a tax-free reorganization, if selling corporation is liquidated – Federal tax rules don’t generally limit post-acquisition planning (state tax laws should be considered)
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 13
6-9 Tax Conference, 28th Annual, May 21, 2015
Introduction: Purchase of Subsidiary Assets
A
$ (2) (1) T P $
(1) Sale of assets. (2) Distribution of proceeds.
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 14
Introduction: Alternative Merger Structure - Forward Subsidiary Cash Merger
A P T stock converted to cash
T Acquiring
State law merger
Treated as if T sold assets to Acquiring and T liquidated, See, Rev. Rul. 69-6, 1969-1 C.B. 104
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 15
6-10 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Introduction: Compare Forward Subsidiary Cash Merger With Asset Sale
■ Both alternatives result in: – Stepped-up basis in T assets – Two levels of tax – Any unused T NOLs disappear ■ Merger – Requires both T shareholder and Acquiring shareholder approval – No re-titling of assets – Acquiring has unlimited liability exposure ■ Direct Asset Sale – Only T shareholder approval – Acquiring assumes specific T liabilities
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 16
Introduction: Purchase of Subsidiary Assets - Tax Effects
Stock basis X of $10
$100 Corporate Level S P $90 gain $10 basis Asset
Shareholder Level $100 $0 gain X liquidating retains attributes distribution S basis disappears
S Asset basis of Section 332 P $100 Cash Liquidation $100
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 17
6-11 Tax Conference, 28th Annual, May 21, 2015
Introduction: Purchase of Stand-alone Corporation’s Assets - Tax Effects
$10 stock A basis
$100 (2) Assets T (1) P
$100 $10 asset basis
(1) Sale of assets. (2) Distribution of proceeds.
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 18
Introduction: Purchase of Stand-alone Corporation’s Assets - Tax Effects (continued)
$10 A Stock basis
$100 Corporate Level T $90 gain P $10 basis Section 1001 Asset basis of Assets $100 $100 proceeds over Section 1012 $10 basis Shareholder Level $90 gain Section 331 T P $100 Cash Liquidation
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 19
6-12 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Introduction: Types of tax risk: Corporations
Federal State City/County Foreign ■ Income ■ Income ■ Property ■ Income ■ Employment ■ Franchise ■ Income ■ Social/payroll ■ Gross receipts ■ Sales/use ■ Property ■ Sales/use ■ Business ■ VAT ■ Real/Personal license/gross property receipts ■ Employment ■ Miscellaneous (e.g., NYC ■ Miscellaneous Commercial Rent excise taxes Tax) ■ Unclaimed property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 20
Introduction: Types of tax risk: S corporations
Federal State City/County ■ Income ■ Income ■ Property (dependent on (dependent on ■ Income quality and timing state treatment of of S status) S corporations) ■ Sales/use ■ Employment ■ Franchise ■ Business license/gross ■ Gross receipts receipts ■ Sales/use ■ Miscellaneous ■ Real/Personal (e.g., NYC property Commercial Rent ■ Employment Tax) ■ Miscellaneous excise taxes ■ Unclaimed property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 21
6-13 Tax Conference, 28th Annual, May 21, 2015
Introduction: Types of tax risk: Partnerships
Federal State City/County ■ Employment ■ Income ■ Property (dependent on ■ Income state treatment of partnerships) ■ Sales/use ■ Franchise ■ Business license/gross ■ Gross receipts receipts ■ Sales/use ■ Miscellaneous ■ Real/Personal (e.g., NYC property Commercial Rent ■ Employment Tax) ■ Miscellaneous excise taxes ■ Unclaimed property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 22
Introduction: Types of tax risk: Disregarded entities
Federal State City/County Foreign ■ Employment ■ Income ■ Property ■ If U.S. DRE owns (dependent on ■ Income a foreign entity, state treatment of local country taxes DRE) ■ Sales/use may carryover in ■ Franchise ■ Business the acquisition of a license/gross U.S. DRE ■ Gross receipts receipts ■ Sales/use ■ Miscellaneous ■ Real/Personal (e.g., NYC property Commercial Rent ■ Employment Tax) ■ Miscellaneous excise taxes ■ Unclaimed property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 23
6-14 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Introduction: Types of tax risk: Foreign branch
Foreign ■ Depending on the foreign branch’s status in the local country, full carry over of historical tax risk is possible, including: – Income – Social/payroll – Property – VAT
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 24
Introduction: Types of tax risk: Assets
Federal State City/County Foreign ■ Employment ■ Sales/use ■ Property ■ If one of the assets (dependent on ■ Real/Personal ■ Sales/use acquired is a state law doctrine property foreign entity, local of successor ■ Business country taxes may liability) ■ Gross receipts license/gross carryover in the ■ Unclaimed receipts acquisition of property ■ Miscellaneous U.S. assets ■ Dependent on (e.g., NYC successor liability Commercial Rent statutes within the Tax, etc.) states: – Income – Franchise – Employment
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 25
6-15 Tax Conference, 28th Annual, May 21, 2015
Tax Attributes
26
Net Operating Losses (“NOLs”) and Other Tax Attributes
■ NOL Definition – excess of allowable deductions over gross income ■ Carryovers – Purpose: smooth out earnings a. Current –2 years back/20 years forward b. Prior to 8/6/97 – 3/15 ■ Other Attributes – General Business Credits, Capital Losses, Foreign Tax Credits
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 27
6-16 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Section 381
Will target’s tax attributes carry forward? Depends on acquisition structure ■ Taxable stock purchase – yes ■ Taxable asset purchase – no ■ Taxable stock purchase with Sections 338(h)(10) or 338(g) election – no ■ Tax-free merger, stock-for-asset or stock-for-stock transaction – yes
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 28
Sections 382 and 383 Overview
■ Section 382 is the operative provision which limits utilization of NOL upon an ownership change ■ Section 383 is a companion provision that applies the same limitations to the use of other tax attribute carryforwards – Examples: Alternative Minimum Tax (“AMT”) Credits; Foreign Tax Credits (“FTCs”); Net Capital Losses & General Business Credits ■ Limitations are based on the “neutrality principle”
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 29
6-17 Tax Conference, 28th Annual, May 21, 2015
Section 382 Overview
■ Determination of whether an ownership change has occurred ■ Computation of annual limitation ■ Net unrealized built-in gain/loss analysis
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 30
Ownership Change
■ In general, a “loss corporation” will have an “ownership change” under Section 382 when on a particular “testing date” the percentage stock ownership (by value) of one or more “5-percent shareholders” has increased by more than 50 percentage points over the lowest percentage stock ownership (by value) held by such shareholders at any time during the “testing period.”
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 31
6-18 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Loss Corporation
■ Any corporation having: – NOL carryover Section 382 – NOL in the year of an ownership change – Net unrealized built-in loss (tax basis in all assets exceeds fair market value of all assets by more than an established threshold) – Capital loss carryover Section 383 – General business credit carryover – Minimum tax credit carryover – Foreign tax credit carryover
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 32
Testing Date and Testing Period
■ Testing Date – Sale by 5-percent shareholder/higher tier entity – Purchase by 5-percent shareholder/higher tier entity – Stock issuance – Stock redemption – Option exercise – Equity structure shift ■ The Testing Period is generally a rolling three-year period ending on the testing date
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 33
6-19 Tax Conference, 28th Annual, May 21, 2015
5-percent Shareholders
Type If ownership percentage ≥ 5-percent Individuals 5-percent shareholder Corporations Attribute ownership to s/h Partnerships Attribute ownership to partners Trusts Attribute ownership to trustee/beneficiary ESOPs 5-percent shareholder Governments 5-percent shareholder Investment Treatment depends whether IA is the “economic owner” advisors
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 34
“Economic Owner”
■ In private letter rulings, the IRS has stated that the economic owner is the relevant ownership for tracking Section 382 owner shifts (e.g., PLR 200747016) ■ The economic owner is the person with the right to receive dividends on the stock if declared and the right to the proceeds upon sale of the stock
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 35
6-20 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Example
A, B, VC Corp. Public, and LossCo B C VC Corp. Public Public are the 5- percent shareholders for Section 382 8% purposes. 30% 62%
VC Corp. A LossCo Public
40% 40% 20%
LossCo
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 36
Annual Limitation
Equity value immediately before ownership change (Special adjustments)
Adjusted equity value x AFR for ownership changes in given month
Basic annual limitation
Direct adjustments to Section 382 annual limitation under certain conditions
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 37
6-21 Tax Conference, 28th Annual, May 21, 2015
Starting Point: Equity Value
■ The relevant equity value is how much it would cost to buy 100-percent of the equity of a company immediately before the ownership change. ■ In the absence of an independent valuation, the taxpayer may, within limits, reasonably project the value of its stock by reference to the stock value in the transaction triggering the ownership change or by reference to the public trading price. Often, such “grossed up” values give a lower figure than an independent valuation.
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 38
Annual Limitation
Example Cumulative NOL$ 100,000,000 Years remaining on carryforward 12 Equity value, net of adjustments$ 50,000,000 AFR for May 2015 2.30%
Limitation under Section 382$ 1,150,000 Years remaining on carryforward 12
Total NOL available 13,800,000
NOL to expire unutilized 86,200,000
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 39
6-22 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Computation of LossCo’s Section 382 Annual Limitation
Equity value, absent a formal valuation: Common Stock Equity value Shares Possible Adjustments Per share value x______Redemption or Series A Preferred corporate contraction Shares Capital contributions Per share value x______Non-business assets Series B Preferred (if threshold is met) Shares Owned controlled group member’s equity value Per share value x______absent an election ______Options ( ) Adjusted stock value Underlying shares AFR x______Per share value Estimated Section 382 less exercise price x______Annual Limitation ______======
======
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 40
Continuity of Business Enterprise
■ Continuity of business enterprise similar to that contained in Section 368 ■ Requirement is met if: – Continue a significant portion of the historical business, or – Use the historical assets of old lossco in a new business ■ If the loss company fails to meet the continuity of enterprise requirement for the two year period following the ownership change, the Section 382 annual limitation is zero from the date of the ownership change
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 41
6-23 Tax Conference, 28th Annual, May 21, 2015
Net Unrealized Built-in Gain/Loss
NUBIG NUBIL FMV of assets before change exclusive of cash & marketable securities exceeds is less than Tax basis in assets + built-in income items – built-in deduction items
by the lesser of
■ 15% of FMV of assets or ■ $10,000,000
[NUBIL Asset FMV may be capped at liabilities plus equity]
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 42
Net Unrealized Built-in Gain/Loss (continued)
■ Compute the difference between: – The fair market value of all assets immediately before the ownership change, and – The loss company’s tax basis in such assets ■ Add/subtract items of built-in income/built-in deduction ■ Compare this net amount to the computed de minimis threshold ■ If the absolute value of the difference does not exceed the de minimis threshold, no special treatment is accorded recognized built-in gains/losses
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 43
6-24 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Net Unrealized Built-in Gain (Loss) and Recognized Built-in Gain (Loss)
If loss corporation Then built-in gains (losses) to the extent is in such position built-in at the time of the change: on change date,
Recognized in 5-year Recognized after recognition period recognition period
BIGs up to amount of NUBIG NUBIG – Increase limitation BILs – No special treatment BIGs – No special treatment NUBIL BILs – Subject to same limitation as other pre-change losses
Proof of amount built-in at change date necessary to refute presumptions that: (i) BIG occurred post-change, or (ii) BIL attributable to pre-change
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 44
Net Unrealized Built-in Gain/Loss
■ Notice 2003-65, September 2003 – Section 338 approach (NUBIG), or – Section 1374 approach (NUBIL) (Not exclusive methods) – Retroactive application
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 45
6-25 Tax Conference, 28th Annual, May 21, 2015
Multiple Ownership Changes
■ A given limitation applies to a set pool of NOLs – “Pre-change NOLs” – NOL carryforwards can be subject to multiple Section 382 limitations ■ Determine the NOL pool and the annual limitation from each ownership change ■ Evaluate the NOL availability in a given year of each NOL pool by determining the availability of each pool chronologically ■ Be careful not to exceed the total amount of pre-change NOLs that can be used (e.g., pre-first change NOL usage reduces the amount of NOL that can be used from the pool of NOLs that are post-first change and pre-second change) ■ A limitation from a second ownership change can further restrict a limitation form a prior ownership change, but a limitation from a second ownership change cannot increase a limitation from a prior ownership change
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 46
Section 382 Limitation – State Conformity
■ States generally adopt Section 382, but the methodology of conformity varies – By its terms, Section 382 limits (a) Section 172 NOLs and (b) recognized built-in losses (RBILs) by a NUBIL corporation – If a state utilizes the federal NOL (i.e., “line 29a”), generally the NOL will be subject to the Section 382 limitation, assuming the state IRC definition embodies Section 382 – If a state does not utilize the federal NOL (i.e., a separate state NOL is utilized), the NOL generally will be subject to the Section 382 limitation if the state either (a) specifically provides for the application of Section 382 to that NOL, or (b) indicates that the NOL is subject the same limitations as a federal NOL (and the state IRC definition embodies Section 382) ■ In such cases, the question of whether the Section 382 limitation is apportioned at the state level becomes relevant – Many states lack specific guidance on how to apply Section 382 limitation at the state level. As a result, a position exists that taxpayers apply the federal limitation to the state NOL carryover
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 47
6-26 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
S Corporations: Diligencing the S Election
48
S Corporations: Tax Risks
Federal ■ Income – depending on quality and timing of S election ■ Employment State and local ■ Income – depending on state treatment of S corps ■ Franchise/gross receipts ■ Sales/use ■ Real/personal property ■ Employment ■ Excise tax, business license tax, miscellaneous ■ Unclaimed property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 49
6-27 Tax Conference, 28th Annual, May 21, 2015
S Corporations: The S Election
■ Election - Form 2553 (and separate state election, if applicable) – Effective date must be beginning of corp’s tax year – Must be filed within 2.5 months of effective date or during the preceding tax year – In first year of existence, election must be filed within 2.5 months of first having shareholders/assets/doing business – Must be eligible to be an S corp at time election is made (and at all times when in effect) – Signatures and consent ■ All shareholders that own stock on the date the election is filed must sign the Form 2553 ■ If retroactive, all shareholders that owned stock during the period covered must sign ■ All spouses of shareholders if in community property state ■ Also needs signature by authorized officer
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 50
S Corporations: Eligibility of Corporation
■ Eligibility of corporation to elect S status – Domestic, eligible corporation ■ If not a corporation, the S election is deemed to be a check-the-box election for elections after 7/20/2004. Previously required to also file Form 8832 ■ Certain entities ineligible (e.g. banks, a corporation that elects to have Section 936 possessions credits apply, a DISC, or an insurance company) ■ Termination– if corp terminates its S election it is not eligible to make an S election for 5 years – The corp must have only one class of stock ■ Do the articles or bylaws authorize another class of stock? ■ Disproportionate distributions (incl. paying state income tax for shareholders) ■ Buy-sell or stock redemption agreements ■ Debt that could be reclassified or is convertible into equity ■ Stock options or warranties
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 51
6-28 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
S Corporations: Eligibility of Shareholders
■ Number and eligibility of shareholders – 100 or fewer shareholders ■ Pre-1997 the maximum was 35; from 1997 to 2005 maximum of 75 ■ Husband and wife and, after 2005, “members of a family” are treated as a single shareholder. – Eligible shareholders ■ Not a nonresident alien ■ Spouse must also be eligible in community property state ■ Estate of decedent or bankrupt ■ Domestic grantor trust if grantor is eligible ■ QSST – beneficiary must be eligible ■ Qualified domestic testamentary trust – 2yr ■ Electing small business trust – all beneficiaries must be eligible ■ A 501(c)(3) or 401(a) organization
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 52
S Corporations: Termination
■ Termination of S election – Corporation ceases to be eligible S corporation ■ Transfer of stock to ineligible shareholder ■ Disproportionate distributions ■ Conversion of debt to stock by ineligible lender – Revocation of S election – If the corporation has E&P and excess passive investment income for 3 consecutive years ■ Passive investment income exceed 25% of gross receipts for 3 consecutive years.
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 53
6-29 Tax Conference, 28th Annual, May 21, 2015
S Corporations: QSubs
■ Qualified Subchapter S Subsidiaries (QSubs) – For tax years after 12/31/1996, the S corp can make a QSub election for certain wholly-owned subsidiaries ■ QSub must be: – An eligible domestic corporation – 100% owned by the S corporation – QSub election was made ■ QSub treated as a division for income tax purposes (like a DRE) but as a separate corporation for employment and excise tax purposes
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 54
Key State and Local Tax Issues
55
6-30 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Key SALT Issues: Successor Liability
Successor Liability ■ Stock sale – All SALT exposures remain with Target – An asset sale for federal income tax purposes may be treated as a stock sale for SALT purposes ■ Some states impose an entity-level tax on S corps, partnerships, and DREs ■ Even if no entity level tax, flow-throughs may be liable for non-resident withholding on partners ■ Asset sale – Income tax and federal withholding/employment taxes generally do not transfer ■ Some states impose successor liability on income taxes (Illinois, Florida, Michigan, Pennsylvania, South Carolina, Texas) – The following taxes generally transfer to Buyer: ■ Sales and use; Gross receipts; State unemployment tax; Property taxes; Unclaimed property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 56
Key SALT Issues: Successor Liability (cont.)
■ Tax clearance certificates – State statutes may require Buyer to establish escrow or otherwise be held liable for all unpaid tax liabilities of Seller unless a tax clearance certificate is obtained ■ See i.e. MCL 205.27a ■ Bulk sale notification – Some states impose a “bulk-sale” filing requirement – Some states require Seller to file a final sales/use tax return – Some states require Buyer to obtain a tax clearance certificate
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 57
6-31 Tax Conference, 28th Annual, May 21, 2015
Key SALT Issues: Target’s Tax Profile
■ Income taxes – Apportionment ■ How is Target sourcing revenue? – services - cost of performance or market based – sales of TPP - by destination ■ Does the aggregate apportionment equal roughly 100%? – Nexus ■ Does Target have a physical presence (personnel or property) in state – Compare apportionment data to tax filings ■ Statute of limitations does not start running until returns have been filed – State filing methodology ■ Separate company v. combined/consolidated filing – 23 states have mandatory combined reporting
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 58
Key SALT Issues: Target’s Tax Profile (cont.)
■ Sales and use tax – Sales and use tax generally imposed on sales of TPP and enumerated services – Each legal entity should file sales/use tax returns (no flow-through) – Nexus is easier to establish (no P.L. 86-272 protection) ■ Physical presence ■ Attributional/agency/affiliate nexus – Exemptions/Exceptions ■ No sales/use tax (Alaska, Delaware, Montana, New Hampshire, Oregon) ■ No nexus ■ Sales for resale – Is Target maintaining adequate documentation (exemption certificates, etc.) and procedures ■ Industrial processing exemption ■ Sales to exempt customers, i.e. non-profits, government, etc.
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 59
6-32 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Key SALT Issues: Target’s Tax Profile (cont.)
■ Property taxes – Real property tax ■ Typically imposed by locality, generally, no return required – Personal property tax ■ Imposed on tangible business property – But not always on inventory ■ Generally requires a return to be filed
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 60
Key SALT Issues: Target’s Tax Profile (cont.)
■ Employment taxes – State personal income tax withholding ■ Multi-state withholding ■ Minimum amount of time spent in state ■ Reciprocity among certain states – Worker classification ■ Employee v. independent contractor – Facts and circumstances analysis – Review of Forms 1099 helpful in determining whether there are repeat individual contractors that are receiving substantial payments
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 61
6-33 Tax Conference, 28th Annual, May 21, 2015
Key SALT Issues: Target’s Tax Profile (cont.)
■ Unclaimed property – Unclaimed property must be reported and ultimately remitted to the state – Target may have unclaimed property in the form of uncashed payroll and/or vendor checks, unused gift cards or gift certificates, unused advertising credits. – Dormancy period varies by state and type of property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 62
Key SALT Issues: Transfer Taxes
■ Sales/use tax – Generally states have an occasional or casual sale exemption that will exempt sales of all the assets of a business. ■ Some exemptions are more restrictive (CA, FL, MD, NY) – Resale exemption may apply but exemption certificate may be required – Manufacturing equipment exemptions ■ Realty transfer tax – About 35 states impose real estate transfer tax based on the consideration paid (between 0.1% and 5%) – Certain states impose realty transfer tax on transfers of certain (long-term) leases of real property (CT, NY, IL, NJ, PA, and others) – Stock deal ■ Certain states impose realty transfer tax on the transfer of a controlling interest in an entity that owns real property
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 63
6-34 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Adding Value
64
Transaction Costs: General Rule
■ A taxpayer must capitalize an amount paid to facilitate a transaction – Without regard to whether the transaction is comprised of a single step or a series of steps carried out as part of a single plan, and – Without regard to whether gain or loss is recognized in the transaction ■ Applies to most “capital” transactions – Acquisition of assets – Acquisition of ownership interests – Formation of entity – Restructurings, recapitalizations, and reorganizations – Stock issuances and other acquisitions of capital
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 65
6-35 Tax Conference, 28th Annual, May 21, 2015
Transaction Costs: Covered Transactions
■ Covered transactions – A taxable acquisition by the taxpayer of assets that constitute a trade or business – A taxable acquisition of an ownership interest in a business entity ■ Applies to acquirer or target of the acquisition, if ■ The acquirer and the target are related immediately after the acquisition (for two corporations, generally more than 50 percent ownership) – A tax-free stock or asset acquisitive reorganization transaction
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 66
Transaction Costs: Inherently Facilitative Costs
■ Inherently Facilitative Costs – Appraisal, written evaluation, fairness opinion – Structuring transaction, negotiating, tax advice – Preparing and reviewing transaction documents – Obtaining regulatory approval – Obtaining shareholder approval of transaction ■ Proxy costs ■ Solicitation costs – Conveying property ■ Transfer taxes ■ Title registration
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 67
6-36 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Transaction Costs: Investigatory Costs
■ Investigatory Costs – Bright Line Date – investigatory activities performed before earlier of: ■ Letter of intent, exclusivity agreement, or similar written communication; or taxpayer’s board approval – Pre-Bright Line Date investigatory expenses not facilitative – Investigatory Expenses ■ Analysis or survey of potential markets, products, labor supply, transportation facilities, etc. ■ Investigate the products, services, reputation of the acquirer, and fit with the target and the target’s community ■ Search for and the investigation of a target business ■ Planning and modeling ■ Due diligence and similar costs
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 68
Transaction Costs: Deductibility
■ Section 162 v. Section 195 Treatment – Section 162: Deductions generally allowed for expenses paid or incurred for carrying on any trade or business ■ Business expansion permissible under Section 162 – Section 195: Amounts paid or incurred with investigating the acquisition of an active trade or business are generally amortizable over a 15-year period if TP makes timely election
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 69
6-37 Tax Conference, 28th Annual, May 21, 2015
Section 338
■ Election to treat “qualified stock purchase” as an asset purchase ■ Two types of elections: – Section 338(g) – Stand-alone T; two levels of tax – Section 338(h)(10) – Subsidiary T or S corp.; one level of tax ■ Legislative history states that a Section 338 election is intended to replace all nonstatutory means of treating a stock purchase as an asset purchase (at least where doing so would result in a stepped-up basis in T’s assets) – Kimbell-Diamond Doctrine ■ Business Advantages – No asset transfer (e.g., re-titling, loan covenants, local transfer taxes, leases, etc.) ■ Business Disadvantages – Must move unwanted assets out of T
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 70
Section 338(g)
■ Election is made by the Acquirer and does not require consent of the Seller ■ Target shareholders are treated as having sold their shares to the purchaser ■ Target is then deemed to sell all of its assets at fair market value at the close of the acquisition date ■ A new corporation (New Target)is deemed to purchase all the assets of Old Target at the beginning of the day after the acquisition date ■ Tax liability arising on the deemed sale of assets, after utilization of any Target tax attributes (e.g., NOLs), will remain the obligation of the purchaser ■ New Target does not acquire Old Target’s tax attributes ■ A corporation should consider making the election if: – Target has NOLs (U.S. tax on deemed asset sale offset by NOLs) – Target is a non-U.S. corporation (no U.S. tax on deemed asset sale because Target is not subject to U.S. tax)
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 71
6-38 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Section 338(g) Election
Actual Transaction
S $100 ($10 basis in T shares) P Effect of Election
100% of T shares T T ($10 basis in assets) ($10 basis in assets) P
S has an $90 gain and P owns T that has a $10 basis in its assets. T assets Old T New T ($90 gain on ($100 basis in sale of assets) assets) $100
P makes a Section 338(g) election which treats Old T as selling assets to New T and realizing $90 gain on this deemed sale. New T gets a step up to $100 in basis of its assets. Any U.S. tax on deemed asset sale is paid by Old T (now owned by P). © 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 72
Section 338(h)(10)
■ Joint election by purchasing corporation and seller to treat the share sale/purchase as an assets sale/purchase (buyer and seller must agree to make election) ■ There must be a “Qualified Stock Purchase” (generally a taxable purchase of more than 80 percent of an unrelated target’s shares within a 12-month period) ■ Target must be a subchapter S Corporation or a subsidiary in a U.S. consolidated or affiliated group (cannot be made for parent of a U.S. consolidated group) ■ Target shareholder’s stock sale is disregarded. Old Target is treated as selling its assets to New Target, and distributing the sales proceeds in liquidation to its shareholders ■ Deemed asset sale generally results in one layer of tax to seller ■ Tax liability on deemed sale is obligation of the seller ■ The election can impact the type of income recognized by the seller (e.g., ordinary vs. capital) and there are sometimes additional state tax costs (the buyer and seller must negotiate which party bears any additional tax costs of making the election – careful drafting of purchase and sale agreements is critical)
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 73
6-39 Tax Conference, 28th Annual, May 21, 2015
Section 338(h)(10) Election (Subsidiary of Consolidated Group)
S ($10 basis in T P shares)
$90 gain $100 $100 Old T New T ($100 basis in ($10 basis in assets) assets) Assets S ($100 basis in T P T (Old T) is treated as selling shares) assets to New T and Old T realizes $90 gain on this deemed sale - New T gets a step $100 Tax-free liquidation up of $100 in basis of its assets New T Old T ($100) ($100 basis in assets) Old T then is treated as liquidating and distributing proceeds to S in a tax-free liquidation - thus, only one layer of tax
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 74
Section 338: Gross Ups
■ Section 338(h)(10) election – To the extent Seller would incur a greater tax liability on the deemed sale of assets as a result of making an Section 338(h)(10) election, often times a Buyer will “gross-up” the seller to compensate the seller for this cost – In addition, a well advised Seller may request that the Buyer share some of the benefit that the Buyer will realize as a result of making an Section 338(h)(10) election
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 75
6-40 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Section 338: State Conformity
■ States generally adopt the federal income tax treatment of an Section 338(h)(10) election ■ Exception: Jurisdictions that do not follow the federal income tax treatment of an S corporation: – New York City: RCNY §11-27(j) ■ New York City does not recognize S corporations and does not recognize deemed asset sale treatment of Section 338(h)(10) ■ There is no step up in the basis of the assets for New York City purposes and also no gain subject to New York City income tax – Texas: Tex. Admin. Code 3.591(e)(2) and (e)(7) ■ Texas does not recognize S corporations ■ For apportionment purposes, gain from intangibles (e.g., goodwill) is sourced to the state of legal domicile of Buyer
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 76
Section 338: Incremental Costs
■ Incremental state tax cost of making the election – Compare cost of making straight stock acquisition of an S corporation ■ Typically subject to tax in the state of shareholder residence ■ Not uncommon for shareholders to be residents (sometimes recent transplants) of states that do not impose a personal income tax – Compare cost of making an asset acquisition ■ Gain typically apportioned among states where company has nexus ■ Personal income tax rates may vary by state ■ Credit in home state for taxes paid in non-resident states ■ Include the amount resulting from entity level tax on S corporations – e.g., California, Illinois, etc.
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 77
6-41 Tax Conference, 28th Annual, May 21, 2015
Section 338: Incremental Costs (cont.)
■ Incremental state tax cost of making the election – Compare cost of acquiring the stock of member of consolidated group ■ Gain recognized by Parent (entity selling the Target stock) ■ Consider business income v non-business income treatment of the gain ■ Consider the sales factor sourcing treatment of the assets held by Target ■ Consider the availability of any NOLs to offset the gain at Parent – Compare cost of making an asset acquisition from Target ■ Gain recognized by Target ■ Consider business income v non-business income treatment of the gain ■ Consider the sales factor sourcing treatment of the assets held by Target ■ Consider the availability of any NOLs to offset the gain at Target
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 78
Section 336(e) Election: Deemed Asset Sale
■ Final regulations promulgated May 10, 2013 ■ In effect, applies Section 338(h)(10) concepts – Treats certain sales and distributions of 80% of T stock as a sale or distribution of T assets – disregards stock sale ■ Does not require a “corporate purchaser” to acquire 80% – Can be diffuse acquisitions by, e.g., corporations, individuals, partnerships, public shareholders – Need not be part of a plan ■ S and T must be domestic corporations (or T must be an S corporation) ■ Loss limitation rule for distributions
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 79
6-42 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Section 336(e): Qualifications
■ An irrevocable election is available for a “qualified stock disposition” (“QSD”) of domestic target stock by a domestic corporate seller (or for an S corporation) ■ The regulations adopt the structure and principles of Section 338(h)(10) and the regulations thereunder. ■ A QSD is – A transaction or series of transactions – Stock meeting the requirements of Section 1504(a)(2) – Of a domestic corporation (C corporation or S corporation) – Sold, exchanged, or distributed, or combination – By a domestic corporation (or by members of a consolidated group or by an S corporation’s shareholders) – Within 12-months
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 80
Section 336(e): Qualifications (cont.)
■ Disposition includes: sale, exchange, or distribution or combination thereof ■ A Disposition does not include: – Carryover basis transactions, – Transactions in which the basis is determined under Section 1014, – Transactions to which Section 351, 354, 355, or 356 applies (exception for transactions within the meaning of Section 355(d) and (e)), or – A sale, exchange, or distribution to a related person ■ Whether a person is related is determined under Section 318(a) (without application of the option rule in 318(a)(4)) – Only attributes stock ownership from a partner to a partnership or from a partnership to a partner if the partner owns 5% or more of the value of the partnership
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 81
6-43 Tax Conference, 28th Annual, May 21, 2015
Section 336(e) - Basic Operational Rules
■ Three models – Basic Model - Like Section 338(h)(10) – Distribution of T stock in non-355 transaction ■ Basic Model with loss limitation rule – Distribution of T stock in Section 355(d)/(e) transaction ■ Sale-to-Self Model: same as general distribution rule except that T keeps its attributes ■ Combination of distribution and sale of T stock – Net Loss Disallowance Percentage: limits net losses on percentage attributable to all distributions within the 12-month period ■ Section 336(e) v. 338 – Generally, in the case of a QSP, Section 338 rather than Section 336(e) will apply – Exception – If deemed sale of lower-tier stock as a result of a Section 336(e) deemed asset sale, election for lower-tier made under Section 336(e) rather than Section 338
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 82
Section 336(e) Basic Model
S PRS
T T
S sells all T stock to PRS Sale not a QSP but is a QSD S and T make Section 336(e) election
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 83
6-44 Red Flags when Buying or Selling a Business - Federal Income Tax Committee
Basic Model (continued)
S PRS
T New T
S’s sale of stock ignored Treated as if T sells assets to New T for ADADP Generally for amount paid for stock plus T liabilities New T gets cost basis equal to AGUB
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 84
Basic Model (continued)
S PRS
Old T New T
Old T deemed to liquidate in transaction generally qualifying as 332
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 85
6-45 Tax Conference, 28th Annual, May 21, 2015
Questions?
© 2015 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 86
© 2015 KPMG, LLP, a Delaware limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.
The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.
6-46 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
by Liam K. Healy Ferguson Widmayer PC Ann Arbor
Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
Liam K. Healy Ferguson Widmayer PC Ann Arbor
I. Introduction...... 7-1 II. Supreme Court Cases Involving ERISA...... 7-1 III. Cases of the 6th Circuit...... 7-10 IV. Other Circuit Court Decisions Involving ERISA ...... 7-14 Exhibit Exhibit A PowerPoint Presentation ...... 7-25 I. Introduction The U.S. Supreme Court has rendered several ERISA decisions in the course of its current and most recent term. The Court is due to issue another opinion shortly. These decisions each have a significant impact on plan fiduciaries and the administration of employee benefit plans. In addition to recent decisions at the Supreme Court level, there have been many circuit court decisions having an effect on the way that employee benefit plans are to be governed. For practitioners charged with advising participants and plan fiduciaries of their respective rights and obligations under ERISA, a basic understanding of these recent decisions is critical. These materials will attempt to provide a summary of the recent opinions impacting plan administration under ERISA. II. Supreme Court Cases Involving ERISA A. Tibble v. Edison International, U.S. Supreme Court Docket No. 13-550 - Statute of Limitations in ERISA Litigation Tibble is a 9th Cir Case currently before the U.S. Supreme Court. Certiorari was granted on October 2nd, 2014 to consider “Whether a claim that ERISA plan fiduciaries breached their duty of prudence by offering higher-cost retail-class mutual funds to plan participants, even though identical lower-cost institution-class mutual funds were avail- able, is barred by 29 U. S. C. §1113(1) when fiduciaries initially chose the higher-cost mutual funds as plan investments more than six years before the claim was filed.” Facts and Procedural History. The case was initially heard in the district court for the central district of California. Defendant, Edison International, is a holding co for mul- tiple electrical utility companies, including the Southern California Edison Company, that provides a self directed401(k) plan to participants. At the time of filing in 2007, the plan help approximately 3.8 billion in assets. Participants originally had an investment menu consisting of six investment options. After a study conducted by the plan fiduciaries and a period of collective bargaining, in or about 1999, participants were provided additional options:
7-1 Tax Conference, 28th Annual, May 21, 2015
• 10 institutional investment funds • A “Unitized Fund” (investing in company stock) • 40 “mutual fund type” investments • Revenue sharing was also introduced in 1999.
The mutual funds were retail class mutual funds with higher fees than alternative institutional funds available to larger investors. Participants of the plan filed suit against Edison and gained class certification. The class alleged that the inclusion of the retail class mutual fund was imprudent in violation ERISA section 404. The participants also alleged that the revenue sharing violated the plan document and was a conflict of interest. Finally, the participants alleged that offering the unitized stock fund was imprudent. The District Court granted summary disposition for most of the claims, determining that ERISA’s statute of limitations barred claims relating to investments included in funds more than six years before the participants filed suit. The court held a bench trial on the issue of the inclusion of retail class investments added within the six year period and defendant’s failure to investigate institutional class alternatives. The District Court awarded damages in the amount of $370,000.00. Defendant appealed the award of dam- ages and plaintiffs appealed the dismissal of claims based on the statute of limitations. 29 USC 1113(ERISA section 413) provides:
No action may be commenced under this subchapter with respect to a fiduciary’s breach of any responsibility, duty, or obligation under this part, or with respect to a violation of this part, after the earlier of— (1) six years after (A) the date of the last action which constituted a part of the breach or violation, or (B) in the case of an omission the latest date on which the fidu- ciary could have cured the breach or violation, or (2) three years after the earliest date on which the plaintiff had actual knowledge of the breach or violation; except that in the case of fraud or concealment, such action may be commenced not later than six years after the date of discovery of such breach or violation.
The Circuit Court. The plaintiff class, with support from the Department of Labor, argued that ERISA Section 413 imposes a continuing violation theory, i.e. fiduciary duties are ongoing and section413 refers to the last action constituting a breach by plan fiducia- ries. Plaintiffs argue the district court erred in applying section 413 to commence with the initial inclusion of the subject funds. The Circuit Court refused to adopt the continuing violation theory stating that to do so confuses a fiduciary’s failure to remedy imprudence with a second act of imprudence. This reading renders section 413(1)(A) meaningless (there is no 6 year statute because the stat- utory period never starts) and would expose trustees to exposure for long ago acts. Further, the court concludes that the omissions provision of section 413(1)(B) already embodies what plaintiffs and the DOL argue is the last action. The court reasoned that 413(B) acts to tie the statutory period to the latest date a fidu- ciary could have cured its breach. To apply the omission concept in a 413(a) context would be to render 413(B) meaningless. The court seems to be saying that if the impru- dence was the act of including the funds, plaintiffs cannot use an omission concept to
7-2 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee carry the act forward indefinitely; it is either an act or an omission, you cannot have it both ways. The court denied that its reading of section 413 will give fiduciaries carte blanche. The lower court allowed evidence of a possible change in circumstances and the right evi- dence of a change could lead to the conclusion that fiduciaries should have acted after the initial breach, amounting to a second breach. The court recognizes that fiduciaries have a duty to invest and to continue to invest prudently. If circumstances change making a par- ticular investment imprudent, fiduciaries would be liable for failure to act (a new breach). This position by the court is embraced by the 4th, 11th and 9th Circuit and is the focus of enquiry at oral arguments before the U.S. Supreme Court. Defendant argued that the District Court erred in failing to apply the three year statute of limitations contained in section 413(B)(2) given that Plaintiff beneficiaries had actual knowledge of the presence of retail class mutual funds more than three years before filing suit. This would have barred certain of the claims allowed. The Court rejected this argu- ment stating that knowledge of inclusion of funds was not knowledge of a breach given that the breach related to the failure to consider institutional class alternatives. The court focused on the fact that the theory of liability pursued at trial was that the fiduciary had failed to investigate retail class alternatives. Despite Defendant’s argument that Plaintiff’s had knowledge of the investments based on summary plan descriptions and other materi- als, the court concluded that liability for imprudent investments is based on how the fidu- ciary selected the investment, not the fact that the investment was made. For this reason, Plaintiffs did not have actual knowledge of the breach and section 413(B)(2) was not applicable. The circuit court affirmed the district court’s application of the statute to bar claims relating to funds added more than six years before the filing of the claim. U.S. Supreme Court. Oral arguments were made on February 24th, 2015. The court focused on the question of what each of the parties believed was the ongoing duty of a plan fiduciary.
Justice Scalia: What’s your position? That—that every—every stock that is owned has to be reviewed every year as though it was a new purchase? Plaintiff’s counsel: No. Our position is that the periodic duty to monitor requires at least some familiarity with the filings of that particular fund and an awareness of what the expenses and performance of it are. This expense ratio information, Justice Scalia, is readily available on the Internet; it is readily available with a phone call or two. One, look at the performance on a regular basis, a periodic basis. Number 2, look at the expenses and determine is there a cheaper way to get the same investment for less money that’s coming out of the beneficiaries’ assets. Number 3, has there been an—an alteration in the management such that one ought to look further and more deeply into it. And at the very least. one would think you’d look at the SEC filings for that mutual fund to determine whether or not there had been something that would require a—a determi- nation of imprudence.
Plaintiff’s counsel argued that ERISA 404 does not require changed circumstances for the imposition of continuing duties, contrary to the ruling in the 9th and other circuits.
7-3 Tax Conference, 28th Annual, May 21, 2015
Plaintiff’s counsel: We do not believe that ERISA’s statutory standard, which is at 1104(a)(1)(b), and it says that the standard by statute is what a reasonable investor would do under the circumstances then prevailing, would require the introduction of an added burden to overcome, which is that there had been significant changed circumstances since the initial investment. That look back within the limitations period looks at whether or not the investment option is an imprudent one. And it doesn’t matter whether there had been significant or insignificant changed circumstances since the initial option. And let me point to you the fact that the district court here adopted this principle and this rule to lead to really absurd results.
The DOL made similar arguments, stating that it was not the court’s task to determine what the duty amounted to in any particular case, only that the statute did impose an ongo- ing duty:
DOL: [W]e essentially want the Court to hold three things. The first is that Plaintiffs can bring a claim for imprudent monitoring and retention of funds based on what happened within the limitations period. That’s timely under the statute. The second is that the Ninth Circuit was wrong to say that the only way the claim can be timely is either if it’s from the time of a new fund or based on this changed circumstances that make it like a new fund because there is an ongoing duty of prudence that runs for the fiduciaries under the statute. Justice Scalia: Well, you want us to say that whatever it is, it isn’t solely whether there’s been a change in circumstances so extreme as to amount to purchasing a new stock. DOL: Yes. That’s right…We say that, you know, you have a duty to look from time to time. You can’t just set the funds and hold them and forget about them. And the duty to look isn’t triggered by something external that’s like a new fund being put in place. You just—you have a duty to look. And it might depend—how often you look might depend on the circumstances, and how deep you look might depend on the circumstances, but you have a duty to look.
Defendant’s counsel argued that, while Defendant did not disagree that ERISA imposes a continuing duty to monitor, the duty to monitor on an ongoing basis does not require a regular review of the same level of diligence as that required initially and does not require a continuing duty to determine if a cheaper share class is available:
[I]t’s absolutely true that there is a fundamental and major difference between the pro- cess for selecting funds initially and the process for monitoring existing funds. When you’re selecting funds, you’re going through this comprehensive review of the market; when you’re monitoring them, you’re basically looking for changed circumstances. That’s what you’re reviewing for. And the reason for that is the enormous disruption, both to the fiduciaries, the enormous work a fiduciary would have to do if literally every month or literally every quarter.
The complete transcript of oral argument is available at http://www.oyez.org/cases/ 2010-2019/2014/2014_13_550. B. M&G Polymers USA, LLC v. Tackett, 135 S.Ct. 926 (2015) - The Demise of the 6th Circuit “Yardman Inference” The U.S. Supreme Court granted certiorari on May 5th, 2014 to review the 6th Cir- cuit’s determination that the intent of a collective bargaining agreement was to vest partic-
7-4 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee ipants with contribution free lifetime healthcare benefits. The District Court in the Southern District of Ohio applied the 6th Circuit’s controversial “Yard-Man” inference leading to review by the U.S. Supreme Court. Facts and Procedural History. In 2007 Plaintiffs, a group of retirees, brought a class action suit against M&G Polymers, LLC and its health plans following the announcement by M&G that Plaintiffs would be required to make health care contributions to receive continuing benefits. The District Court initially dismissed the complaint for failure to state a claim. Plaintiff’s appealed and the 6th Circuit Court affirmed the dismissal of Plaintiff’s claim for breach of fiduciary duty but reversed and remanded plaintiff’s remaining claims which were (1) violation of labor agreements under the Labor Management Relations Act and (2) violation of Section 502(a)(1)(B) of ERISA (“Tackett I”). After a bench trial the District court found that Defendant M&G had violated the LMRA and ERISA by refusing to recognize the Plaintiffs’ vested rights in health benefits. Plaintiffs while working were represented by a union, Local 644, that negotiated the collective bargaining agreement between union members and M&G. The collective bar- gaining process resulted in CBA and also Pension and Insurance Agreements (“P&I Agreements”). The national union would negotiate a master agreement and then the local would either adopt it `as is’ or modify it through negotiations applicable to the local plant. The language in the subject P&I Agreement was comparable to the language in prior P&I agreements. The language in the P&I agreement provided health care benefit cover- age based on points awarded for age and years of service:
Employees who retire on or after January 1, 1996 and who are eligible for and receiving a monthly pension under the 1993 Pension Plan…whose full years of attained age and full years of attained continuous service…at the time of retirement equals 95 or more points will receive a full Company contribution towards the cost of health care benefits ..Employees who have less than 95 points at the time of retirement will receive a reduced Company contribution. The Company contribution will be reduced by 2% for every point less than 95. Employees will be required to pay the balance of the health care con- tribution, as estimated by the Company annually in advance, for the health care bene- fits..Failure to pay the required medical contribution will result in cancellation of coverage.
The factual dispute at the district court level was whether certain side or “cap” letters applied to require contributions for excess costs. The Circuit Court The circuit court began its analysis by reciting the applicable standards of review applicable to each issue: Whether the cap letters were part of Apple Grove’s CBAs is an issue of fact, review- able only for clear error.
At best, Hoover and Moore acknowledged the possibility that the cap letters applied to Apple Grove, but neither had any firm knowledge or documentation of the letters’ appli- cability. In the face of such ambiguity, the district court did not clearly err by concluding that the letters did not apply to Apple Grove…Apple Grove employees’ lack of knowl- edge regarding the cap letters was cited as an example of absence of evidence of the let-
7-5 Tax Conference, 28th Annual, May 21, 2015
ters’ inclusion in the Apple Grove agreements. As Plaintiffs point out, this was “but one piece of evidence among many.” Similarly, the district court did not err by considering the lack of awareness of the cap letters on the part of Shell’s accountants and M&G’s actuaries.
Whether the CBA vested a right to contribution free health benefits for life is also reviewed for clear error:
Interpretation of a CBA is a matter of law only when the parties rely wholly on the terms of the CBA and do not present any extrinsic evidence of intent. See Yard-Man..In this case, the determination of intent becomes a mixed question of both law and fact, for which the standard of review is clear error.
The court cites Yard Man as offering guidance in interpreting the CBA and states that while Takett I was not conclusive on the ultimate issue of vesting (it was up to the district court on remand to determine whether the cap letters would apply), Tackett I did establish, as far as the court was concerned, an intent to vest in the absence of extrinsic evidence. Application of Yard-Man:
(1) look to the explicit language, (2) evaluate that language in light of the context that led to its use, (3) interpret each provision…as part of the integrated whole, (4) construe each provision “consistently with the entire document and the relative positions and pur- poses of the parties, (5) construe the terms so as to render none nugatory and to avoid illusory promises, (6) look to other words and phrases in the document to resolve ambi- guities, and (7) review the interpretation…for consistency with federal labor policy.
In applying the Yard-Man inference, the 6th circuit determined that it was not clear error on the part of the district court to find that, in the absence of extrinsic evidence to the contrary, the agreements indicated an intent to vest lifetime contribution-free benefits. The circuit court found this to be in accordance with both Tackett I and the CBA lan- guage promising a full contribution to qualifying employees and affirmed the decision in of the District Court (Tackett III). U.S. Supreme Court. On January 15, 2015, the Supreme Court rendered an opinion vacating and remanding the decision by the 6th Circuit, holding that the Circuit Court’s opinion, and its application of the Yard-Man inference to determine an intent to vest par- ticipants in health care benefits, was inconsistent with ordinary principles of contract law. The Court reviewed the procedural history at the lower court, stating that after dis- missal by the district court the circuit court reversed based on its reasoning in the earlier decision in Yard-Man. The court summarizes the Yard-Man decision:
Although the court found the text of the provision in that case ambiguous, it relied on the “context” of labor negotiations to resolve that ambiguity in favor of the retirees’ inter- pretation..Specifically, the court inferred that parties to collective bargaining would intend retiree benefits to vest for life because such benefits are “not mandatory” or required to be included in collective-bargaining agreements, are “typically understood as a form of delayed compensation or reward for past services,” and are keyed to the acqui- sition of retirement status. The court concluded that these inferences “outweighed any contrary implications ..derived from” general termination clauses.
7-6 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
Applying the Yard-Man inferences on review of the District Court’s dismissal of the action, the Court of Appeals concluded that the retirees had stated a plausible claim. The court then examined the differing treatment of pension plans and healthcare plans within the provisions of ERISA, noting that health plans are not subject to the same elabo- rate vesting provisions but rather must simply be provided pursuant to a written plan doc- ument. The court went on to note prior precedence allowing employers to modify the provisions of a health care plan and providing large leeway to do so.
And, we have observed, the rule that contractual “provisions ordinarily should be enforced as written is especially appropriate when enforcing an ERISA welfare benefits plan. That is because the focus on the written terms of the plan is the linchpin of a sys- tem that is not so complex that administrative costs, or litigation expenses, unduly dis- courage employers from offering[welfare benefits plans in the first place. We interpret collective-bargaining agreements, including those establishing ERISA plans, according to ordinary principles of contract law, at least when those principles are not inconsistent with federal labor policy.
The Supreme Court takes issue with the Yard-Man Inference for a number of reasons. The lower courts apply Yard Man across various industries to tip the scales in favor of vesting which the court determined is inconsistent with basic rule that that intent of the parties should be ascertained and carried out. Although courts can look to industry prac- tice and standards, record evidence must support its conclusion as to those practices and standards, which the Court found did not occur. The court had no record evidence to sug- gest that employers and unions customarily vest retiree health benefits. Further, the lower court refused to apply the CBA’s general durational clause based on an assumption that the parties would not leave the issue of vesting of healthcare benefits unresolved and subject to future negotiations given the nature of the benefits. This was due in part to the Yard-Man’s concept of status benefits, i.e. retirement benefits are status benefits and assumed to apply through retirement. This assumption the Court found dis- torts the text of the agreement and is contrary to the principal in contract law that a written agreement is presumed to encompass the entire agreement. The Court found that the lower court’s determination that a contrary interpretation of the collective bargaining agreement would make the promise regarding vesting of health care benefits an illusory promise was unsupported. The lower court construed provisions of the contract that admittedly benefitted some classes of participants as illusory merely because it did not benefit all participants. The Court determined this to be error.The illu- sory promise doctrine requires a court to avoid reading a contract in a way that makes the promises within the contract illusory because an illusory promise cannot serve as consid- eration. But a promise that benefits some participants necessarily serves as consideration and is not illusory.The lower court’s failure to properly apply the illusory promise doctrine in the context of collective bargaining agreements is particularly problematic given that collective bargaining seeks provide for participants in a wide range of differing employ- ment circumstances. Finally, the lower courts ignoredthe traditional principal that ambiguous contract should not be read to create lifetime promises. The lower court also ignoredthe traditional principal in contract interpretation that contract obligations will cease in the normal course upon expiration of the contract. The Court pointed out that this does not preclude conclu-
7-7 Tax Conference, 28th Annual, May 21, 2015 sion that parties intend to vest benefits for life or beyond duration of agreement but simply requires that to do so, the CBAmust say as much in the terms of the document. When an agreement is silent, the obligation should be construed to be limited to the term of agree- ment. For the reasons stated, the court vacates the lower court’s determination and remands the matter for further consideration without the application of the inference for vesting previously available based on Yard-Man. C. Heimeshoff v. Hartford Life & Acc. Ins. Co., 134 S.Ct. 604 (2013) - Enforceability of Contractual Limitations Period Heimeshoff was a 2013 Supreme Court case that examined the issue of whether par- ties can agree to a statute of limitations period outside of that provided by state law. ERISA does not contain a limitations period for actions brought pursuant to section 502(a)(1)(B). Instead, ERISA borrows from the most analogous state law in the state where the claim arises. Facts and Procedural History. The plan document at issue required commencement of an action not more than three years following the date when proof of loss was due from a claimant. Plaintiff filed a claim for long term disability benefits in October of 2006. Plaintiff’s claim was denied in November of 2006. Plaintiff requested an extension of her appeal and submitted appeal in September of 2007. Final denial of plaintiff’s claim was issued in November of 2007. Plaintiff filed an action in district court in November of 2010, less than three years after final denial of her claim. Defendant moved for dismissal based on plaintiff’s claim being time barred by the plan’s limitations period. The district court granted the motion finding that the plan’s period was not inconsistent with the applicable limitations period under state law. The statute in Connecticut provided that a plan could specify a period of not less than one year. The District Court. The second circuit affirmed the district court’s ruling based on circuit precedent that a three year period was not unreasonable. The court found that the policy unambiguously stated that the period began to run as of the date that a claimant’s proof of loss was due. The court found that the provision was not inconsistent with ERISA. U.S. Supreme Court. The Supreme Court granted certiorari to resolve a split among the circuits as to the enforceability of contractual limitations period in ERISA governed plans. Plaintiff’s argument focused on the fact that the provision at issue required the limita- tions period commence when proof of loss was due, rather than upon the completion of administrative review and denial of the claim. Plaintiff argued that, under this language, the statute began to run before plaintiff’s claim accrued, drastically shortening the effec- tive limitations and running afoul of the general rule as set forth by the court in prior cases and ERISA. The Court responded by pointing out that there are exceptions to the general rule as to the commencement of limitations periods (e.g. the limitations period in suits of admiralty run from the date of injury rather than when a party can sue).The Court considered the question of the commencement of the limitations period to be inexorably tied to the cen-
7-8 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee tral question before the court: whether parties can agree through contractual provisions to shorten or alter the applicable limitations period in the context of ERISA litigation. The court cites a 1947 case for the rule that parties can modify a limitations period so long as the resulting period is reasonable. Order of United Commercial Travelers of America v. Wolfe, 331 U.S. 586, 608, 67 S. Ct. 1355, 91 L. Ed. 1687 (1947). The court recognizes that some state statutes do not allow limitations shorter than a certain period or to be altered, while others simply provide a default. The court concludes that Wolfe allows not only the modification of the applicable period, but also the ability of the parties to agree on when the period begins to run, as one is necessarily tied to the other. The court concludes that the Wolfe rule is consistent with ERISA: The principle that contractual limitations provisions ordinarily should be enforced as written is especially appropriate when enforcing an ERISA plan. The plan, in short, is at the center of ERISA. Employers have large leeway to design disability and other welfare plans as they see fit. And once a plan is established, the administrator’s duty is to see that the plan is “maintained pursuant to that written instrument.” 29 U. S. C. §1102(a)(1). This focus on the written terms of the plan is the linchpin of “a system that is so complex that administrative costs, or litigation expenses, unduly discourage employers from offering ERISA plans in the first place. The court points out that the statutory basis of plaintiff’s cause of action, ERISA 502(a)(1), is in fact wholly based upon the terms of the plan document as written: ERISA §502(a)(1)(B) authorizes a plan participant to bring suit to recover benefits due to him under the terms of his plan, to enforce his rights under the terms of the plan, or to clarify his rights to future benefits under the terms of the plan.” 29 U. S. C. 1132(a)(1)(B) (emphasis added). That “statutory language speaks of enforcing the terms of the plan, not of changing them. For that reason, we have recognized the particular importance of enforcing plan terms as written in 502(a)(1)(B) claims. Plaintiff was not disputing that the applicable three year period was reasonable given that most claims for administrative review are resolved in a year, leaving a typical plaintiff two years following review to file suit. Rather, plaintiff argued that ERISA is a “control- ling statute to the contrary” in that the enforceability of contractual limitations periods would undermine ERISA’s two tiered remedial scheme. Plaintiff argued that such a provi- sion would either encourage employers to delay review to shorten the limitations period or it would encourage claimant’s to forego full review at the administrative level to lengthen the effective limitation period. The court was not persuaded by plaintiff’s arguments. The administrative review pro- cess is intended to be completed in one year; in the event that an employer runs afoul of the timelines associated with administrative review, a claimant is deemed to have com- pleted review and can immediately file suit. Further, in the event of an abuse at the administrative level, the courts have the tools to address such abuse including estoppel, laches and waiver. Finally, the court does not believe a claimant is likely forego the establishment of a complete record at the adminis- trative review level because the district court will review based on the record established at the administrative level and generally review is based on an abuse of discretion stan- dard.
7-9 Tax Conference, 28th Annual, May 21, 2015
In short, participants have much to lose and little to gain by giving up the full measure of internal review in favor of marginal extra time to seek judicial review. Lessons from Heimeshoff. Heimeshoff confirms that contractual limitation periods are enforceable so long as they are reasonable and do not contradict state law. Plan spon- sors should consider adding a limitation clause based upon a date certain rather than final denial of claim. Plan claims procedures should expeditiously adjudicate benefit claims. The plan document and the summary plan description should be reviewed for consistency. III. Cases of the 6th Circuit A. Smith v. Aegon Company Pension Plan, 769 F.3d 922 (6th Cir. 2014) - The Enforceability of Venue Selection Clauses in ERISA Plans Plaintiff was an employee of the General Commonwealth corporation which was to merge with the Aegon company in 1997. Employees of General Commonwealth who were nearing retirement were offered a supplemental retirement benefit through a “Volun- tary Employee Retirement and Retention Program (“VERRP”) as an inducement to stay on until the merger was complete. Smith was to retire in March of 2000. In the period leading up to the completion of the merger, plaintiff was presented with an election form allowing for monthly benefits under both a qualified and a non-qualified pension plan. The VERRP was described in an attachment to the general election form which stated that participants would receive an additional benefit in the form of a lump sum payment under the VERRP. Plaintiff was to receive $1066 per month under qualified plan and $1122 under the non-qualified plan pursuant to the “Aegon USA Pension Plan—Election for Distribution and Explanation of Benefits”. An attached letter stated that if plaintiff participated in VERRP Smith would be entitled to receive additional benefits from CGC under that pro- gram. VERRP Attachment A stated that Smith was entitled to $154k under the General Commonwealth corporation plan. Attachment B stated that as VERRP Participant, plain- tiff was entitled to a supplemental benefit payable as either an annuity or as a lump sum. On February 1, 2000, plaintiff received a booklet stating that (1) CGC & Aegon Plans had been merged, and (2) Defining a CGCVERRP Participant as a grandfathered partici- pant in plans effective up until Feb 29, 2000. Plaintiff retired in March of 2000. In 2007, the Aegon pension plan was amended to include a venue selection clause. In 2011, plaintiff was notified that the plan had been overpaying him apparently based on the administrator’s determination that plaintiff was to receive either a lump sum or an annuity under the non-qualified plan, but not both. Plain- tiff’s benefits were reduced and eventually eliminated, after which he received a demand to repay $154,000 to the plan. Plaintiff exhausted his administrative remedies and then filed suit against General Commonwealth Corporation in state court alleging breach of contract, bad faith and state wage violations. Defendant removed the action to federal district court and moved for dis- missal under Federal Rule of Civil Procedure 12(b)(6). The district court granted the motion ruling that ERISA governed the issue of what benefits were payable under the plan. The district Court also ruled that the pension committee was the proper defendant,
7-10 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee not General Commonwealth. The district court’s ruling was affirmed on appeal (“Smith I”). Plaintiff re-filed in the federal district court for the Western district of Kentucky. The district court dismissed Smith’s complaint based on venue being improper pursuant to the plan’s 2007 venue selection clause. The DOL filed an amicus brief stating the position that the venue selection clause should not be enforced because it is incompatible with ERISA. Smith argues that the DOL’s position as expressed in its brief is entitled to Chevron deference, and failing Chev- ron, Skidmore deference. The circuit court determined that the DOLs position was not entitled to Chevron def- erence because the agency when stating its position through amicus brief was not acting pursuant to authority having the force of law as required under Chevron. Interpretations contained in briefs, opinion letters, policy statements, agency manuals and enforcement guidelines—lack force of law and are not entitled to deference under Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). The Supreme Court and the 6th circuit have afforded deference to Amicus Briefs under Skidmore when an agency has outlined its position through informal rulings and interpretive bulletins and then taken the position in an amicus brief, Skidmore v. Swift & Co., 323 U.S. 134 (1944).The court may look to this for guidance but the weight given will depend on factors of thoroughness, consistency, validity of reasoning, formality, rela- tive expertness. The court determined that the DOL’s position was NOT entitled to Skidmore defer- ence because the DOL was no more expert as to application of venue clauses than the cir- cuit court. The court felt that the bare textual analysis in DOLS brief spoke of a lack of thoroughness and noted that the DOL’s interpretation was expressed only once previously. The DOL had taken no position in 39 years prior and its previous acquiescence was incon- sistent with its current position. In other cases where Skidmore deference had been afforded, there was a history of the agency asserting the position and evidenced by enforcement actions, amicus briefs, agency practice, and written guidelines. Here, the DOL position was merely an “expression of a mood”. The enforceability of the venue selection clause is reviewed by the court De Novo. The court began its analysis with the recognition that the foundation of the ERISA statu- tory scheme is reliance on the written plan document and that plan administrators and employers are generally free to adopt, modify or terminate a plan. The court is not per- suaded by Plaintiff’s position that venue selection clauses will impose excessive burdens on plan participants because participants can challenge the reasonableness of any venue selection clause based on the same three part test applicable to forum selection clauses. A provision is presumed reasonable unless (1) it is based on fraud, duress or unconscionable terms, (2) the proposed forum is ineffective or unfair or (3) it is so seriously inconvenient that it leads to injustice, citing FD Rich Co., Inc. v. Industrial Lumber Co., 417 U.S. 116 (1974). The court reasoned that given the latitude afforded to plan administrators under ERISA, the Supreme Court’s ruling that forum selection clauses are presumptively enforceable absent fraud should apply to venue selection clauses.
7-11 Tax Conference, 28th Annual, May 21, 2015
The court rejects the position that venue selection clauses violate ERISA’ stated pol- icy of providing ready access to federal courts. ERISA venue selection provision is per- missive, providing that venue can be based upon one of several statutory options, including the place of administration. There is no language preventing parties from select- ing among the statutory provisions or narrowing the options. In addition, other ERISA policies are furthered by the enforceability of venue selection:
• Venue selection encourages the uniformity in the application of federal law to a particular plan • Lowers cost administration of employee benefit plans by controlling cost of liti- gation
Even if a venue selection clause provided for venue outside of the options in ERISA section 502(e), the fact that the Court has previously accepted the enforceability of arbitra- tion clauses in ERISA plans supports venue selection. The court reasoned that if parties can agree to remove litigation from federal courts through application of arbitration, par- ties ought to be able to select one federal court over another. Lessons from Smith v. Aegon. Venue selection clauses are available for use by plan sponsors and will likely be enforced unless unreasonable. Further, employers will enjoy a presumption of reasonableness under the three part test applicable to forum selection clauses. The ability of the DOL to circumvent formal rulemaking through Amicus brief writing is brought into question by cases like Smith. B. Moyer v. Metropolitan Life Ins. Co., 762 F.3d 503 (2014) - More on Contractual Limitations Periods In Moyer, plaintiff began receiving disability benefits in 2005. Those benefits were revoked in 2007 when the plan administrator determined that plaintiff was no longer dis- abled. Moyer sought administrative review and his appeal was denied. The plan document contained a provision limiting the time that a claimant could seek judicial review but this provision was not described in either the summary plan description or the letter of denial provided to plaintiff. Plaintiff sued in U.S. District Court for the Eastern District of Michigan. Defendant, Metropolitan Life, argued that plaintiff’s claim was barred by the limitations period con- tained in the plan. The district court dismissed the claim, finding that the plan document contained the provision limiting appeal and plaintiff had constructive notice of the limita- tion regardless of its absence in the notice and SPD. The circuit court did not agree, ruling that the denial letter provided to plaintiff was required to contain any applicable time limit for judicial review pursuant to ERISA and its regulations. Specifically, the court focuses on ERISA section 503, relating to the require- ments for claim denial letters. The dissent argues that the court could not look to the letter or related regulation because the regulation governing claim denial letters was not cited by plaintiff. Plaintiff argued generally that the plan fiduciaries had failed to provide him notice, either in the SPD or in the denial letter as required by ERISA, and that equitable tolling should apply. The dissent argues that we may not examine the requirements for claim-denial letters because Moyer’s arguments failed to specifically reference that statute and that regulation.
7-12 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
We do not see our review as so narrowly circumscribed. Moyer argues in his brief, as he did before the district court, that MetLife’s correspondence with him—including specifi- cally the adverse benefit determination letter—was required to include the time limits for judicial review. The issue, therefore, was properly raised and we may consider the relevant arguments, including application of the appropriate ERISA provisions. The dissent also argues that there is nothing in section 503 and its regulations that require time limits for judicial review be disclosed, rather, the claim denial letter must pro- vide information about the basis for claim denial. But the court reads the regulation as requiring a fair opportunity for review which was absent in Moyer.
Substantial compliance entails provision of all that is necessary to satisfy the purpose of §1133—notice of the reasons for denial and a fair opportunity for the type of review that is appropriate under the particular facts of the case..The exclusion of the judicial review time limits from the adverse benefit determination letter was inconsistent with ensuring a fair opportunity for review and rendered the letter not in substantial compliance..notice that fails to substantially comply with these ..requirements does not trigger a time bar contained within the plan.
The court does not see the need to discuss the SPD failure based on its finding as to the denial letter. Lessons from Moyer. Following up on the decision by the Supreme Court in Heime- shoff, the 6th Circuit determines that not only must a contractual limitation period be rea- sonable, participants must be made aware of its application. If revising a plan to include such a provision, the limitation period should also be described in the SPD and other notices to participants. C. DiGeronimo Aggregates, LLC v. Zemla, 763 F.3d 506 (2014) - No ERISA Common-Law Negligence Claim for Employers Plaintiff, DiGeronimo Aggregates, was a contributing employer to a multiemployer pension plan. In 2009 the plan trustees terminated the plan after substantially all employ- ers withdrew from making contributions. The trustees assessed withdrawal liability against plaintiff and other employers under the Multiemployer Pension Plan Amendment Act (“MPPAA”). The assessment of withdrawal liability against plaintiff was in excess of 1.7 million dollars. Facts and Procedural History. In 2013, plaintiff filed suit in federal district against the plan trustees based upon standing provided by 29 USC 1451(a) and pursuant to a the- ory of common law negligence. Plaintiff alleged that negligence on the part of the plan trustees in negotiating and affirming insufficient contribution rates significantly contrib- uted to Plaintiff’s high withdrawal liability. Plaintiff acknowledged that 29 USC 1451(a) did not provide a substantive basis for the claim. While 1451(a) provides that an employer “may bring an action for appropriate legal or equitable relief”, Section 1451 is a standing provision and contains no substantive basis for a claim by an employer. Plaintiff cited no other provision within ERISA giving a basis for plaintiff’s claim, but argued that the court had the power under federal common law to recognize a negligence claim brought by an employer against plan trustees. The district court dismissed based on Defendant’s FRCP12(b)(6) motion.
7-13 Tax Conference, 28th Annual, May 21, 2015
The Circuit Court. On appeal, the Court of Appeals for the 6th Circuit considered the limited basis upon which a court can make common law in the context of ERISA: (1) ERISA is silent or ambiguous, (2) there is a gap in the statutory scheme, (3) federal com- mon law is essential to the promotion of ERISA.
The court finds that none of such requirements are satisfied by plaintiff. ERISA is not silent or ambiguous as to negligence claims against fiduciaries. ERISA contains the spe- cific means by which participants and beneficiaries can bring such an action but pro- vides no such claim for employers. The court considers such omission to be intentional: “…a strong presumption exists that congress deliberately omitted such a remedy”.
The court finds no gap in the statutory scheme. While the Plaintiff argues that the absence of a common law negligence claim against employers allows trustees to escape any liability for negligent acts injuring employers, the court concludes that the statutory scheme is not designed to protect employers. The statute is designed to protect participants and beneficiaries and so the absence of a mechanism benefiting employers is not a gap in the statutory scheme. Finally, for the reasons stated above, allowing employers to sue for negligence is not essential to furthering ERISA policy. The court observes that there is no precedence for a negligence claim by employers. While the third circuit allowed an employer to sue plan trustees under federal common law based on fraudulent inducement, this involved fraud rather than negligence and the ruling was limited to cases involving fraud. Lessons from DeGeronimo. DeGeronimo is an example of a circuit court’s reluc- tance to expand the protections of ERISA through use of the courts lawmaking powers. The courts recognize the potential for lawmaking in ERISA litigation but it must benefit participants or beneficiaries and provide relief not otherwise available under ERISA. IV. Other Circuit Court Decisions Involving ERISA A. Tussey v. ABB, 764 F.3d 327 (2014) - Duty to Monitor Costs and Leverage Plan Assets Tussey was an 8th Cir case out of the Western District of Missouri. Ronald Tussey and other participants sued the plan sponsor, the plan’s pension committee, certain indi- vidual fiduciaries and also Fidelity Investments alleging a breach of fiduciary duty. The circuit court decision was rendered in March of 2014. The decision was appealed to the Supreme Court and certiorari was denied in November of 2014. Facts and Procedural History. The plan in Tussey was a 401(k) plan with approxi- mately 1.4 billion in assets and 14,000 participants. The plan was a self-directed plan offering an open architecture investment platform. Defendant Fidelity Management and Trust Company became the plan’s record keeper in 1995 after a competitive bidding pro- cess. Initially Fidelity was paid a flat fee for its services but beginning in 2000, a revenue sharing relationship was established. Fidelity began to provide services unrelated to the plan including payroll services and recordkeeping services for ABB’s health, welfare and pension plan. Fidelity incurred losses from the additional services but realized significant profits from its revenue sharing arrangement relating to the 401(k) plan.ABB was advised by an outside consulting firm that it was overpaying for record-keeping services and that it
7-14 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee might be subsidizing other corporate services through the revenue sharing arrangement with Fidelity. In 2000, ABB adopted an investment policy which specified a risk return spectrum and a process for choosing, monitoring and retaining investments. A target date fund was to be offered to plan participants. The pension committee replaced a longstanding index fund, the Vanguard Wellington Fund, with the Fidelity Freedom Fund, concluding that the target date fund options would allow participants to have a balanced fund through that mechanism. After a 16 day bench trial, the district court ruled that defendants had breached their fiduciary duty to plan participants because the plan fiduciaries had:
• Failed to monitor record keeping • Failed to negotiate rebates for the plan from Fidelity or otherwise • Selected more expensive share classes from investment platform when less expensive classes were available • Removed the Vanguard Wellington fund and replaced it with Fidelity’s Freedom Fund
As for Fidelity, the court determined that Fidelity Investments violated its fiduciary duty to plan participants when it benefited from “float income” properly belonging to the plan. The Circuit Court. A significant portion of the opinion relates to the proper standard of review applicable at both the district and circuit court level. The defendants argued that the district court applied a de novo standard of review in reviewing the decisions of the plan fiduciaries and that such improper standard tainted the court’s entire analysis. The district court opinion is silent as to the standard of review applied. Plaintiffs argued that a deferential standard of review is appropriate only in the con- text of a claim for benefits under ERISA. The circuit court rejects Plaintiff’s argument and follows the 3rd, 6th, 7th and 9th cir- cuits: If plan fiduciaries are afforded discretion in matters of plan interpretation, the dis- trict court must review for an abuse of discretion on the part of the fiduciaries.
ERISA represents a ‘careful balancing between ensuring fair and prompt enforcement of rights under a plan and the encouragement of the creation of such plans..Preserving that balance by permitting an employer to grant primary interpretive authority over an ERISA plan to the plan administrator. Firestone deference (1) encourages employers to offer ERISA plans by controlling administrative costs and litigation expenses; (2) cre- ates administrative efficiency; (3) promotes predictability, as an employer can rely on the expertise of the plan administrator rather than worry about unexpected and inaccu- rate plan interpretations that might result from de novo judicial review; and (4) serves the interest of uniformity, helping to avoid a patchwork of different interpretations of a plan.
The circuit court, however, reviews the district court’s opinion de novo.
7-15 Tax Conference, 28th Annual, May 21, 2015
Recordkeeping. The court rejected Defendant’s argument that the number of funds offered combined with the participant’s ability to choose among funds bars claim for breach relating to recordkeeping costs and distinguished the cases offered by Defendants, stating that a fiduciaries breach in this context is fact sensitive. The court concludes that the district court did not condemn bundled services but found breach based on failure to diligently investigate and monitor plan record keeping costs, failure to leverage plan assets, and failure to prevent use of plan assets to subsidize other services. Under these cir- cumstances the circuit court found ample support for a ruling by the district court that a breach of fiduciary duty had occurred. Any failure to apply a deferential standard of review under these facts is considered harmless error by the circuit court. The Defendant also argued that the district court erred in its award of damages. The circuit court is unmoved and states simply that it gives wide latitude to a district court’s acceptance of expert testimony. Selection of Plan Investments and Mapping. Defendants argued that any breach by the fiduciaries is outside of the applicable statute of limitations period under ERISA 413 (removal of the Wellington Fund occurred more than six years before commencement of action). The court however views the actions amounting to breach to include several actions, including selection of the Freedom Fund and the mapping of the plan investments (the process of moving participant investments within the old fund to similar investments within the new fund). The court determined that the last action occurred within the 6 year statute of limitations period. Defendants again argue that the district court applied a de novo standard of review which was improper given the discretion afforded to fiduciaries to select investments and interpret the plan. Specifically, the district court substituted its own hindsight judgment, comparing the performance of the Wellington Fund with the Freedom Fund in the period 2000 to 2008. The circuit court agreed that the proper analysis as to breach is not concerned with the results of the decisions made by the fiduciaries but rather, with the process involved in selecting the funds and the actions taken viewed in light of the information available at the time of the alleged breach. The court concludes that it is not clear that the application of the correct deferential standard would not have had a different result. The court vacated the district court’s decision as to breach for selection of invest- ments and mapping and instructed the lower court that any award of damages after a find- ing of breach should focus not on a comparison of the Freedom Fund to the Wellington Fund but as compared to the lowest return on investments under other investment options absent fiduciary breach. Float Income. Fidelity’s appeal resulted in the reversal of the district court’s decision as to the misuse of float income as a plan asset. The circuit court’s analysis focused on basic property law and whether, when a contribution is made by or on behalf of a partici- pant resulting in shares being transferred to the account of the participant, the contribution (and any income associated with it) can still be considered a plan asset. The court con- cluded that once the plan becomes the owner of purchased shares, it is no longer the owner of the money used to purchase those shares. The district court’s judgment as to breach of fiduciary duty on the part of Fidelity was reversed by the circuit court.
7-16 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
Lessons from Tussey: Plan fiduciaries have a duty to calculate fees being paid, to seek competitive fees, to leverage the size of the plan and to avoid subsidizing other ser- vices with plan assets. A court it more likely to scrutinize the a fiduciary’s process for selecting investments and less likely to scrutinize investment performance. B. Amara v. Cigna Corporation, 775 F.3d 510 (2014) - Equitable Remedies in ERISA Litigation The decision rendered by the second circuit in 2014 is the latest development in a long-running dispute reaching back to 2001. Amara involves the conversion of a tradi- tional pension plan to a cash balance plan and the failures of the plan fiduciaries to provide sufficient notice of benefit reductions under ERISA 204(h). Facts and Procedural History—Amara Recap. In 2008, the district court for the district of Connecticut determined that plan fiduciaries had breached their duty to provide sufficient notice of the effect of a plan conversion and that the breach had caused “likely harm” to the plan participants. The court awarded equitable relief to the participants pur- suant to ERISA 502(a)(1)(B) in the form of an “A+B” benefit. The court reformed the terms of the plan to provide A, the benefits under the plan pre-conversion, plus B, benefits under the new cash balance formula(rather than the greater of A or B (“Amara I”). The district court’s decision was appealed to the circuit court for the second circuit. The circuit court issued a summary order affirming the district court’s decision. Certiorari was granted by the U.S. Supreme Court on the question of whether the dis- trict court applied to the correct legal standard, i.e. the “likely harm” standard, in deter- mining whether relief was warranted. The court determined that it was first necessary to consider whether the statutory subsection, ERISA 502(a)(1)(B), used by the district court to provide the relief granted was the proper source of relief. The court was unwilling to read ERISA 502(a)(1)(B) to allow the modification of the terms of the plan. The Court found that ERISA 502(a)(1)(B) is an enforcement provision limited by the terms of the plan and it contains no language affording a change in the lan- guage of the plan which would be akin to an equitable remedy. The court rejected the argument that the SPD(which could be read to provide benefits consistent with the relief being provided by the court) is a part of the plan, allowing enforcement through application of (a)(1)(B).
• The SPD is typically produced by the plan administrator, not the settlor • The language of the SPD speaks of rights and obligations under the plan • If the SPD is found to be legally binding, the principal purposes of the SPD as being clear and understandable would be sacrificed in the face of concerns for legal sufficiency
The Court determined that the district court’s reliance on ERISA 502(a)(1)(B) to allow the relief provided was in error but determines that relief as provided is available under 502(a)(3) which allows for “appropriate equitable relief”. The court distinguished cases in which equitable relief was previously denied as involving specific relief that is non-equitable in nature. The district court had been reluc-
7-17 Tax Conference, 28th Annual, May 21, 2015 tant to apply (a)(3) in part due to its reading of certain opinions previously denying the application of (a)(3). But the Court points out that these involved specific forms of relief that the Court simply did not consider equitable, such as a lien to be placed on monies that were not specific funds or involving relief against a non-fiduciary for money damages. Both of these claims are legal in nature, rather than equitable, and so the precedence did not bind the Court in Amara. The Court then examined the forms of relief typically available in equity and poten- tially available under ERISA 502(a)(3):
• Contract Reformation—Requires Mutual mistake or Fraud and Reliance • Equitable Estoppel—Requires Promise and Reliance (action or forbearance induced by promise) • Surcharge—Requires breach of fiduciary duty causing loss and unjust enrichment
The Court concluded that ERISA does not specify what level of harm is required under 502(a)(3) and that the courts must look to traditional concepts of equity and the spe- cific requirements under each of the various forms of relief (the form of relief will dictate what level of harm is required). The Court then remanded the case for the lower court to determine what relief was proper under 502(a)(3) and whether the standard of harm was met by the participants in the Plaintiff class (“Amara III”). On remand, the district court determined reformation to be available under the facts of the case applying contract principles. The court then adopted the previous court’s anal- ysis of the appropriate remedy. The court required Defendant to provide A+B benefits, part A being the full value of accrued benefits before conversion and part B being the accrued benefit after conversion under the new benefit structure. Amara v. Cigna Corporation, 775 F.3d 510 (2014) (“Amara V”). On appeal to the circuit court from the district court after remand, the circuit court found that there was no abuse of discretion by the district court in determining that the requirements of reforma- tion had been satisfied. The Defendant appealed the ruling of the district court after remand claiming the court erroneously applied contract principles in determining grounds for reformation. Ref- ormation under trust principles focuses on the question of the parties’ intent. Defendant argued that Cigna never intended to provide an A+B benefit structure, making reformation inappropriate. The second circuit observed that retirement plans are similar to both trusts and con- tracts and that the Supreme Court in Amara III referred to principles of contract law when discussing reformation as an available remedy in the retirement plan context. The circuit court found that the district court did not err in determining that contract principles apply when plan benefits are offered in the context of an employment relationship. We agree with the district court that, because the CIGNA Pension Plan is part of a compensation package for employees that stems from their employment agreements, plaintiffs have given consideration for their participation in the retirement plan so that it is appropriate, to the extent this plan constitutes a trust, to analyze reformation under con- tract principles.
7-18 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
ERISA does not provide requirements for reformation. In ERISA cases, Court looks to federal common law for reformation requirements rather than state law. Under contract principles, reformation requires mutual mistake or mistake by one party and fraud or ineq- uitable conduct by the other party. The circuit court concludes that the district court did not err in determining that Defendant had engaged in inequitable conduct in concealing the effects of wear away and failing to provide notice of other material modifications that would result from the plan’s conversion from a traditional pension plan to a cash balance plan. The court found that the requirement for unilateral mistake is similarly satisfied. While Defendants argued that mistake should be required to be established on an individ- ual basis through a demonstration that no participant understood the effects of the change, the court was satisfied that, especially in situations involving intentional or blanket mis- representations, mistake can be established circumstantially. Further, there is no evidence of an absence of mistake in the record. But plaintiffs can prove ignorance of a contract’s terms through generalized circum- stantial evidence in appropriate cases. Such proof may be more than sufficient, moreover, in certain cases where, as here, defendants have made uniform misrepresentations about an agreement’s contents and have undertaken efforts to conceal its effect. As to the question whether “likely harm” is the appropriate standard for determining whether plaintiffs are entitled to relief, the court agreed with the district court’s reading of Amara III that the prerequisite for equitable relief varies among the various forms avail- able and reformation does not require a showing of actual harm.
…reformation does require a showing of mutual mistake or mistake coupled with fraud, so that harm (actual or otherwise) flows from the mistaken party’s failure to receive its expected agreement. Traditional equitable principles do not require a separate showing of harm for reformation.
Having determined that the district court did not err in finding fraud, mistake and no requirement for actual harm, the court considers whether the district court abused its dis- cretion in providing (a second time) the A+B benefit. Defendants argue that the district court should have simply restored the participants to the pre-conversion benefits being identified as Part A. The district court on remand chose to use the original A+B remedy, finding that it remained the most appropriate remedy under ERISA 502(a)(3). First, Cigna communications to participants made clear that part A benefits would be discontinued. Second, Part B communications were legally valid and accurate, including methods, examples, etc. Third, returning participants to part A benefits would be difficult and bur- densome to participants and would delay implementation of the plan. Finally, participants had a reasonable expectation that part B benefits would preserve and protect part A bene- fits. For these reasons, the circuit court finds no abuse of discretion in the district courts return to the A+B remedy. Lessons from Amara “V”: The second circuits decision on remand provides addi- tional support for the position that reformation is an equitable remedy available to remedy miscommunication with participants and that contract principles will be applied in deter- mining whether the required prerequisites at common law have been met. No actual harm is required for reformation and mistake can be established circumstantially depending on
7-19 Tax Conference, 28th Annual, May 21, 2015 the facts of the case. Of course, the primary lesson to employers is still that employers need be diligent in providing sufficient notice to participants. C. Gabriel v. Alaska Electrical Pension Fund, 773 F.3d 945 (2014) - Additional Equitable Remedies Under Amara In Gabriel, the 9th Circuit considered under what circumstances surcharge is avail- able as an equitable remedy in ERISA litigation. On appeal, the circuit court initially dis- allowed Plaintiff’s surcharge claim, granting summary disposition to Defendants. A dissenting opinion argued that the court misinterpreted Amara. The original opinion was later withdrawn and a new opinion issued remanding the issue of surcharge to the district court. Facts and Procedural History. Plaintiff, Gabriel, was a participant in a collectively bargained retirement plan that required ten years of service before a participant was vested in a retirement benefit. From 1968 to 1975, plaintiff worked as an electrician for various contributing employers. In 1975, plaintiff became a sole proprietor and began contributing to the plan on behalf of himself and other of his company’s employees. In 1979, the plan administrator became aware that plaintiff was an owner/ sole propri- etor and not eligible to participate in the plan. The plan prepared to refund plaintiff the contributions made in the period from 1975 to 1978 and informed plaintiff that his partici- pation in the plan was terminated. Plaintiff was informed that he had eight years of cred- ited service taking into account the years as an employee participant and provided a letter outlining the requirements that would need to be satisfied in order for plaintiff to become vested in the plan. Notwithstanding the above, in 1996, plaintiff contacted the plan and enquired as to the amount of the pension benefit he would receive if he retired. The plan responded in a letter of January, 1997 in which the plan stated that, based on years of credited service from 1968 to 1978, plaintiff would receive a pension benefit in the amount of $1,236 per month. Plaintiff retired and began receiving benefits in March of 1997. In 2000, plaintiff took employment as an OSHA safety inspector to supplement his retirement income. Plaintiff was warned by the plan that his employment could result in a suspension of his retirement benefits. Plaintiff objected on the basis that he was not work- ing in the same industry as that covered by the plan (making suspension of benefits inap- plicable). Plaintiff’s benefits were nevertheless suspended by the plan administrator in 2001. Plaintiff pursued his administrative appeals. Plaintiff stopped working and the plan reinstated his benefits in 2004. Plaintiff continued to pursue payment of the suspended benefits and attorney fees. On the eve of settlement, the plan became aware of its previous determination of ineligibility, revoked its offer in settlement and demanded return of $81,033 in benefits. Plaintiff filed an ERISA action in the U.S. district court for the district of Alaska seeking recovery of benefits and alleging a breach of fiduciary duty under ERISA section 404, misrepresentation and estoppel. Defendant moved for summary disposition on plaintiff’s claims. The district court found the existence of a material fact as to whether plaintiff had satisfied the plan’s vesting requirements and remanded the issue back to the appeals committee. Before the appeals
7-20 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee committee, plaintiff argued not that he had satisfied the vesting requirements but that he had detrimentally relied upon the plan administrator’s representations that he was vested and entitled to benefits. The committee rejected this argument given that plaintiff had received previous notice of his vesting status and, regardless, that reliance would not prop- erly result in providing for benefits in a manner inconsistent with the terms of the plan. After review of the committee’s findings based on an abuse of discretion standard, the district court granted summary disposition to defendants on the issue of vesting. The dis- trict court granted the motion for summary disposition on plaintiff’s claim as to equitable estoppel. The district court denied plaintiff’s claim for equitable relief stating that the relief plaintiff sought was compensatory in nature and not equitable. The Circuit Court (Opinion as Re-Issued). The court first considered whether plaintiff was entitled to remedy under ERISA 502(a). The court points out that the plaintiff must satisfy the second prong of 502(a), that the relief sought is “appropriate equitable relief”. The court cites Cigna Corp. v. Amara for the conclusion that “appropriate equita- ble relief” refers to relief traditionally equitable in nature (such as injunctive relief or resti- tution). The court then considered plaintiff’s equitable estoppel argument. An equitable estop- pel claim in the ERISA context requires the traditional elements of estoppel (representa- tion, ignorance, reliance on representation) but also two additional requirements: (1) that the representations made by plan representatives were based on an ambiguity, and (2), that extraordinary circumstances apply. The ambiguity requirement is derived from the princi- pal that the written plan document must govern; estoppel based on misrepresentation can- not act to modify the plan document to the detriment of the plan. The court concluded that the plan representatives in Gabriel simply made a mistake as to what benefits plaintiff was entitled to. The representations were not based on interpreting an ambiguity in the plan document and the fact that plaintiff relied on the statements to his detriment does not allow the terms of the plan to be ignored or rewritten. The court was also not persuaded that plaintiff was without knowledge of the fact that he was not fully vested, this being a traditional requirement of estoppel (he was not relying on defendant’s representation while being without knowledge of the underlying facts). The court found that equitable estoppel was not a remedy available to plaintiff and affirmed the district court’s finding. The court then considered whether plaintiff raised a material issue as to his entitle- ment to reformation. The court recites the requirements for reformation being either mutual mistake of fact or mistake combined with fraud by one party. The court observes that there was no mistake in the terms of the plan document. Plaintiff does not dispute that he was not eligible as a sole proprietor and that defendant’s correction making him ineligi- ble is consistent with the terms of the plan document. Instead, plaintiff seeks to reform the plan based on the plan’s erroneous records reflecting his entitlement to a benefit despite a lack of vesting. The court concludes that the administrative records are not part of the plan document, citing Amara.Plaintiff also fails to allege fraud on the part of the plan represen- tatives. Based on the above, the court affirmed the district court’s grant of summary dispo- sition as to plaintiff’s claim for reformation. Finally, the court examined the district court’s ruling as to plaintiff’s claim for the remedy of surcharge. The district court’s ruling was made before the Supreme Court’s
7-21 Tax Conference, 28th Annual, May 21, 2015 decision in Cigna v. Amara and so was based on prior case law that did not involve a suit by a beneficiary against a plan fiduciary and did not consider whether surcharge would be “appropriate equitable relief” under ERISA 502(a)(3). The court remanded the question for the district court to determine. This ruling as to the surcharge claim is consistent with the dissent in the original opin- ion which stated that the majority opinion had misread Cigna v. Amara and created a split among the circuits. In the original majority opinion in Gabriel, the court concluded that surcharge was not an available remedy because a traditional surcharge remedy requires a loss to the trust estate or profit to the fiduciary from a loss to the trust. But as the dissent in the original opinion pointed out, the Supreme Court in Amara categorized the sort of “make whole” relief sought by plaintiff (monetary relief against a fiduciary) as essentially equitable in nature, stating that it fit within the relief intended as “appropriate equitable relief” to be provided by ERISA 502(a)(3). Amara was concerned with whether relief sought under 29 U.S.C.§1132(a)(3) resem- bles forms of traditional equitable relief not whether the precise requirements for obtain- ing such relief under the common law of trusts are met. Make-whole relief for breach of fiduciary duty against a trustee conforms to that description, whether or not traditional trust law would have provided that relief under the “surcharge” terminology. The dissent in the original opinion states further:
Given its breadth, Amara has rightly been described as a striking development that sig- nificantly altered the understanding of equitable relief available under 1132(a)(3), in cases alleging a breach of fiduciary duty. Indeed, several other circuits have overruled their own precedents in its wake. Before Amara, various lower courts, including this one, had (mis)construed Supreme Court precedent to limit severely the remedies avail- able to plaintiffs suing fiduciaries under 1132(a)(3). The majority nonetheless treats Amara as a continuation of prior case law.
Lessons from Gabriel. Gabriel represents the latest circuit court struggle in interpret- ing Cigna Corp v. Amara. As stated, the original opinion refrained from applying Amara in a way that would allow plaintiff to pursue any of the available equitable remedies because the court found that plaintiff could not satisfy the prerequisites associated with the various remedies under common law. However, this application caused a split with the 4th, 5th and 7th circuits so the opinion was re-issued and ultimately plaintiff’s surcharge claim was remanded back to district court. This is considered a punt by the circuit court and in fact, the other circuits have acted likewise. Nevertheless, the trend in the applica- tion of Amara is to allow equitable remedies under ERISA 502(a)(3) without a strict appli- cation of the common law prerequisites. D. Munro-Kienstra v. Carpenters Health and Welfare Trust Fund of St. Louis, 2014 WL 562557 (2014) Munro is a district court case in the Eastern District of Missouri that applies Heime- shoff and provides additional guidance on what courts consider a reasonable contractual limitation period. Plaintiff applied for disability benefits and her claim was denied in December of 2008. Plaintiff appealed the decision in June of 2009. The appeal was denied and the denial communicated to Plaintiff in July of 2009. The plaintiff did not file claim with the district court until January of 2012.
7-22 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
The plan document provides that actions under 502(a) of ERISA must be brought within two years of when the denial of appeal is communicated. The statute of limitations for analogous claims in Missouri is ten years. The court states that the ten year statute would apply were it not for the “clear mandate” in the plan document providing the two year period, which trumps the governing law provision and the general rule that ERISA plans borrow the limitation period in the most analogous state statute. The court recites rule from Wolfe (as applied in Heimeshoff) limiting a plan’s ability to impose a limitations period through the terms of the plan that is shorter than the applica- ble state statute: There cannot be a governing statute to the contrary and the limitation period imposed cannot be unreasonably short. The court points to the fact that Plaintiff did not argue the presence of a controlling statute to the contrary. The court reviews Heime- shoff which dealt with a three year limitation period commencing before the exhaustion of administrative review, the court there recognizing that even if internal review took two year (twice as long as average) a plaintiff would still have a year to file suit and describing the three year statute as a common provision among ERISA plans. On this basis, the court in Munro concluded that a two year statute that did not begin to run until a decision was rendered and denial communicated to the participant, was reasonable. Finally, the court considers whether the limitation period is properly tolled under Heimeshoff based on Defendant’s failure to provide a copy of the policy with the notice of denial of appeal. The Heimeshoff court explicitly referenced a court’s ability to use such tools as tolling or equitable estoppel in situations in which a delay by fiduciaries causes a participant to file beyond a deadline. The court points to a letter provided to plaintiff describing the process for appeal, filing of claim after denial and the applicable limitations period. The court does not accept that the fiduciaries caused plaintiff to file beyond the two year period. Lessons from Munro. Munro stands for the proposition that a contractual limitation period of as little as two years can be considered reasonable and enforced so long as it is clearly communicated to the participant and absent delay by the fiduciary. E. Nelson v. Standard Insurance Company, 2014 WL 4244048 (2014) Nelson is a case in the district court for the southern district of California that involved a limitation provision similar to that in Heimeshoff. The plan contained a provi- sion that required any claim to be brought within three years of the earlier of when proof of loss is submitted by the participant or the period in which it was required to be given. Plaintiff submitted a claim for long term disability benefits on May 30, 2008. Defendant paid benefits until 2010 when it informed plaintiff that she no longer satisfied the require- ments for disability coverage under the plan. Plaintiff sought review in 2010. Defendant rendered it final decision in October of 2011. Plaintiff filed suit January 23, 2013. Defendant made motion for summary disposi- tion based on the position that plaintiff’s claim was time barred by the limitation period stated in the plan. Defendant argued that the three year period began to run on May 30, 2008 when plaintiff submitted her claim, making any action filed after May 30, 2011 time barred.
7-23 Tax Conference, 28th Annual, May 21, 2015
Plaintiff argued that the limitation period in the plan document is unenforceable and not available to defendant:
• Defendant failed to raise the defense in its initial pleading • Plaintiff was within the period because it began to run upon her submission of final proof of loss in March of 2011 • The limitation period argued by defendant expired before the defendant issued its final decision • Defendant should be barred based on estoppel because defendant did not provide notice of the limitation period in its correspondence to her
The court concludes that defendant did not waive the defense by failing to raise it in its initial pleadings. But the court is not able to determine after review of the pleadings when the contractual limitation period began to run. Further the court questions whether the limitations period could be considered reasonable if it accepted defendant’s conclusion as to the commencement and expiration of the period. Defendant argues that plaintiff’s cause of action accrued on February 11, 2008, providing plaintiff with a period of time between benefit accrual and expiration of the limitation period. The court is not convinced that such a short period is reasonable given the delay involved in rendering a decision. The court also recognized the possibility of an equitable estoppel claim by plaintiff. For the reasons above, the Court denied defendant’s motion to dispose of plaintiff’s claim as a matter of law. Lessons from Nelson. While a contractual limitation period has been held to be enforceable so long as reasonable, plaintiff must have a sufficient opportunity to bring claim following completion of administrative review. When limit begins to before claim accrues (end of administrative appeal process) undue delay shortens period. Nelson stands for position that a limitation period that leaves plaintiff with 100 days to file appeal after denial at administrative level is arguably unreasonable and may warrant equitable tolling.
7-24 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
Exhibit A PowerPoint Presentation
1:I8 V:C7 V`$%QJ1RI:7V`5 :75
: % VQ` 1I1 : 1QJ `V:H.Q` 1R%H1:`7% 7 J`Q`HV:G1C1 7QJ `:H %:C1I1 : 1QJV`1QR V 1J$Q`V:C .H:`V VJV`1 J`Q`HV:G1C1 7 Q`VJ%VVCVH 1QJC:%V 6HV`VVC1 1$: 1QJ _%1 :GCV`VIVR1V V0VCQ]IVJ 1J .V V`1J1 1QJQ`!"# $1R%H1:`7 :IVV6%:``1:$V]R: V
T 1GGCV 08 R1 QJ J V`J: 1QJ:C • . 1`H%1 :VH%``VJ C7GV`Q`V .V%]`VIV Q%` • .V .V`:HC:1I .: !"#]C:J`1R%H1:`1V G`V:H.VR .V1`R% 7Q`]`%RVJHVG7Q``V`1J$ .1$.V`RHQ `V :1CRHC:I% %:C`%JR Q]C:J ]:` 1H1]:J 5V0VJ .Q%$.1RVJ 1H:CCQ1V`RHQ 1J 1 % 1QJRHC:I% %:C`%JR1V`V:0:1C:GCV51 G:``VRG7 888 ^_1.VJ`1R%H1:`1V 1J1 1:CC7H.QV .V.1$.V`RHQ I% %:C`%JR: ]C:J1J0V IVJ IQ`V .:J167V:`GV`Q`V .V HC:1I1:`1CVR8
7-25 Tax Conference, 28th Annual, May 21, 2015
T 888 ^_^VH 1QJ_7 ^_ Q:H 1QJI:7GVHQIIVJHVR%JRV` .1 %GH.:] V`11 . `V ]VH Q:`1R%H1:`7; G`V:H.Q`:J7`V ]QJ 1G1C1 75R% 75Q` QGC1$: 1QJ%JRV` .1 ]:` 5Q`11 .`V ]VH Q:01QC: 1QJQ` .1 ]:` 5:` V` .VV:`C1V`Q`V ^_ 167V:` :` V` ^'_ .VR: VQ` .VC: :H 1QJ1.1H.HQJ 1 % VR: ]:` Q` .VG`V:H.Q`01QC: 1QJ5Q` ^_1J .VH: VQ`:JQI1 1QJ .VC: V R: VQJ1.1H. .V`1R%H1:`7HQ%CR.:0VH%`VR .VG`V:H.Q` 01QC: 1QJ5Q` ^_ .`VV7V:` :` V` .VV:`C1V R: VQJ1.1H. .V]C:1J 1`` .:R:H %:C@JQ1CVR$VQ` .VG`V:H.Q`01QC: 1QJ6 V6HV] .: 1J .VH: VQ```:%RQ`HQJHV:CIVJ 5 %H. :H 1QJI:7GVHQIIVJHVRJQ C: V` .:J 167V:` :` V` .VR: VQ`R1 HQ0V`7Q` %H.G`V:H.Q`01QC: 1QJ
T 4C:1J 1``:JR 5 :`$%V:HQJ 1J%1J$01QC: 1QJ .VQ`77 • $1R%H1:`7R% 1V:`VQJ$Q1J$ • `V`V` QC: :H 1QJ • 8QIV:%`V``QI]Q1J Q``1` 1JHC%1QJQ``%JR1 V``Q`
T 1`H%1 HQ%` `V`% V Q :RQ] HQJ 1J%1J$ 01QC: 1QJ .VQ`7 • 4C:1J 1``:JR 5 :`VHQJ`%1J$:`:1C%`V Q `VIVR7 11 .:VHQJR:H Q`1I]`%RVJHV • !VJRV`VH8^_^#_IV:J1J$CV^ .V`V1JQ 7V:` : % VGVH:%V : % Q`7]V`1QRJV0V` :` _ • Q%CRV6]QV`1R%H1:`1V QC1:G1C1 7`Q`CQJ$:$Q :H
7-26 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
T Q%` RVJ1V .: 1 `V:R1J$Q`11CC$10V `1R%H1:`1VH:` VGC:JH.V 01RVJHVQ`:>H.:J$V1JH1`H%I :JHV?HQ%CRIV:J VHQJRG`V:H.8 .:J$V1JH1`H%I :JHVHQJHV] VIG`:HVRG7 .5
. :JR . H1`H%1
T %]`VIV Q%` .V:`RQ`:C:`$%IVJ QJVG`%:`7 .5 • % 1HVJ QJ1J H:C1:7.: 7Q%`]Q 1 1QJ-&.: RR .: V0V`7RR V0V`7 QH@ .: 1 Q1JVR.: QGV `V01V1VRV0V`77V:`: .Q%$.1 1: :JV1]%`H.: V- .C:1J 1`` HQ%J VC7.V`1QR1HR% 7 QIQJ1 Q` • 1QQ@: .V]V``Q`I:JHVQJ:`V$%C:`G: 1 • 1QQ@: .VV6]VJ V :JRRV V`I1JV1`CV V6]VJ 10V :C V`J: 10V • 3QH.:J$V1JH1`H%I :JHV `V_%1`VR%JRV` Q `1$$V`HQJ 1J%1J$R% 7 QIQJ1 Q`
T 5 1:J HQ%` Q`%CV7 • .C:1J 1`` H:JG`1J$:HC:1I`Q`1I]`%RVJ IQJ1 Q`1J$ :JR`V VJ 1QJQ``%JR G: VRQJ1.: .:]]VJVR 11 .1J .VC1I1 : 1QJ ]V`1QR • 31J .1`H%1 1: 1`QJ$ Q`V_%1`VH.:J$VQ` H1`H%I :JHV ]]VCCVV7`a :G QC% VC7 `%V .: .V`V1 : `%JR:IVJ :C:JRI:=Q`R1``V`VJHVGV 1VVJ .V]`QHV `Q` VCVH 1J$`%JR 1J1 1:CC7:JR .V]`QHV `Q` IQJ1 Q`1J$V61 1J$`%JR 8.VJ7Q%`V VCVH 1J$`%JR 5 7Q%`V$Q1J$ .`Q%$. .1 HQI]`V.VJ 10V`V01V1Q` .V I:`@V 61.VJ7Q%`VIQJ1 Q`1J$ .VI57Q%`VG: 1H:CC7 CQQ@1J$`Q`H.:J$VRH1`H%I :JHV
7-27 Tax Conference, 28th Annual, May 21, 2015
V1IV .Q`` 08 :` `Q`R J %`:JHV Q8 • %]`VIVQ%` `V01V1Q`RVH11QJQ% Q`JR 1`H%1 • !"#RQVJQ ]`Q01RV : % VQ`C1I1 : 1QJ`Q` `1C1J$%1 %JRV` ^:_^_^_R %Q :J:CQ$Q% : V : % VQ`C1I1 : 1QJ:]]C1V • QJJVH 1H% C:1:CCQ1VR`Q`JQ CV .:JQJV7V:` ``QIR: VQ`CQ • 4C:J`V_%1`VR`1C1J$Q`HC:1I11 .1J7V:`Q`1.VJ ]`QQ`Q`CQ1:R%V
C:1J 1``:`$%VR .: !"#1:HQJ `QCC1J$ : % V Q .VHQJ `:`71J .: .VVJ`Q`HV:G1C1 7Q` HQJ `:H %:CC1I1 : 1QJ]V`1QR1Q%CR%JRV`I1JV !"# 1Q 1V`VR`VIVR1:CH.VIV8 Q%` RQVJQ :$`VV7 • "`:RI1J1 `: 10V`V01V1 QQCQJ$5HC:1I:J H:J 1IIVR1: VC7`1CV%1 • Q%` H:J%V QQC%H.:V Q]]VC5C:H.V :JR1:10V` Q:RR`V:G%V
Q7V` 08 V `Q]QC1 :J 1`V J 8 Q T . 1`H%1 • QJ `:H %:CC1I1 : 1QJ]V`1QR1I1C:` Q V1IV.Q`` • >Q 1HVQ`]V`1QRJQ HQJ :1JVR1J4 Q`JQ 1HVQ` HC:1IRVJ1:C • 1`H%1 HQ%` RV V`I1JVR01QC: VR!"# `VC: 1J$ QJQ 1HVQ`HC:1IRVJ1:C • >Q 1HVQ`HQJ `:H %:CC1I1 : 1QJ]V`1QRI% GV ]`Q01RVR Q]:` 1H1]:J `Q`]`Q011QJ QGV VJ`Q`HV:GCV
7-28 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee
%J`Q R R"1VJ `: 08 :`]VJ V` V:C . :JR VC`:`V `% $%JR Q` % 8 Q%1 • 4C:1JHQJ :1JVRHQJ `:H %:CC1I1 : 1QJ]V`1QR `V_%1`1J$HQI]C:1J GV`1CVR11 .1J7V:`Q` 1.VJ:RI1J1 `: 10VRVJ1:CHQII%J1H: VR • VJ1:CCV V`V6]C:1JVR7V:`C1I1 • Q%` `V01V1V1IV.Q`` :JRHQJHC%RV7V:` ]V`1QR Q`1CVHC:1I1`V:QJ:GCV
*VCQJ08 :JR:`R"J%`:JHV QI]:J7 • ;1 `1H Q%` 58;8:C1`Q`J1:^_ • C1I1 : 1QJ]`Q01 1QJ 1I1C:` Q +V`VJR:J • .C:1J 1``; :H 1QJ 1IVG:``VR%JRV` 7-29 Tax Conference, 28th Annual, May 21, 2015 %8&8 :C1`Q`J1: &1 `1H Q%` ^_ • V`VJVJQ 1:10VR • >Q HCV:```QI]CV:R1J$1.VJ:H 1QJ:HH`%VR • ?%V 1QJQ``:H : Q_%1 :GCV8QCC1J$ • >Q HCV:` .: R:71Q%CRGVHQJ1RV`VR `V:QJ:GCV%JRV`V1IV.Q`` :H@V 08 / 0QC7IV` • %]`VIVQ%` RVH11QJ`V]`V%I] 1QJQ` 0V 1J$Q`.V:C .H:`VGVJV`1 T !V=VH VR>:`RR %:J"J`V`VJHV? • :`RR%:JHQJ `Q0V`1:C1J`V`VJHVGQ`J1J . H1`H%1 T #08:`RR%:J5"JH8 $8R ^ _ • ``VH 10VC7H`V: VR]`V%I] 1QJQ`1J VJ Q0V 1J HQJ V6 Q`# • .5 . :JR . H1`H%1 :]]C1VR • !V=VH VRG7`R5 . :JR . H1`H%1 C:1J 1`` 1V`V %G=VH Q : QCCVH 10V :`$:1J1J$ $`VVIVJ 8 .V `VC: VR GVJV`1 :$`VVIVJ : VR7 > I]CQ7VV 1.Q `V 1`V QJ Q` :` V` ":J%:`7 5 881.Q V `%CC 7V:` Q` : :1JVR :$V :JR `%CC 7V:` Q` : :1JVR HQJ 1J%Q% V`01HV 8 8 : .V 1IV Q` `V 1`VIVJ V_%:C Q` IQ`V ]Q1J 11CC `VHV10V : `%CC QI]:J7 HQJ `1G% 1QJ Q1:`R .V HQ Q` `.V:C . H:`Va GVJV`1 RV H`1GVR 1J .1 6.1G1 T 8 8 8 8 I]CQ7VV 1.Q .:0V CV .:J ]Q1J : .V 1IV Q` `V 1`VIVJ 11CC `VHV10V : `VR%HVR QI]:J7 HQJ `1G% 1QJ8 .V QI]:J7 HQJ `1G% 1QJ 11CC GV `VR%HVR G7 Q `Q` V0V`7 ]Q1J CV .:J 8 I]CQ7VV 11CC GV `V_%1`VR Q ]:7 .V G:C:JHV Q` .V .V:C . H:`V HQJ `1G% 1QJ5 : V 1I: VR G7 .V QI]:J788 7-30 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee • +]1J1QJ1 %VR,:J%:`7Q` • Q%` 1J V`]`V ' V :GC1 .1J$GVJV`1 ]C:J :HHQ`R1J$ QQ`R1J:`7]`1JH1]CV Q`HQJ `:H C:1%JCV 1JHQJ 1 VJ 11 .`VRV`:CC:GQ`]QC1H7 • .VJ:'1 %J:IG1$%Q% 51 IV:J1J$I% GV : HV` :1JVR11 .]C:1JC7V6]`V VR1J VJ • QJ 1RV`: 1QJ `QCCQ11J$02 • C:J ]QJ Q` HQJ 1RV`1J$ .VIQR1`1H: 1QJQ` .V:C .H:`VGVJV`1 .Q%CRH:`V`%CC7`V01V1:CC1`1 VJ ]C:JRQH%IVJ 6 • 3V01V1.V:C .]C:J : R%VR1C1$VJHV1JIV`$V` L :H_%1 1 1QJ • 6 :7 %JVR Q . 1``VI:JR %I1 . 08 1V$QJ • . 1`H:VRVH1RVR5H QGV`5 • 4`1I:`7"%V7 • V0VCQ`V`V`VJHV:``Q`RVR Q6VH`V :`7Q`:GQ` ]Q 1 1QJ: V` VR1J'I1H% %`1:V`1V` • .V .V`VJ%V6VCVH 1QJC:% V1 J`Q`HV:GCV%JRV` 396' %I1 . 08 1V$QJ • 5 ]Q1 1QJ0VJ%VVCVH 1QJ1JHQJ1 VJ 11 . `V_%1`VIVJ Q`!"# • #]]VCC:J 7 5 ]Q1 1QJRVV`0V.V0`QJQ` @1RIQ`VRV`V`VJHV • Q%` 7 5 ]Q1 1QJJQ VJ 1 CVR QV1 .V`.V0`QJ Q`@1RIQ`V 7-31 Tax Conference, 28th Annual, May 21, 2015 Q%` `V=VH :`$%IVJ .: VJ%V %VCVH 1QJ C:% V 1J 01QC: 1QJ Q` 4%17 • 4`Q01R1J$`Q`]VH1`1H0VJ%V1J`VRV`:CHQ%` RQV JQ 1I]VRV`V:R7:HHV Q`VRV`:CHQ%` • $%` .V`Q .V`!"#QG=VH 10V7 • JHQ%`:$V %J1`Q`I1 71J:]]C1H: 1QJQ``VRV`:CC:1 Q ]:` 1H%C:`]C:J^QJVHQ%` _ • 3VR%HV HQ Q`:RI1J1 `: 1QJ %V7 08 ^_ • . 1`H%1 RVH1 1QJ • 3; 9 • 6VC`R1`VH VR]C:JQ``V`1J$Q]VJ:`H.1 VH %`V1J0V IVJ ]C: `Q`I • 3V0VJ%V .:`1J$:``:J$VIVJ V :GC1 .VR11 . 1RVC1 71J • 1RVC1 7]`Q01RVR V`01HV Q' .: 1V`V%J`VC: VR Q ^@_]C:J • :7`QCC V`01HV • 3VHQ`R@VV]1J$`Q`1VC`:`VL]VJ 1QJ]C:J • ':R01 VRG7HQJ %C :J .: Q0V`]:71J$`Q` V`01HV .`Q%$.`V0VJ%V .:`1J$:JRI:7GV %G 1R1<1J$%J`VC: VR V`01HV 1` V` GVJH. `1:C5 &1 `1H Q%` `%CVR G`V:H. Q` `1R%H1:`7 R% 1V %JRV` 4%1 5 :JR • 8I1CC1QJ`Q``:1C%`V QHQJ `QC`VHQ`RR@VV]1J$ HQ • 8 I1CC1QJ`Q`CQVR%V Q1J0V IVJ I:]]1J$ • 8 I1CC1QJ:$:1J $1RVC1 7`Q`CQ >`CQ: 1JHQIV? • FQ1J V0V`:C 1:G1C1 7`Q`8I1CC1QJ1J: Q`JV7 `VV 7-32 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee Q%` :H: V & &VH1 1QJ %VCVH 1QJ Q` J0V IVJ :JR :]]1J$ Q%` 4V0V` V RVH1 1QJ :$:1J $1RVC1 7 `Q` 8`V:H. 1J `V $CQ: JHQIV Q%` 0:H: V :1:`R Q` 1 Q`JV7 $VV Q%` RV V`I1JV & .:R :I]CV %]]Q` `Q` `1JR1J$ G`V:H. Q` `1R%H1:`7 R% 7 %JRV` H1`H%I :JHV V QJ ``QI % V7 • "J0V 1$: VHQI]V 10VJVQ``VVLRQH%IVJ • % 7 Q: VI] QCV0V`:$V1 1I:`: 4VH:] R 1I:`: 08 1$J: Q`]85 $8 %%]]8R ^ _ ^>1I:`: ?_ • "J0QC0VRHQJ0V`1QJQ` `:R1 1QJ:C ]C:J QH:. G:C:JHV]C:J • $1R%H1:`1V.:R`:1CVR Q]`Q01RV%``1H1VJ JQ 1HV Q`GVJV`1 `VR%H 1QJ%JRV`^._ • RV V`I1JVRV_%1 :GCV`VIVR7^`V`Q`I: 1QJ_ :0:1C:GCV%JRV`!"# ^:_^_^_ QHQJ`Q`I ]C:J Q1.: 1:`V]`VVJ VR Q]:` 1H1]:J • Q%` ]`Q01RVR>#U?GVJV`1 7-33 Tax Conference, 28th Annual, May 21, 2015 I:`: 08 1$J: Q`]5 8R ^_^>I:`: ?_ • Q:G% VQ`R1 H`V 1QJG71JRV V`I1J1J$`V_%1`VIVJ Q``V`Q`I: 1QJ : 1 `1VR • 1$J:; I1 `V]`V VJ : 1QJ :IQ%J VR Q``:%RL1J VJ Q RVHV10V5 : 1 `71J$`V`Q`I: 1QJ :JR:`R • Q`V_%1`VIVJ Q` .Q11J$Q`:H %:C.:`I`Q``V`Q`I: 1QJ %JRV`HQIIQJC:1T .:`I1 `:1C%`V Q`VHV10VGVJV`1 Q` HQJ `:H $10VJI1 :@VQ`RVHV] 1QJG7Q .V`]:` 7 • C:J]`Q]V`C7`V`Q`IVR QGVHQJ 1 VJ 11 . `V]`V VJ : 1QJ I:RV Q]:` 1H1]:J 1J^._JQ 1HV G: VRQJ]`1JH1]CV Q`V_%1 7 /:G`1VC 08 1C: @: CVH `1H:C • . 1`H:VHQJ1RV`1J$%`H.:`$V::`VIVR7 :` V`#I:`: • R1I1VRHC:1I`Q`V_%1 :GCV`VC1V` RV V`I1J1J$ .: `VIVR7Q%$. 1: HQI]VJ: Q`7R:I:$V:JRJQ V_%1 :GCV`VC1V` %JRV` ^:_^_ • . 1`H%1 :``1`IVR5`1JR1J$%`H.:`$VJQ :0:1C:GCV R JQCQ Q]C:JLJQ%J=% VJ`1H.IVJ &1 VJ T :=Q`1 7 ?]1J1QJ &1 `V$:`R 1I:`: • >: `1@1J$RV0VCQ]IVJ .: 1$J1`1H:J C7:C V`VR .V %JRV` :JR1J$Q` .V:0:1C:G1C1 7Q`V_%1 :GCV`VC1V` %JRV` ^:_^_ • 'I:`: :]]C1VRV_%1 :GCV`VIVR1V IQ`VG`Q:RC7 Q :``Q`R>I:@V1.QCV?`VC1V`6R1RJQ `V_%1`VCQ Q]C:J Q`%J=% VJ`1H.IVJ `V: V]C1 7 .5 . :JR . 1`H%1 .:0V:]]C1VR I:@V1.QCV`VC1V`:GVJ ]C:JCQQ`VJ`1H.IVJ 7-34 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee %VHQJR Q]1J1QJ R Q%` `VI:JR HC:1I `Q` %%`H.:`$V • 1 `1H HQ%` R1RJQ HQJ1RV` .: .11%1 G7 GVJV`1H1:`7:$:1J ]C:J`1R%H1:`75H`1 1H:C R1 1JH 1QJ%JRV`#I:`: • 1RJQ HQJ1RV`1.V .V`K:G`1VCV :GC1.VR 1J=%`7R%V QG`V:H.Q`:]]C1H:G1C1 7Q`%`H.:`$V Q:RR`V1J=%`7 • #I:`: `V_%1`V`VI:JR1` `:1CVR QHQJ1RV` .V:]]C1H: 1QJQ`V_%1 :GCV`VC1V`%JRV` ^:_^_ V1I@%V.CV` 08 IV`1H:J J1 VR 1`V J8 Q8 ^_ ^ . 1`_ • V0VJ%V .:`1J$`VHV10VRG7 V`01HV]`Q01RV` G: VRQJ`%JR 1JHC%RVR1J]C:JT .C:1J 1``:`$%V 01QC: 1QJQ` $10VJ`1R%H1:`7 : % • ;B1 ]Q 1 1QJ .: Q``V`1J$:`%JRQJ:J1J0V IVJ ]C: `Q`I1 V6V`H1 VQ`R1 H`V 1QJQ0V`]C:J: V T `1$. Q 1:]`%JR T RV]:` %`V``QIR01 Q`7 B]1J1QJ • . 1`H%1 `V_%1`V :H %:CV6V`H1 VQ`:% .Q`1 7`Q` RV V`I1J: 1QJ`1R%H1:`7 : % QCRVJ :`08 :$$ % %:C 1`V J$8Q8 ^_^8 :$$_ • : :`%JH 1QJ:C`1R%H1:`7%JRV`^_^1_:JR^111_- • .:R:% .Q`1 7 Q 1:]`%JR `V %C 1J$1J1JH`V: VR`VV 01: `V0VJ%V .:`1J$ • .:R:% .Q`1 7 Q V Q1J`VV]:7:GCVG7]C:J^%] QQ_ • % .Q`1 7Q0V`1J0V IVJ R H %:CV6V`H1 V Q`:% .Q`1 7 Q %G 1 % V1J0V IVJ 1 `V_%1`VR QHQJ`V``1R%H1:`7 : % • 0VJ .Q%$.^_^111_G: VRQJ:% .Q`1 75HQ%` RV V`I1JV ^_^111_ :`$%IVJ `VC: 1J$ Q1J0V IVJ VCVH 1QJ`:1C GVH:% V5V0VJ1`]C:J :RI1J1 `: 1QJ`V:RG`Q:RC75> Q .VV6 VJ ?`V_%1`VIVJ JQ : 1 `1VR ^JV0V`V6V`H1 VRR1 H`V 1QJ:IQ%J 1J$ QG`V:H._ • % .Q`1 7 Q:R=% `VV `V %C 1J`1R%H1:`7 : % %JRV`^1_:JR^111_ • %1 `1H HQ%` RVJ1V ^G_^ _IQ 1QJ`1JR1J$1 %VQ``:H : Q 1.V .V`:``:J$VIVJ `V %C VR1J`1R%H1:`7 : % 7-35 Tax Conference, 28th Annual, May 21, 2015 V:C .H:`V `: V$1V 08 ^_ ^8 QJJ_ • JJ%1 7HQJ `:H :CCQ1]`Q01RV`R1H`V 1QJ Q H.:J$V`%JR11 .QJC7JQ 1HV Q]C:J • C .Q%$. .V J%`V`V6V`H1V:% .Q`1 7 QH.:J$V `%JRQJ 1QQHH:1QJ5 .VHQ%` `V:R ^_^111_G`Q:RC7Q .: .V%G 1 % 1QJQ``%JR1J HQJ1RV`VR>:RI1J1 `: 1QJ?%JRV`^111_ • 396' ^_^111_`V_%1`V QJC7:% .Q`1 7:JRJQ :H %:C V6V`H1 V • V CVIVJ `V_%1`VRH.:J$V1J]`QHVR%`V HQJ 1 VJ 11 .R01 Q`7B]1J1QJ R 0`Q]Q VR 4V$%C: 1QJ `VCV: VR G7 &? 1]`1C .5 R:7 HQIIVJ ]V`1QR V6]1`V B%C7 .5 :` V` 1.1H. .V`V 11CC GV ]%GC1H .V:`1J$ :JR .VJ IQ`V HQIIVJ 4%CV 1Q%CR `V_%1`V G`Q@V` Q :H ]%` %:J Q >GV 1J V`V ? :JR:`R J1 VR : V 081JR Q`^_ • /VH 1QJ Q` 1V`VJ V Q` 2:``1:$V H .VCR %JHQJ 1 % 1QJ:C : 01QC: 1QJ Q` R%V ]`QHV • 34/ 1J $%1R:JHV :RQ] >C:HV Q` VCVG`: 1QJ 4%CV? • 1JR Q` R1R JQ RVH1RV 1.V .V` : V HQ%CR ]`Q.1G1 :IV V6 I:``1:$V ;VGQV` 08J7RV` • 1H.1$:J; :``1:$V IVJRIVJ H.:CCVJ$VR 1J R1 `1H HQ%` • 1 `1H HQ%` `Q` : V`J 1 `1H Q` 1H.1$:J `%CVR 1H.1$:J :``1:$V H 01QC: VR V_%:C ]`Q VH 1QJ • . H1`H%1 :7VR `%C1J$ ]VJR1J$ :]]V:C :JR %C 1I: VC7 Q0V` %`JVR R1 `1H HQ%` • V` $`:J VR :J%:`7 5 5 HQJ QC1R: VR H: V 11 . .`VV Q .V` Q% Q` . H1`H%1 7-36 Employee Benefit Litigation Update - Estates and Trusts Committee/Employee Benefits Committee VQV` QJVQ``Q%`H:VHQJQC1R: VR`Q``V01V1 GV`Q`V88%]`VIVQ%` • ?%V 1QJ]`VVJ VR7 8 QV .V Q%` VVJ .'IVJRIVJ `V_%1`V: : V Q C1HVJ V:I:``1:$VGV 1VVJ 1Q]VQ]CVQ` .V :IV V6- 8 QV .V Q%` VVJ .'IVJRIVJ `V_%1`V: : V Q `VHQ$J1 D%V 1QJ -- 7-37 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee by Stefan F. Tucker Venable LLP Washington, DC Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee Stefan F. Tucker Venable LLP Washington, DC Tammara F. Langlieb Venable LLP Washington, DC TABLE OF CONTENTS I. S CORPORATION/LLC COMPARISON ...... 8-1 A. Structure ...... 8-1 B. Taxation ...... 8-3 C. Estate Planning...... 8-8 II. BUSINESS USE OF FLPs AND FLLCs ...... 8-9 A. Retain Control over the Business ...... 8-9 B. Provide Continuous Ownership of Property within the Family Unit ...... 8-9 C. Protect the Owners from Liability and Creditors of the Entity ...... 8-10 D. Protect the Assets of the Entity from the Owners’ Liability and Creditors ...... 8-10 E. Litigation Avoidance ...... 8-12 F. Probate Avoidance ...... 8-13 G. More Advantageous Annual Gifting by Parents ...... 8-13 H. More Flexible than Trusts ...... 8-13 III. RECENT CASES REGARDING ESTATE INCLUSION OF FLP AND FLLC INTERESTS ...... 8-14 B. Estate of Jorgensen v. Comm’r, 107 AFTR 2d 2011-2069 (11th Cir. 2011) .... 8-14 B. Keller v. U.S., 110 AFTR 2d 2012-6061 (5th Cir. 2012) ...... 8-14 C. Estate of Kelly v. Comm’r, T.C. Memo 2012-73 ...... 8-15 A. Estate of Liljestrand v. Comm’r, T.C. Memo 2011-259 ...... 8-17 E. Estate of Stone v. Comm’r, T.C. Memo 2012-48 ...... 8-18 F. Estate of Turner v. Comm’r, T.C. Memo 138 T.C. No. 14 (2012) ...... 8-20 IV. RECENT CASES REGARDING VALUATION OF FLP AND FLLC INTERESTS ...... 8-21 A. Estate of Gallagher v. Comm’r, T.C. Memo 2011-148 ...... 8-21 B. Estate of Giustina v. Comm’r, 114 AFTR 2d 2014-6848 (9th Cir. 2014) ...... 8-22 C. Estate of Koons v. Comm’r, T.C. Memo 2013-94...... 8-23 8-i Tax Conference, 28th Annual, May 21, 2015 D. Estate of Tanenblatt v. Comm’r, T.C. Memo 2013-263 ...... 8-25 E. Wandry v. Comm’r, T.C. Memo 2012-88 ...... 8-26 Exhibit Exhibit A Buy-Sell Agreements: An Issues Checklist ...... 8-29 8-ii Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee I. S CORPORATION/LLC COMPARISON S Corporation LLC A. STRUCTURE Organizational • A corporation may be • A limited liability company which has structure treated as an S corporation more than one member is a state law only if it is a small business entity that is taxed as a partnership corporation unless it makes an election otherwise • The corporation must be a • Any organizational requirements domestic corporation that: would be imposed under state law. 1. is not ineligible For purposes of this chart, it is 2. does not have more than assumed that it is taxed as a 100 SHs partnership 3. does not have any SH that is other than an individual, estate, certain trusts or charitable organizations 4. does not have any SH that is a non-resident alien; and 5. does not have more than one class of stock (can have differences in voting rights) Management • Management is periodically • Limited only by the owner’s structure elected by the owners imagination (can be managed by • State law usually provides managers or members, or both) that the board of directors is • Can have representative management to govern the affairs of a in a manager-managed LLC with corporation elected managers • Managers do not have to stand for election • Managers may not have to be natural persons • Manager does not have to be a member • Can allocate different functions of the LLC to different managers • May cause member to become subject to self-employment tax 8-1 Tax Conference, 28th Annual, May 21, 2015 S Corporation LLC Scope of • Function of state law • Function of state law, but manager’s managerial authority is generally limited to that authority set forth in the operating agreement Formalities / • New corporation must file S • Few legal requirements operational election with IRS within 2½ requirements months after the earliest of the following: the corporation (i) has shareholders, (ii) acquires assets, or (iii) begins doing business. • Same state law requirements as a C corporation • Must have officers and directors • Annual meeting typically required (held at a time designated in the bylaws) – this is where shareholders vote to hire and fire directors and to vote on fundamental changes • Shareholder votes require unanimous written consent or a meeting that satisfies notice, quorum, and voting requirements • Officers are selected and removed by the Directors • Director action requires unanimous written consent or a meeting that satisfies notice, quorum, and voting requirements • Books, records of account, and minutes from shareholder meetings must be kept as part of the normal course of business • Annual reporting required 8-2 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee S Corporation LLC Limitations on • Nonresident aliens and • There are no limitations on who may types of owners entities other than certain be a member or manager trusts, estates, and tax- exempt shareholders may not own interests Number of owners • No more than 100 • One-member LLC allowed, but shareholders disregarded for Federal tax purposes. At least 2 members required to be taxed as partnership Classes of • Limited to one class of • No limit ownership stock Subsidiaries • Wholly-owned corporation • Wholly-owned LLC will be may elect QSub status disregarded • Wholly-owned LLC will be disregarded Governing • Articles of Incorporation, • Articles of Organization or Certificate documents bylaws, shareholder of Formation and Operating agreement Agreement or LLC Agreement Persons entitled to • Directors and officers • Members or managers, depending on participate in state law and the operating agreement ordinary decisions Persons with • Officers • Members (member-managed LLC) or authority to bind managers (manager-managed LLC), the organization depending on state law and the operating agreement Permissible • Shareholders participate in • Members or managers may participate participation in management by electing in management, depending on state management directors law and the operating agreement B. TAXATION Taxation of the • Each shareholder takes into • Single member (disregarded entity) – owner account a pro rata share of net income from a single member the S corporation’s items of LLC would be subject to self- income, deduction, loss and employment tax unless one of the credit in the shareholder’s exceptions to taxation applied taxable year in which the S • Multiple Member – taxed as a corporation’s taxable year partnership, and each member takes ends into account the allocated share of the • The character of any such LLC’s items of income, deduction, item is determined at the loss and credit in the member’s entity level taxable year in which the LLC’s • The determination of taxable year ends 8-3 Tax Conference, 28th Annual, May 21, 2015 S Corporation LLC whether income from the • The character of any such item is discharge of an S determined at the entity level corporation’s debt is • However, the determination of excluded from a whether income from the discharge of shareholder’s gross income an LLC’s debt is excluded from a because of insolvency or member’s gross income because of bankruptcy (under Sec. 108, bankruptcy or insolvency (under Sec. I.R.C.) is also determined at 108, I.R.C.) is determined at the the entity level member level • Generally, the shareholders • Generally, the members are directly are directly taxed on the taxed on the income of an LLC, income of a corporation, whether distributed to them or retained whether distributed to them by the LLC, and distributions are or retained by the generally not taxed corporation, and distributions are generally not taxed Taxation of the • Pass through • Pass through organization • Generally not subject to tax, • Single member – disregarded for tax but an S corp. that was a C purposes corp. and has C corp. • Any other LLC – subject to earnings and profits must partnership taxation under Subchapter pay tax on excessive K unless a different classification is passive investment income elected and net recognized built-in • LLC must file an information return – gains taxable income generally computed as • S corp. must file an though the LLC is an individual, but information return – taxable any item that may have different tax income generally computed treatment for different members must as though the S corp. is an be separately stated individual, but any item that may have different tax treatment for different shareholders must be separately stated Ability of owners • Loss deductions are limited • Single member – owner may use to use losses of to the shareholder’s stock losses to offset other income, except the organization basis and loans made by the as limited by at-risk rules and passive shareholder to the activity rules corporation • Any other LLC – member may use • Losses are deductible by the losses of the LLC to offset other shareholders in proportion income as limited by basis, at risk 8-4 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee S Corporation LLC to their shares of ownership rules, and passive activity loss rules • Shareholder must satisfy at • A member interest is not treated as a risk rules and passive “limited partner” interest for purposes activity loss rules of applying the passive activity loss • Shareholder may carry rules forward disallowed losses, which are treated as incurred by the S corporation in the next taxable year • Disallowed losses and deductions are personal to the shareholder and cannot be transferred Assets that may be • If an S corp. has earnings • An LLC is expressly authorized to owned and profits from a prior hold real or personal property year in which it was a C corp., and passive income in excess of 25% gross receipts, then its excessive passive income is subject to a 35% penalty tax. If the condition exists for 3 years, S corp. election terminates th at the beginning of the 4 year Computation of • Basis is initially the amount • Basis is initially the amount of cash basis of cash contributed and the contributed and the basis of property basis of property contributed less liabilities assumed by contributed less liabilities the LLC assumed by the corporation • Increased by contributions • Increased by contributions • Increased by member’s share of the to the corporation and loans LLC’s debts to the corporation, BUT no • No basis for contribution of increase in basis for debts promissory note until payments made of the corporation to any on note (question as to whether this is creditor, even if the applicable for the contribution of a shareholder is liable on the personal promissory note) debt (however, the shareholder can take out a loan and then loan to the S corporation to get a basis increase) 8-5 Tax Conference, 28th Annual, May 21, 2015 S Corporation LLC Dealer property • An S corp. is better suited • By contrast, an LLC (like a to insulate owners from the partnership) is sometimes treated as an taint caused by dealer aggregate of its partners rather than a property since the treatment separate entity of a corporation as an entity distinct from its shareholders is firmly entrenched in the law Sale of an interest • Generally stock sales are • The sale of an interest in an LLC is in the organization treated as giving rise to generally treated as the sale of a capital gains and losses capital asset • As of 2013, generally, a • The sale of withdrawing member’s 3.8% Medicare contribution interest will create a technical tax will be imposed on the termination for the LLC, if 50% or income earned on the more of the interest in the LLC is sold disposition of an interest in within a 12-month period. an S corporation to the • As of 2013, generally, a 3.8% extent of the net gain that Medicare contribution tax will be would be taken into account imposed on the income earned on the by the transferor if all disposition of an interest in an LLC to property of the entity were the extent of the net gain that would sold for its FMV be taken into account by the transferor immediately before the if all property of the entity were sold disposition of such interest for its FMV immediately before the disposition of such interest Sale of • Gain or loss realized by the • Gain or loss realized by the LLC will substantially all S corporation will pass pass through and be taxed to its assets through to its shareholders. members. A member’s basis in its Gain will increase a interest is increased by this gain, so shareholder’s basis so that that the distribution of sales proceeds no gain should be realized is not subject to a second level of tax. with respect to the receipt • Generally, gain from the sale is of sale proceeds by the eligible for the installment method shareholder. • Potential for two levels of tax, if any of the sold property is subject to built- in gains. • Generally, gain is eligible for the installment method Disposition of • May yield ordinary loss • Generally yields a capital loss ownership interest under Sec. 1244, I.R.C. at a loss 8-6 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee S Corporation LLC Allocations • Allocations of income, loss, • Allocations may be made in any deduction, or credit must be manner agreed upon by the members, pro rata among so long as the allocations have shareholders substantial economic effect or are • The profits and losses are otherwise in accordance with the allocated on a strict per members’ interests in the LLC share, per day basis Contributions of • A contribution of property • Generally tax free, unless “disguised property is taxable to the shareholder sale” or member relieved of debt in unless control tests are met excess of basis and liabilities do not exceed • Receipt of member interest for the adjusted basis of the services may be taxable as transferred property compensation for services rendered or • Receipt of stock for may be treated as a “profits interest” services is taxable as or “promote interest” ultimately compensation taxable as capital gain Contributed • Unrecognized gain or loss • Built-in gain or loss must be allocated property with a from contributed property is to the contributing member (who has built-in gain or shared by the shareholders the book/tax disparity) loss on a per day, per share basis Distributions of • Must be proportionate to • Need not be proportionate to LLC property stock ownership ownership. • A distribution of • Generally tax free, unless member is appreciated property will relieved of debt in excess of basis in generally cause gain to be partnership interest or money received recognized at the corporate by member is in excess of adjusted level (gain is recognized as basis of member interest or is a if the property were sold for “disguised sale” its fair market value on the date of distribution); such gain is shared pro rata among shareholders • The corporation does not recognize any realized loss for distributions of loss property • If an S corporation has no earnings and profits (from existence as a C Corp), amounts received by shareholders in distributions are tax free to the extent of the shareholder’s basis; 8-7 Tax Conference, 28th Annual, May 21, 2015 S Corporation LLC amounts received in excess of basis are treated as gain from the sale or exchange of an asset Tax-free • Tax-free corporate • Tax-free corporate reorganization reorganization reorganization provisions provisions do not apply apply C. ESTATE PLANNING Owner’s default • The death of a shareholder • On the death of a member, if the right to payment does not require the business of the LLC is continued, the on death corporation to repurchase legal representative of the deceased the deceased shareholder’s member may have the value of the shares member’s interest at the time of dissociation, or, if later, at the expiration of the term Basis adjustment • Not applicable • If a 754 election is not made, the sale under Sec. 754, of an appreciated LLC asset by the I.R.C. LLC causes the LLC, and therefore successor member (or estate of the deceased member), to recognize gain on the sale, even though the successor member or estate has a stepped up outside basis in his/her/its LLC interests • If a 754 election is made, the basis of the LLC’s assets will be adjusted with respect to the successor member (or estate of the deceased member) thereby avoiding gain (on the difference between the old/deceased member’s basis and the new member’s stepped up basis) on the sale of the LLC asset • The outside basis for the new member/estate may be stepped down if the value of the asset has fallen below its basis; the 754 election would thus prevent the new member/estate from taking a loss on the sale of the asset Non-tax reasons • Non-voting stock can be • LLCs (like FLPs) allow the owner to for entity used to shift ownership control the management of real estate ownership of real among family members and establish a plan for succession, no without shifting control matter who the members are 8-8 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee S Corporation LLC estate • Entities, like LLCs, protect the real estate from creditor claims that are made against any of the members or against any other real estate owned by a member in a different entity Continuity of life / • A corporation has perpetual • LLCs typically will have continuity of period of duration duration unless limited in life in that the personal representative the Articles of of the last remaining members may Incorporation elect to continue the LLC II. BUSINESS USE OF FLPs AND FLLCs Real estate owners use entities such as Family Limited Partnerships (“FLPs”) and Family Limited Liability Companies (“FLLCs”) for several reasons, the most important of which are not tax related. These entities allow the owner to continue to control the management of the real estate and establish a plan for the succession of that management, no matter who the limited partners or members may be, which is imperative, given the specialized nature of real estate management and development. Furthermore, the entities protect the real estate from creditor claims that are made against any of the entity’s owners or against any other real estate the individual owns, which presumably are held in separate entities. Finally, these entities provide many non-tax estate planning benefits, such as probate avoidance. A. Retain Control over the Business. 1. The use of an FLP or FLLC allows older family members to transfer their property interests to younger family members while still retaining control over the transferred assets by acting as (i) the general partner (“GP”) of an FLP (preferably through ownership of a separate limited liability entity), or (ii) the Manager of an FLLC. a. Some older family members may not be ready to hand over control of the transferred property to younger family members. b. Some younger family members may not be ready to assume control of the transferred property, either (i) because they are not old enough or (ii) because they lack the business knowledge and skills necessary for managing the transferred property. 2. The older family members will still be able to control the assets of the FLP or FLLC as the GP or Manager, even as they continue to transfer their interests in the FLP or FLLC through annual gift giving. B. Provide Continuous Ownership of Property within the Family Unit. 1. The use of an FLP or FLLC allows the older family members to restrict the younger family members’ ability to sell or transfer his or her interests. 8-9 Tax Conference, 28th Annual, May 21, 2015 2. Examples of these restrictions are: a. Rights of first refusal; b. Buy-sell provisions; and c. Prohibitions on selling or transferring FLP or FLLC interests in a manner that is disruptive to (i) the entity or (ii) the family. 3. In all events, the entity agreement should provide that the other owners and the entity should have the first right to purchase the interest, if it is to be sold. 4. Older family members can continue to manage the assets while they adopt a plan for the succession of (i) ownership, (ii) management and (iii) control of the assets, regardless of who the limited partners or members may be. This is especially important when dealing with the specialized nature of real estate management and development. C. Protect the Owners from Liability and Creditors of the Entity. 1. Owners of FLP and FLLC interests will be protected from the liability or creditors of the entity unless: a. The owners are personally responsible for the act or omission that resulted in the liability; b. The owners personally guaranteed the debts of the FLP or FLLC; or c. The owners are liable as owners or operators under environmental law. 2. The use of more than one entity to hold ownership interests in real estate should be considered for the following reasons: a. Claims against an entity’s property (such as environmental claims) will only extend to the assets held in that entity, to the general partner’s assets (if it’s a partnership), or, if the general partner is a corporation or other entity, to such entity’s assets. b. Accordingly, if assets are held in different entities, the claims against one entity will not “taint” the assets in a separate entity. c. As a result of the general partner’s liability, consideration should be given to using a separate entity general partner for each partnership, since the entity general partner’s interest in the other partnerships could be reached because of the claims against one partnership’s assets. D. Protect the Assets of the Entity from the Owners’ Liability and Creditors. 8-10 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee 1. FLPs and FLLCs protect the transferred property from creditor claims that are made against any of the entity’s owners or against any other property the individual owns, which presumably is held in separate entities. 2. FLP and FLLC assets generally cannot be directly attached to satisfy the personal debts of the partners or members. The owners’ creditors are typically left to the following three options: a. Charging Order: A charging order is the court-ordered remedy of a creditor if the creditor is unable to force a partner or member to assign his or her interest. A charging order is neither an assignment nor an attachment. It is a court order that directs the entity to make any distributions to the owner’s creditors that it otherwise would have made to the owner. Under many limited liability company statutes, a charging order is the only remedy a creditor possesses. b. Assignment of partnership or LLC interest to a creditor: This occurs when a creditor is able to force an owner to assign his or her interest in the entity to the creditor. The creditor could become a partner or member (and, if a general partner interest or Manager interest is so assigned, control the entity) unless the entity’s agreement provides otherwise. c. Power to sell interest: If a creditor can establish that the claim may never be paid, a court may consider an order forcing the sale of the debtor’s entity interest, although such an order is rare since a sale could cause a material adverse disruption to the entity. Even if such an order is obtained, the interest will have little value to an outside party, especially since the purchaser will merely become an assignee. 3. The use of more than one entity to hold ownership interests in real estate should be considered. a. Creating more than one entity and choosing different jurisdictions for each entity will make it much more difficult on the part of a creditor to reach all of the assets, so that the creditor may decide to attempt to reach the interests in the entities closest to the creditor or to seek to reach only certain entities, leaving the rest undisturbed. b. A creditor may be more likely to settle with a debtor who owns most of his or her assets in one or multiple FLPs or FLLCs in one or multiple jurisdictions. c. However, there may be an adverse income tax consequence of creating more than one entity and holding different assets in different entities. 4. Owner’s Right to Receive “Fair Value” upon Withdrawal or Dissolution. a. Notwithstanding the right of an owner to receive fair value upon liquidation, the ambiguity of the term “fair value” may well provide protection against creditors. For creditor purposes, the agreement determines what rights the owners have to withdraw and liquidate his or her interest, and, further, the value such owner will get for his or her interest upon withdrawal. 8-11 Tax Conference, 28th Annual, May 21, 2015 b. The valuation of the interest to which an owner is entitled is binding on creditors as well. As a result, the agreement should address two goals: (i) making the entity interest as unattractive as possible to a creditor by imposing a method of valuing the interest that will result in the lowest value possible, and (ii) establishing a value that the family can afford to pay when buying the owner out of the entity. Generally, the basis on which value can be determined is either “going concern” value, under which the entity is valued as a ongoing business with no disruptions, including the element of goodwill, or “liquidation” value, which is the value the assets would bring if the owners were to sell all of the assets at one time for whatever they could obtain, without any element of goodwill. Obviously, valuing the interests by using the liquidation value method will result in a lower value. Furthermore, the agreement will either give the owner a pro rata percent of the entity assets, as valued either on a going concern or liquidation basis, or an amount after discounting the pro rata percent of the assets for the owner’s minority interest in the entity. Again, the second alternative will result in a lower value for both creditor attachment purposes (thereby forcing the creditor to look elsewhere for repayment) and family repurchase purposes. c. The disadvantage of these valuation alternatives is that they cannot be used only for creditor protection purposes if they are to withstand court scrutiny. As a result, there may be reasons that a owner wants to withdraw that have nothing to do with financial issues, but the entity must (in the absence of new negotiations) pay the owner this lower value, thereby forcing the owner to remain in the entity so that he or she may recoup his or her investment. 5. Convert Real Property to Personalty. a. Being able to change the situs of personal property can also have creditor and tax advantages, although it is recommended that there be some ties to the jurisdiction selected so that the choice of jurisdiction is not perceived as shopping for the most favorable situs for creditor, probate or tax purposes. b. As a result, it is possible to change the situs of real property by placing it into a partnership and moving the situs to a more favorable jurisdiction for probate (at least to the extent of moving the situs from the location of real estate to the decedent’s domicile), state transfer tax and creditor purposes. E. Litigation Avoidance. 1. The use of FLPs and FLLCs allow families to negotiate with each other to determine a means of managing the property without intra-family litigation. If the family members are beyond negotiation, then the entity agreement allows the parents/older generation a means of imposing a system of management on future owners. 2. The Partnership Agreement of an FLP or the Operating Agreement of an FLLC will typically include a provision requiring that arbitration will be used to settle family disputes over the entity’s assets. 8-12 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee 3. The operative Agreements can also include a provision that requires the losing party to the pay legal fees and costs incurred by the winning party during litigation or arbitration. F. Probate Avoidance. 1. The use of FLPs and FLLCs may allow for probate avoidance. a. A partnership or LLC interest is personalty; as a result, the situs of the entity may be established in any jurisdiction, including a foreign jurisdiction. b. Real property not held in an entity is probated in the place where it is located. c. Personal property, however, is subject to probate in the decedent’s domicile and may even avoid probate all together, if the personal property is converted into a non-probate asset, such as transferring it to a revocable trust or into joint ownership. d. As personalty, the real estate may, depending on state law, be subject to state estate tax in the descendant’s state of residence and not in the state where the real estate is located. G. More Advantageous Annual Gifting by Parents. 1. Giving undivided interests in real property directly to younger family members, compared to giving interests in an FLP or FLLC, is a simpler method of transfer. However, there are far greater disadvantages to direct giving. a. As a tenant in common, the donee’s interest will be subject to his creditors, who will at the least have the right to compel the sale of that tenant in common interest, and may have the right to compel the sale of the entire property, in order to satisfy their claims. b. The property interest can be gifted or devised to any person, thereby leaving the remaining co-tenants with no control over their future co-owners. c. Such interests will pass through probate upon each co-tenant’s death with the resulting delay or other impediments in conveyancing. H. More Flexible than Trusts. 1. The older family member will have greater management flexibility as a GP of an FLP or a Manager of an FLLC then they would if they were the trustee of a trust holding assets for the benefit of younger family members. 2. An FLP or FLLC is much easier to modify than a trust. 8-13 Tax Conference, 28th Annual, May 21, 2015 3. Transferring property to a trust would not provide for lack of control and lack of marketability discounts. 4. Trustees are held to a much higher standard (prudent person) than a GP in an FLP or a Manager in an FLLC. III. RECENT CASES REGARDING ESTATE INCLUSION OF FLP AND FLLC INTERESTS A. Estate of Jorgensen v. Comm’r, 107 AFTR 2d 2011-2069 (11th Cir. 2011) . The Tax Court affirmed the Service’s position that certain transfers decedent had made to two family limited partnerships were to be included in the estate valuation because the decedent had retained the economic benefits and control of such property and that the transfers were not bona fide sales for full consideration. The Estate appealed to the Eleventh Circuit. Although the Estate acknowledged that the decedent retained some benefits in the transferred property because she had written checks on partnership accounts to pay some personal expenses and to make some family gifts, it argued that these amounts should either be considered de minimis or Section 2036 should be limited to the actual amount accessed by the decedent. With respect to the de minimis argument, because the decedent personally wrote over $90,000 in checks on the accounts post-transfer, and the partnerships paid over $200,000 of her personal estate taxes from partnership funds, the Court upheld the Tax Court’s decision. With respect to the argument that Section 2036 should be limited to the actual amount accessed by the decedent, the Court upheld the Tax Court’ s conclusion that there was an implied agreement that decedent could have accessed any amount of the “transferred” assets. Finally, the Court upheld the Tax Court’s decision that the transfer was not a bona fide sale for adequate and full consideration. The Court focused on the facts that there were little non-tax justifications for the transfer and there was some disregard of partnership formalities. B. Keller v. U.S., 110 AFTR 2d 2012-6061 (5th Cir. 2012). This case involves a wealthy Texas widow who passed away, leaving behind both a substantial fortune and incomplete estate planning documents. Specifically, as the result of her husband’s death, Maude Williams became the trustee of Trusts which held approximately $300 million of cash, CDs and bonds. Mrs. Williams consulted with her accountant, Rayford Keller, and his son Lane. They ultimately decided to form a family limited partnership. The Trusts, as limited partners, were to fund the family limited partnership and a new corporate LLC was to be formed to be the general partner. In January 2000, Lane Keller formalized these plans in a flowchart and a series of notes indicating how various trust accounts would fund the family limited partnership, principally with bonds and cash amounting to $250 million. In March, Mrs. Williams was diagnosed with cancer and was hospitalized several times in May. Her advisors reduced Mrs. Williams’ estate plans to a partnership agreement and 8-14 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee LLC incorporation documents and she signed the agreements. However, Lane Keller left the capital contribution schedule (Schedule A of the partnership agreement) blank because he did not have the firm market value of the bonds on hand. Nevertheless, there were several extrinsic sources that provided that Mrs. William intended to make a $250 million capital contribution. Mrs. Williams passed away before Schedule A of the partnership agreement was completed and before the capitalization of the corporate LLC was made. Her advisors initially believed they failed to fully create and fund the family limited partnership before Mrs. Williams’ death and ceased attempts to activate the family limited partnership and the LLC. The Estate paid over $147 million in estate taxes in February 2001. In May 2001, Lane reconsidered this position after he attended a continuing legal education seminar. He resumed activity with the family limited partnership, including formally transferring the bonds to the family limited partnership. The Kellers then realized that having successfully established the partnership meant the Estate lacked the liquid assets to issue the $147 million tax payment, so they retroactively restructured the transaction as a $114 million loan from the family limited partnership. The Estate filed a claim for a refund with the Service on two grounds: (1) the Estate’s initial fair market value assessment of Mrs. Williams’ assets failed to discount appropriately the value of the partner interests, thereby leading to an initial overpayment and (2) the Estate accrued interest on its loan from the family limited partnership to pay estate taxes, thereby entitling the Estate to a deduction. After six months passed without action by the Service, the Estate filed a complaint in the District Court on the same grounds. In the District Court trial, the Estate argued that under Texas law, Mrs. Williams’ intent to transfer bonds in to the partnership transformed the bonds into partnership property, notwithstanding her failure to complete the partnership documents. The Service argued that Mrs. Williams failed to create the family limited partnership at all. Agreeing with the Estate, the Court found that Mrs. Williams’ intent bound all of the relevant entities—the LLC as general partner and the Trusts as limited partners. The Service appealed. Upholding the District Court’s decision, the Court found that under Texas Law, the intent determines property ownership and, therefore, Mrs. Williams transferred the full amount of the bonds before her death to the family limited partnership. The Court also upheld the Estate’s loan interest deduction resulting from the loan from the family limited partnership. Relying on Estate v. Graegin, 56 TCM 387 (1988), the Court refused to accept the Service’s argument and collapse the Estate and the family limited partnership to functionally the same entity. C. Estate of Kelly v. Comm’r, T.C. Memo 2012-73. In a pro-taxpayer decision, the Court held that the assets transferred to four limited partnerships were not included in Decedent’s gross estate under Section 2036(a). In this case, after her husband’s death in 1990, Decedent inherited ownership in two quarries, real property, promissory notes, and stock. 8-15 Tax Conference, 28th Annual, May 21, 2015 In 1998, Decedent was diagnosed with Alzheimer’s disease. In 2001 and 2002, the children signed a settlement agreement pursuant to which they determined the distribution of Decedent’s estate. To ensure the legal enforceability of the settlement agreements, the children spoke with an attorney who recommended that they discuss the matter with Woodrow Stewart, an estate planning attorney. Decedent’s children informed Mr. Stewart about certain dangerous incidents that had occurred on Decedent’s property, in addition to discussing their desire to equalize Decedent’s estate. When Decedent hired Mr. Stewart, neither Decedent nor her children considered tax consequences Mr. Stewart prepared a plan that called for Decedent to create four limited partnerships (one for the benefit of each of Decedent’s children and one to be retained in her own name) and a corporation (“KWC”), which would serve as general partner of the limited partnerships. Decedent transferred equally valued assets to each of the three partnerships to benefit the children and the quarries to a fourth partnership, and retained over $1,100,000 of liquid assets in her own name. In addition, Decedent transferred real property (listed as specific bequests in her will) to the partnerships. The specific bequests would be converted to equal devises of partner interests, passing pursuant to the residuary clause in Decedent’s will. On December 31, 2003, January 1, 2004 and January 1, 2005, Decedent gave partnership interests to her children and their descendants. Decedent reported the gifts of partner interests on Form 706, “United States Gift (and Generation-Skipping Transfer) Tax Return”. In a notice of deficiency to Decedent’s estate, the Service determined an approximate $2 million deficiency, based on its determination that the value of the assets contributed to the partnerships was includable in Decedent’s gross estate. In making its decision, the Court examined whether the property transferred to the partnerships was considered a bona fide sale, for full and adequate consideration, as set forth in Section 2036. The Court held that, because Decedent had legitimate and significant nontax reasons for creating the limited partnerships (i.e., ensure the equal distribution of her estate, thereby avoiding litigation and mitigating any potential liability related to her assets) and received partner interests proportionate to the value of the property transferred, under Bongard v. Comm’r, 124 T.C. 95 (2005), Decedent’s transfer of assets to the partnership met the bona fide sale exception. The Court also examined whether Decedent retained an enjoyment of the property that she transferred to the partnerships, thereby resulting in the inclusion of such property in her gross estate under Section 2036(a)(1). The Service contended that the parties had an implied agreement that Decedent would continue to enjoy the income from the partnerships. However, based on the facts that Decedent retained sufficient assets for her personal needs and respected the partnerships and the corporate managing partner as separate and distinct legal entities, the Court did not agree with the Service. The Service also contended that the management fee the limited partnerships paid to KWC (which was wholly-owned by Decedent) was an express retention of income by Decedent in the partnership interests, and therefore the value of those interests needed to be included in Decedent’s gross estate under Section 2036. The Court, again, did not agree with the Service. Under the facts, the Court found that Decedent had a bona fide purpose for creating 8-16 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee KWC to manage the partnership and that the children, in their role as officers and directors of KWC, determined the appropriate management fee and held regular officer/director meetings to address the significant, active management that the partnerships required. D. Estate of Liljestrand v. Comm’r, T.C. Memo 2011-259. In 1984, Decedent created a revocable trust to hold certain real estate he acquired in a Section 1031 exchange. He, along with his son Robert, were trustees of the trust, and Robert was paid an annual salary to manage the trust’s real estate. During his life, Decedent had full access to all the trust income and corpus without restrictions, and, upon his death, the trust’s assets were distributed to a residuary trust for the benefit of his children and a children’s trust. Robert was the trustee of both of these trusts. In 1996, Decedent and Robert met with an estate planning attorney because Decedent wanted to leave his property to his four children, but wanted to ensure that Robert continued employment as manager of the real estate. In 1997, Decedent and Robert formed a limited partnership. Decedent, through the trust, transferred approximately $5 million in real estate to the limited partnership in exchange for a partner interest. Title to the real estate was transferred to the partnership. As a result, Decedent, through the trust, held a 99.98% interest in the family partnership, and Robert was granted 1 unit of Class A limited partner interest, even though Robert made no contribution. In 1998 and 1999, all of Decedent’s children received interests in the limited partnership through gifts by Decedent. To value the partner interests, Decedent’s estate planning attorney hired an appraiser who calculated a $2,140,000 fair market value for the Class B limited partner interest and a $5,195,200 fair market value for the Class A limited partner interest. However, the parties ignored the valuation and instead decided that the partnership should have 59 general partner units with a value of $59,000, 310 Class A limited partner units with a value of $310,000 and 5,546 Class B limited partner units with a value of $2,007,652. As a result of these valuations, gift tax was due on both the 1998 and 1999 gifts of partner interest to Decedent’s children; however, no gift tax return was filed until 2005, after Decedent’s death. Despite having transferred legal title to the real estate to the limited partnership in 1997, the limited partnership failed to open a bank account until 1999. As a result, any income generated by the real estate was deposited in the trust’s bank account. In addition, the limited partnership did not execute a management agreement with Robert to manage the real estate until 2001 (with an effective date of January 1, 1998). Decedent contributed almost all of his income-producing assets to the limited partnership, and his retained assets were insufficient to pay his living expenses. In order to assist Decedent, the partnership made disproportionate distributions to the trust and directly paid Decedent’s personal expenses. In addition, the partnership agreement guaranteed the Class A limited partners a 14% preferred return. After Decedent’s death, the Service issued Decedent’s Estate a notice of deficiency claiming that the real estate that Decedent transferred to the limited partnership should be included in his gross estate. In determining whether the real estate should be includable in Decedent’s Estate, the Court examined Section 2036(a) and the underlying case law. First, the Court reviewed 8-17 Tax Conference, 28th Annual, May 21, 2015 whether the transfers were bona fide sales for adequate and full consideration. For purposes of determining whether the sales were bona fide, the Court looked at whether Decedent had a significant nontax reason for transferring his property. Although the Estate argued that Decedent had several nontax reasons (such as the assurance that Decedent’s property would be centrally managed by Robert, would not be partitioned, and would be protected from potential creditors), the Court did not find the Estate’s arguments convincing. In addition, the Court held that the limited partnership failed to follow “even the most basic of partnership formalities”. The limited partnership failed to open and maintain a separate bank account for the first 2 years of its existence; there were no formal meetings of the partners; and no minutes were ever kept. Decedent and Robert failed to treat the partnership as a separate entity, and Decedent used partnership assets to pay personal expenses. Additionally, the limited partnership failed to make the proportionate distributions as required under the partnership agreement. Finally, the Court found that the transfers to the partnership were not at arms’-length. It focused on the facts that Decedent both formed and fully funded the partnerships, the only attorneys involved were Decedent’s attorneys, and that Decedent’s attorneys testified that they formed the limited partnership solely to address his goals and had had no contact with his children (other than Robert). Second, the Court focused on whether the transaction was for adequate and full consideration. The Estate argued that each partner had received an interest in the limited partnership proportionate to the fair market value of the property each had contributed to the limited partnership. However, because the parties ignored the third-party valuation, because the trust exchanged approximately $5 million of real estate for partner interests valued at approximately $2 million, and because the limited partnership failed to maintain capital accounts upon formation of the partnership, the Court found that the trust did not receive an interest in the limited partnership proportionate to the fair market value of the assets contributed. Finally, the Court reviewed whether Decedent retained the possession or enjoyment of the property he transferred to the limited partnership. The Court found that Decedent did possess the enjoyment of the transferred property because he used partnership assets to pay personal expenses and the limited partnership served primarily as an alternative vehicle through which Decedent was able to provide for his children. As a result, the Court concluded that the value of Decedent’s gross estate included the value of the assets he transferred to the limited partnership. E. Estate of Stone v. Comm’r, T.C. Memo 2012-48. In this pro-taxpayer decision, the Court held that the real property transferred by Joanne Stone (“Decedent”) to a family limited partnership did not need to be includable in her gross estate under Section 2036(a). Decedent and her husband had six children and numerous grandchildren. Decedent owned approximately 30 parcels of real property in Crossville, Tennessee, of which 9 parcels were undeveloped land (the “Woodland Parcels”). In the early 1990s, one of Decedent’s sons acquired real estate near the Woodlands Parcels, built a home on such property, and constructed a lake near it. Once the lake was constructed, Decedent and her spouse decided that they wanted the Woodland Parcels to become a family asset. To help accomplish this goal, they sought the advice of their attorney, who referred them to another attorney in the area, Harry Sabine. 8-18 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee Decedent and her husband (“Mr. Stone”) informed Mr. Sabine that they wanted to give gifts of real estate to various family members and were seeking the best method to accomplish this goal. Mr. Sabine suggested a family limited partnership because it would simplify the gift-giving process, as new deeds would not have to be provided each year and would help guard against partition suits. In 1997, Decedent and Mr. Stone formed a family limited partnership (the “Partnership”), whose agreement provided that its purpose was to hold and manage property for family members. The Partnership’s limited partnership agreement was terminable by the written agreement of partners owning at least 67% of the Partnership, and limited partners owning 67% of the Partnership could remove a general partner. After having the Woodland Parcels appraised, Decedent and her spouse contributed the property to the Partnership and used the appraised value as the basis for the computation of partner interest values and did not discount the value of a partner interest for gift tax purposes. By the end of 2000, Decedent and Mr. Stone each owned a 1% general partner interest and their children, children’s spouses and grandchildren owned the remaining 98% limited partner interests. The Woodland Parcels were not developed and improved. Although the Partnership initially had a bank account, it was closed because the Partnership earned no income. The Partnership’s only expense was real property tax, which Decedent and Mr. Stone paid directly from their personal funds. The Service issued Decedent’s estate a notice of deficiency claiming that the Woodland Parcels needed to be included in her estate under Section 2036(a) because: (1) Decedent made an inter vivos transfer of property, (2) Decedent’s transfer of the Woodland Parcels to the Partnership was not a bona fide sale for adequate and full consideration, and (3) Decedent retained an interest or right (as described in Section 2036) in the transferred property which she did not relinquish before her death. The Court’s analysis focused on whether the transfer was a bona fide sale for adequate and full consideration and specifically reviewed whether, under Estate of Bongard v. Comm’r, 124 T.C. 95 (2005), there were legitimate and nontax reasons for creating the Partnership (i.e., whether it was a bona fide sale) and whether Decedent and Mr. Stone received partner interests proportional to the value of the property transferred (i.e., whether Decedent received adequate and full consideration). With respect to the bona fide sale element, the Service argued that the Decedent formed the Partnership only in hopes of simplifying the gift-giving process, while the Estate argued that the Partnership was formed to create a family asset and to protect the Woodland Parcels. Although the Court agreed that gift-giving was one of Decedent’s motives in forming the Partnership, it did not agree that it was the only motive based on testimony at trial demonstrating that Decedent and her spouse wanted their descendants to work together to build and sell homes near the lake, thereby managing the Woodland Parcels as a family asset. In addition, the Court stated that, although the partners of the Partnership failed to respect certain partnership formalities (such as in divorce proceedings, their ex-son-in-law quitclaimed his interest in the Woodland Parcels but failed to transfer his limited partner interest, 8-19 Tax Conference, 28th Annual, May 21, 2015 and Decedent and her husband paid Partnership property taxes out of their personal funds), it believed other factors supported the fact that a bona fide sale had occurred. Decedent and Mr. Stone did not receive any distributions from the Partnership and thus were not dependent on partnership funds; Decedent and Mr. Stone actually transferred the Woodland Parcels to the Partnership; there was no commingling of personal and Partnership funds; there was no discounting of partner interests for gift tax purposes; and Decedent and Mr. Stone were in good health at the time of transfer. F. Estate of Turner v. Comm’r, 138 T.C. No. 14 (2012). Mr. and Mrs. Turner established a family limited liability partnership. They each contributed assets with a fair market value of approximately $4 million, and in exchange, they each received a 0.5% general partner interest and a 49.5% limited partner interest. Approximately 60% of the assets contributed were shares in Regions Bank, and none of the contributed assets was an interest in an operating business or in a regularly conducted real estate activity that required active management. The partner interests they received in exchange for their contributions were proportionate to the fair market value of the assets contributed. Mr. Turner transferred limited partner interests as gifts to his family members. Mr. Turner died in 2004. On the date of his death, he held a 0.5% general partner interest and a 27.7554% limited partner interest. In 2008, the Service issued a notice of deficiency to the Estate claiming that the value of the assets Mr. Turner transferred to the family limited liability partnership was included in his gross estate. The Tax Court, in Estate of Turner v. Comm’r, T.C. Memo 2011-209, held that the bona fide sale exception to Section 2036 did not apply and that Mr. Turner retained, by both express and implied agreement, the right to possess and enjoy the transferred property. As a result, the Tax Court concluded that, under Section 2036, the value of the transferred property was included in Mr. Turner’s gross estate. The Estate filed a motion for reconsideration and asked the Court to reconsider the application of Section 2036 and its alternative position – that, even if Section 2036 applies, the Estate has no estate tax deficiency because it is entitled to an increased marital deduction equal to the increased value of the gross estate. At the time of the filing, the Estate also reported that an 18.8525% limited partner interest was allocated to Mrs. Turner and an 8.9029% interest was allocated to a bypass trust. The Service objected to the Estate’s motion. The Court upheld its conclusion that Section 2036 was applicable because it felt that the Estate “pointed to no instance where we found or failed to find facts inappropriately or erroneously”. The Court also declined to permit a marital deduction equal to the value of the assets underlying the partner interests or the partner interests that Mr. Turner transferred as a gift. The Court recognized that Section 2036 can cause a mismatch, where it pulls assets underlying the partner interest into the gross estate while, at the same time, the assets are not considered to pass to the surviving spouse, as was the case in this instance. The Estate tried to argue that it would be inconsistent to conclude that Mr. Turner retained a right to possess or enjoy assets he contributed to the partnership and at the same time ignore the value of those assets in calculating 8-20 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee the marital deduction. In addition, it argued that, under Mr. Turner’s will, which included a marital deduction formula provision - that provided that an amount would be transferred that would result in the smallest Federal estate tax being imposed on his estate - the Estate was entitled to deduct the transfer of the gifted limited partner interests. However, the Court agreed with the Service that Mr. Turner no longer owned the assets underlying the transferred partner interests and, therefore, could not “pass” the assets to Mrs. Turner. The Court reviewed Section 2056(c) and its underlying Regulation and held that it limits the marital deduction to the value of property which actually passes to the spouse. In this case, neither the partner interests nor their underlying assets passed or could have passed to Mrs. Turner, as the assets were transferred to the limited liability partnership and the partner interests were gifted to other family members. IV. RECENT CASES REGARDING VALUATION OF FLP AND FLLC INTERESTS A. Estate of Gallagher v. Comm’r, T.C. Memo 2011-148. At her death, Decedent owned 3,970 membership units in PMG, a company that engaged in print media. On the estate tax return, the membership units were valued at $34,936,000, based on an appraisal by PMG’s President and CEO. The Service issued a notice of deficiency, which asserted that the fair market value of the units was $49,500,000. Before the start of the trial, the estate of Decedent hired another appraiser, who valued the units at $28,200,000, and the Service hired an appraiser who valued the units at $40,863,000. The issue before the Court was the fair market value of Decedent’s membership unit in PMG. The Service’s expert valued the units using both a market approach and an income approach. He applied a 17% minority interest discount to the value under the income approach and a 31% lack of marketability discount to the values under both approaches. The estate’s appraiser relied primarily on the income approach to value Decedent’s units, using the market approach only to establish a reasonable estimate of fair market value. He applied a 30% lack of marketability discount. The Court discussed each appraisal report and the areas of disagreement, including the propriety of relying on a market-based valuation approach in valuing the units, the application of the discounted cash flow method, and the size of applicable discounts. With respect to the reliance on a market-based approach (specifically, the use of the guideline company method which estimates the value of a subject company by comparing it to similar public companies), only the Service’s expert relied upon this method for valuing Decedent’s units. The estate felt such reliance was improper because of the lack of companies sufficiently similar to PMG to support the method’s application. The Court agreed with the estate because it felt that PMG was smaller and had a different business product and a greater revenue growth than the four guideline companies discussed in the Service’s appraiser’s report. Because of the lack of public companies, the Court believed that the discounted cash flow method was the most appropriate method with which to value the units. Although both appraisers used this method, their valuation computation methods were different. To determine the value, the Court discussed in detail each expert’s computation and compared all aspects of the reports, including revenue growth projections, operating income, the impact of 8-21 Tax Conference, 28th Annual, May 21, 2015 taxes on PMG’s earnings and cash flow adjustments. In some instances, it resolved disputes in favor of the Service, and in others, in favor of the estate. Although both parties agreed that it was appropriate to take into account a minority interest and lack of marketability discount, they differed on the size of the discounts and, with respect to the minority interest discount, the method of application. The Service’s expert applied a 17% minority interest discount and then applied a 31% lack of marketability discount. The estate’s expert applied a 30% lack of marketability discount because he believed the discounted cash flow methodology was adjusted to reflect a minority interest value. The Court agreed with the Service’s expert that there should be a separate minority interest discount and determined that a 23% minority interest discount to the equity value of PMG computed on a 30% controlling interest basis under the discounted cash flow method was appropriate. In addition, the Court determined that a 31% lack of marketability discount was appropriate based on the restrictive nature of the stock (i.e., there was a shareholder agreement in existence). Based on these findings, the Court determined that the value of the units was $32,601,640, which was actually less than the amount reported on the estate tax return. B. Estate of Giustina v. Comm’r, 114 AFTR 2d 2014-6848 (9th Cir. 2014). Natale Giustina (“Giustina”) was the trustee of a revocable trust, which owned a limited partner interest in Giustina Land & Timber Co. Limited Partnership (the “LP”). In 1990, the LP was one of three new partnerships formed to which were contributed interests in the assets of two family businesses. The LP was owned by Giustina and his family, as well as his brother and his family and another relative. Giustina died in 2005, at which time he owned a 41.28% limited partner interest in the LP, which owned 47,939 acres of timberland in Oregon. From the date of formation, the LP was governed by a written partnership agreement, which included a buy-sell agreement that barred a limited partner from transferring an interest in the LP, unless the transfer was to a member of the transferring partner’s “family group”. Giustina’s family group included him, his children and his grandchildren. The buy-sell agreement was in effect at the time of Giustina’s death. On the Estate tax return, the value of the 41.28% limited partner interest was reported to be $12,678,117. The Service issued a notice of deficiency, claiming that the limited partner interest had a value of $35,710,000. In the Tax Court trial proceedings in Estate of Giustina v. Comm’r, T.C. Memo 2011-141, the Service contended that the value was $33,515,000, and the Estate contended that the value was $12,995,000. In addition, in the Tax Court proceedings, both the Estate and the Service provided expert witnesses as to the value of the limited partner interest. The Court found two methods helpful – the cash flow method (which was based upon how much cash the partnership would be expected to earn if it had continued its ongoing forestry operations) and the asset method (which was based upon the value of the partnership’s assets if they were sold). With respect to the cash flow method, the Service’s expert valued the total future cash flow, discounted to present value, at $65,760,000 and the Estate’s expert valued it at $33,800,000. In Estate of Giustina v. Comm’r, T.C. Memo 2011-141, the Tax Court found that 8-22 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee the Service’s expert’s valuation had internal inconsistencies and therefore disregarded it. With regard to the Estate’s expert’s valuation, the Tax Court found problems with the application of the cash flow method, but adjusted the computation to arrive at the correct value. Specifically, the Court eliminated a 25% reduction for taxes because the cash flow was based on a pre-tax rate of return (not a post-tax rate of return), and it reduced a 3.5% discount for partnership-specific risks by half. As a result, under the cash flow method, the Court calculated that the value of the LP was $51,702,857. Regarding the discount for lack of marketability, because the Estate’s expert did not rebut the Service’s expert’s testimony that he used studies which overstated the discount for lack of marketability, the Tax Court adopted the Service’s expert’s discount of 25%. With respect to the asset method, the Service’s expert claimed that the total value of the assets of the LP was $150,680,000. Because this valuation was essentially unchallenged by the Estate, the Court accepted this valuation. The Court did not feel it was appropriate to apply a discount for lack of control or marketability to the asset method, even though the Service’s expert applied such a discount. Instead, it reflected the “lack of control to cause a sale” in the weighing of the two methods. In addition, the Court reasoned that there was a 75% probability that the LP would continue its operations rather than liquidate its assets. For this reason and because the Giustina family had a long history of acquiring and retaining timberlands, it gave a 75% weight to the cash flow method and a 25% weight to the asset method. As a result, the Tax Court held that the value of the limited partner interest was $27,454,115. The Estate appealed the Tax Court’s decision. The Ninth Circuit reversed the Tax Court’s decision and remanded the case back to the Tax Court to recalculate its valuation. The Ninth Circuit stated that the Court’s underlying conclusion that there was a 25% probability that the LP would liquidate was “clearly erroneous” as it was based on hypothetical events and was contrary to the evidence in the record. In addition, the Ninth Circuit found that Tax Court did not adequately explain its basis for cutting in half the Estate’s expert’s partnership-specific risk premium. However, the Ninth Circuit affirmed the Tax Court’s disregard of tax-effecting and the 25% discount for lack of marketability. C. Estate of Koons v. Comm’r, T.C. Memo 2013-94. Decedent was the largest stockholder of Central Investment Corp (“CIC”), a company that bottled and distributed Pepsi products and engaged in the vending machine business. CIC’s other shareholders included Decedent’s children. CIC and PepsiCo became involved in a dispute and in 2004, CIC began negotiations with PepsiCo and PepsiAmericas, the nation’s second largest Pepsi bottling company. In August 2004, CIC formed a wholly-owned subsidiary, CI LLC, in preparation for the sale of its soft drink and vending machine business to PepsiAmericas. In December 2004, PepsiAmericas and CIC executed a stock purchase agreement which required that CIC’s non-soft drink and non-vending machine assets be transferred to CI LLC and that CIC distribute its member interests in CI LLC to its shareholders on or before closing. Also in December 2004, CI LLC issued a letter to each of Decedent’s children in which it offered to redeem their member interests. On January 7, 2005, PepsiCo paid $50 million to CIC to settle the lawsuit. CIC contributed the $50 million to CI LLC. On January 8, 2005, CIC distributed its entire interest in CI LLC to the shareholders of CIC, in the same proportion as their ownership interests in CIC. The stock purchase between CIC and PepsiAmericas closed on January 12, 2005. As a result, CI LLC owned the proceeds from sale to PepsiAmericas ($352.4 million), the $50 8-23 Tax Conference, 28th Annual, May 21, 2015 million PepsiCo paid to settle the lawsuit and the assets CIC formerly owned, except for the soft- drink and vending machine assets. On January 7, 2005, Decedent borrowed $30 million from U.S. Bank. The loan was to be repaid by January 21, 2005, which Decedent did. Also, on January 21, 2005, CI LLC made a pro rata distribution of $100 million to its members, with Decedent receiving approximately $50 million and his four children receiving approximately $29.6 million. Between January 21, 2005 and February 27, 2005, each of Decedent’s children signed a redemption offer letter. On February 10, 2005, Decedent contributed his member interest in CI LLC to a revocable trust. On March 3, 2005, Decedent died. At the time of his death, the revocable trust held a 50.5% member interest in CI LLC (comprising 46.94% of the voting interests), which had a net asset value of approximately $318 million. As of April 30, 2005, the redemption of CI LLC member interests owned by Decedent’s children closed and final payments were made on or about July 1, 2005. After the redemption of Decedent’s children’s interest, the revocable trust held a 70.93% member interest in CI LLC (comprising 70.42% of the voting interests). On February 28, 2006, CI LLC lent the revocable trust $10,750,000 to be used to make a payment toward the estate and gift tax liabilities. The interest and principal payments were to be made by the revocable trust in installments from the years 2024 through 2031. In June 2006, the Estate timely filed a Form 706, which reported that the fair market value of the revocable trust’s interest in CI LLC was approximately $117 million. The Estate also took a deduction of approximately $71 million for the interest on the loan from CI LLC to the revocable trust. On May 21, 2009, the Service issued Decedent’s Estate a notice of deficiency. Other than computational issues, at the time of the trial, the only decisions were whether the Estate was entitled to a deduction for the interest on the loan from CI LLC to the revocable trust and the fair market value of the revocable trust’s interest in CI LLC at the date of Decedent’s death. With respect to the deduction for the loan, the Court found that the loan was unnecessary because the revocable trust held a majority interest in CI LLC and could have forced CI LLC to distribute assets that could have been used to pay the Estate’s estate and gift tax liabilities. (CI LLC had over $200 million in highly liquid assets). Therefore, the Court held that the projected interest to be paid under the loan was not a deductible administration expense by the Estate. With respect to the fair market value of the revocable trust’s interest in CI LLC, the Court focused on the appropriate marketability and control discounts to be used to determine the fair market value. The Estate’s expert report argued the marketability discount was 31.7%, while the Service contended it was 7.5%. The Estate’s expert opinion concluded that there was a substantial risk that the redemption of Decedent’s children’s interest in CI LLC might not be consummated, and, therefore valued the revocable trust’s interest based on the assumption that it would not have control over CI LLC. The Service’s expert concluded that there was only a small risk that redemptions of Decedent’s children’s interest would not take place (which would 8-24 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee increase the revocable trust’s voting interest to 70.42%), and therefore valued the revocable trust’s interest without a discount for lack of control. The Court agreed with the Service, based primarily on the facts that Decedent’s children’s signed the offer letters before his death, the offer letters were enforceable under state law, and the testimony at trial demonstrated that Decedent’s children wanted to sell their interests. Therefore, the Court upheld the Service’s expert’s discount of 7.5%. D. Estate of Tanenblatt v. Comm’r, T.C. Memo 2013-263. Decedent was a member of a limited liability company (the “LLC”), whose only significant asset was a 10-story commercial building in Manhattan. During her lifetime, Decedent transferred her member interest in the LLC to a trust, retaining the power to revoke the transfer. The trust was a member of the LLC at the time of Decedent’s death. Membership of the LLC was divided among three family groups. Under the LLC’s operating agreement, the members managed and controlled the LLC and could not transfer member interests to a non-family member without the approval of all the members. A non-family member transferee who received a member interest but was not a member was entitled to receive distributions and allocations of profit and losses but had no right to participate in the management of the LLC. On Decedent’s estate tax return, the Estate determined the net asset value of Decedent’s member interest in the LLC, based on an appraisal which valued the building under an income capitalization approach, adding to that amount the value of the LLC’s other assets less liabilities. The appraisal concluded that the net asset value of the LLC at the date of Decedent’s death was $20,628,221. The appraisal applied a 20% discount for lack of control and a 35% discount for lack of marketability. This amount was then multiplied by the Estate’s 1/6 interest in the LLC, to reach a fair market value of $1,788,000. However, the Service argued for a lower valuation. The Service’s position was that the Estate’s net asset value as reported on the Form 706 was correct (i.e., the net asset value of the LLC was $20,628,221) but that the discounts should be reduced to 10% for lack of control and 26% for lack of marketability, resulting in a fair market value of $2,303,000. The Estate raised three objections to the Service’s valuation. First, it argued that the Service’s appraiser erred in classifying the interest as a member interest, instead of a nonfamily member’s assignee interest. (A member’s interest would be more valuable because a member could participate in the management of the LLC.) However, the Court stated because, on the date of Decedent’s death, the interest in dispute was a member interest and the holder of the interest enjoyed fully the benefits and burdens of being a member of the LLC, the Service’s appraiser did not err in classifying the interest as a member interest. Second, the Estate argued that under the “willing buyer willing seller” standard under Reg. § 20.2031-1(b), the Service should have used an assignee interest to value the subject interest because a hypothetical willing buyer “must be assumed to be a nonfamily member”. Although the Court recognized that it was important to take into account limitations in the operating agreement when valuing a member interest (which the Service’s appraiser considered), the Court believed that the Estate was incorrect in claiming that Reg. §20.2031-1(b) required the character of the interest be characterized as an assignee interest. The Court further stated that 8-25 Tax Conference, 28th Annual, May 21, 2015 any concern that the Estate had about a member (or an assignee’s) lack of influence on decision making was addressed in the lack of control discount applied by the Service’s appraiser in determining the fair market value of the interest. The Estate also criticized the Service’s appraiser reliance exclusively on a net asset value approach. Although the Court recognized that other valuation approaches might be appropriate, in this instance, the Service’s appraisal used the same net asset value used in the Estate’s appraisal, which the Estate relied on in reporting the value of the interest on the Form 706. Because the Court had “no cogent proof” that the value the Estate relied on in reporting the value of the interest was wrong, the Court held the value of the LLC before determination of Decedent’s proportionate interest and application of discounts (i.e., $20,628,221) was correct. Finally, with respect to the appropriate discounts, the Court stated that although the Estate criticized the Service’s expert’s methodologies for determining the lack of control and lack of marketability discounts, it failed to provide expert testimony. Therefore, it concluded that the value of the Estate’s interest in the LLC was $2,303,000, the value conceded by the Service. E. Wandry v. Comm’r, T.C. Memo 2012-88. In 2001, Taxpayers and their children started a family business and, as a result, formed Norseman Capital, LLC (“Norseman”). Taxpayers previously had formed a limited liability limited partnership and had worked with their attorney to institute a tax-free giving plan through the transfer of interests in such limited liability limited partnership to their descendants. By 2002, all the assets of the limited liability limited partnership were transferred to Norseman, and Taxpayers wanted to continue their gift- giving through Norseman. As with the gift-giving program with the limited liability limited partnership, Taxpayers’ tax attorney had advised them that, because the number of Norseman membership units that would equal the desired dollar amount of their gifts on any given date could not be known until a later date when a valuation could be made of Norseman’s assets, all gifts should be given in a specific dollar amount, rather than a specific number of membership units. In 2004, Taxpayers executed separate gift documents and assigned membership units for Federal gift tax purposes based on dollar amounts intended to conform to dollar amounts equal to their Federal gift tax exclusions. In addition, the gift documents provided that, if the Service challenged the valuation and a final determination of a different value was made by the Service or a court of law, the number of gifted units would be adjusted by the valuation redetermination. Taxpayers’ C.P.A. prepared a Form 709, “United Stated Gift (and Generation- Skipping Transfer) Tax Return” for each Taxpayer, consistent with the gift documents. However, the schedule on the return described the gifts as percentage interests in Norseman, rather than dollar amounts. In 2006, the Service examined Taxpayers’ gift tax returns and determined that the value of the gifts exceeded Taxpayers’ Federal gift tax exclusions. The Service and Taxpayers agreed to a valuation of the gifted units. The issue was whether Taxpayers were liable for the gift tax because they transferred completed gifts of fixed percentage interests in Norseman, instead of fixed dollar amounts. 8-26 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee The Service argued that Taxpayers transferred percentage interests in Norseman because the Form 709 described the gifts in terms of percentage interests. However, the Court found that Taxpayers’ actions and intent were to transfer specified dollar amounts to their children and grandchildren. Taxpayers’ C.P.A. merely derived the gift descriptions from Taxpayers’ net dollar value transfers. The Service also argued that Norseman’s capital accounts controlled the nature of the gifts transferred from Taxpayers to the donees and that such capital accounts reflected gifts of fixed percentage interests. The Service relied on Thomas v. Thomas, 197 P. 243 (Colo. 1921), where the Court held that Mr. Thomas gave a completed gift to Mrs. Thomas because the shares had been transferred on the corporation’s books. The Court did not agree because it felt the Service’s reliance on Thomas was misplaced, as that case was whether a gift of corporate stock was complete and, therefore, had “no bearing on the nature of [Taxpayers’] gifts.” The Service’s final argument was that the clause which allowed for a retroactive readjustment based on a final determination by the Service or a court of law was an impermissible transfer clause because it contained a condition subsequent to the Taxpayers’ gifts. Relying on Estate of Petter v. Comm’r¸ T.C. Memo 2009-280, the Court held that, in this instance, the clause was a valid “formula clause” because the transfer was related to a fixed ascertainable dollar value, even though the units themselves had an unknown value. According to the Court, the gift documents did not allow the Taxpayers to “take property back”, but rather corrected the allocation of Norseman membership units among Taxpayers and the donees because the appraisal report understated Norseman’s value. The Court recognized that in Petter the adjustment clause reallocated membership units among the Taxpayer and a charitable organization and that the Court in Petter supported its holding by citing Congress’s overall policy of encouraging gifts to charitable organizations. However, the lack of a charitable component in this case did not result in an immediate “severe and immediate” public policy concern. As a result, the Court found in favor of the Taxpayers. On November 13, 2012, the Service issued Action on Decision 2012-004, 2012- 46 I.R.B., stating that it believed the Court erred in Wandry in determining that the property transferred for gift tax purposes was anything other than a fixed percentage membership interest transferred on the date of the gift to each donor. As a result, the Service stated that it will not acquiesce in the Wandry decision. 8-27 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee Exhibit A Buy-Sell Agreements: An Issues Checklist 1. Type of Entity (a) C corporation? (b) S corporation? (c) Limited Liability Company? (d) Partnership? 2. Parties to the Agreement 1/ (a) All owners (b) If not all owners, how will excluded owners be dealt with? 3. Governance (a) Vote pooling arrangements for Board of Directors, Board of Managers, officers or other governing body. (b) Voting arrangements and veto rights over certain entity actions. (c) Minority owner protections. 4. Transferability of Ownership Interests (a) Permitted lifetime transfers to third parties (i) Rights of first refusal (ii) Gifts – outright and in trust (b) Pledges (c) Tag along rights (d) Drag along rights 1 For purposes of this checklist, the term “owner” refers either to shareholders of a corporation, members of a limited liability company or partners of a partnership. Further, “ownership interest” refers either to shares of stock, limited liability company membership interest or partnership interest. 8-29 Tax Conference, 28th Annual, May 21, 2015 5. Buyout Provisions Regarding Ownership Interests (a) Triggering events: (i) Death (ii) Disability (iii) Retirement (iv) Termination of employment Voluntary Termination with/without cause Termination for good reason (v) Removal/resignation from Board of Directors, Board of Managers and/or other governing bodies (vi) Other buyout events Bankruptcy of owner Loss of professional license by a owner if entity is a professional corporation, limited liability company or partnership Dissolution or change of control of owner which is an entity Owner providing services to, or owning an interest in, a competing business (vii) Russian roulette provisions (b) Mandatory versus optional buyouts (i) Cross-purchase versus redemption (ii) Possible buyout scenarios: Entity or other owners have an obligation to purchase the ownership interest and the owner has an obligation to sell Entity or other owners have an option to purchase (i.e., call) the ownership interest 8-30 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee Owner has an option to sell (i.e., put) the ownership interest to the corporation or other shareholders Coexistent cross-options between the shareholder and the entity (and/or other owners) (c) Consider buyouts in related entities that do business with the entity 6. Ownership Interest Purchase Price Considerations (a) Book value (b) Capitalization of earnings formula (c) Discounted cash flow formula (d) Appraisal procedure (e) Annual valuation updates (f) Use of minority discounts and control premiums (g) Contingent purchase price adjustment if the entity experiences a “change of control” transaction 7. Payment Terms Upon Purchase of Ownership Interest (a) Cash (b) Insurance funding (c) Bank financing (d) Selling owner financing (i) Payment term (ii) Frequency of payments (iii) Rate of interest (iv) Collateral (v) Guarantees (e) Restrictions on annual deferred payments if there have been multiple ownership interest buyouts 8-31 Tax Conference, 28th Annual, May 21, 2015 8. Planning for Other Entity Strategies (a) Initial public offering (b) Lock-up agreements (c) Demand or piggyback registration rights 9. Tax Considerations (a) Buyouts of Ownership Interest (i) Qualification as sale or exchange under I.R.C. Section 302 for corporate repurchase; evaluate any potential impact of family attribution rules under I.R.C. Section 318 (ii) Partnership tax considerations (iii) Installment reporting under I.R.C. Section 453 for deferred payments (iv) Avoidance of imputation of interest for deferred payments under I.R.C. Section 1272 (v) Alternative minimum tax considerations under I.R.C. Sections 55 and 56 if funding with corporate-owned life insurance in the case of a C corporation (vi) Stock basis implications associated with cross-purchase versus redemption (b) S corporation considerations (i) Preservation of S corporation status, including safeguards against third party transfers to impermissible S corporation shareholders (ii) Imposition of liability upon shareholders who jeopardize S corporation status (iii) Permitting periodic distributions to shareholders to cover tax liability on allocable share of S corporation taxable income 10. State Corporate Law Restrictions on Corporate Repurchases 11. Restrictive Covenants (a) Confidentiality agreement (b) Assignment of intellectual property rights (c) Covenants against competition and solicitation of customers and employees 8-32 Tax Consequences of Negotiating Buy-Sell Agreements - Estates and Trusts Committee (d) Duration and scope of restrictions (e) Specify civil and equitable remedies in the event of a breach 12. Miscellaneous Considerations (a) Indemnification for guarantees of entity obligations (e.g., leases or loans) (b) Indemnification of officers, directors and managers (c) Dispute resolution (i) Mediation (ii) Arbitration (iii) Judicial 13. Amendment of Agreement (a) Unanimous? (b) Less than unanimous? (c) Combination of (a) and (b) depending upon the event triggering an amendment? 14. Termination of Agreement (a) Use a date certain (b) Buyout of a certain number or percentage of owners (c) Agreement by owners (d) Survivability of certain provisions post-termination 8-33 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation - Practice and Procedure Committee/Young Lawyers Committee by Eric M. Nemeth Varnum LLP Novi Eric R. Skinner IRS Office of Chief Counsel Detroit Detroit The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation - Practice and Procedure Committee/Young Lawyers Committee Eric M. Nemeth Varnum LLP Novi Eric R. Skinner IRS Office of Chief Counsel Detroit Detroit I. Overview of the IRS ...... 9-1 II. The Tax Examination ...... 9-2 III. Criminal Investigation ...... 9-2 IV. IRS Appeals...... 9-2 V. IRS Chief Counsel...... 9-2 VI. IRS Collection Division ...... 9-2 Exhibits Exhibit A Form 2848 Power of Attorney and Declaration of Representative . . . . 9-3 Exhibit B Information Document Request Response Letter...... 9-5 Exhibit C Notice of Determination 30 Day Letter ...... 9-7 Exhibit D Notice of Deficiency 90 Day Letter ...... 9-9 Exhibit E Correspondence Regarding Prosecuting of Taxpayer...... 9-13 Exhibit F Information Re Filing a Case in the United States Tax Court ...... 9-17 Exhibit G Letter Re Stipulation of Facts ...... 9-23 Exhibit H US Tax Court Decision ...... 9-25 Exhibit I Notice of Federal Tax Lien Filing and Your Right to a Hearing Under IRC 6320 ...... 9-29 Exhibit J Form 12153 Request for a Collection Due Process or Equivalent Hearing ...... 9-35 Exhibit K Form 433-A Collection Information Statement for Wage Earners and Self-Employed Individuals ...... 9-39 Exhibit L Form 656 Offer in Compromise ...... 9-47 I. Overview of the IRS A. Discussions B. The Players 9-1 Tax Conference, 28th Annual, May 21, 2015 II. The Tax Examination A. Opening Letter B. Information Document Request C. Meetings D. 30 Day Letter E. 90 Day Letter III. Criminal Investigation A. Investigation B. Review C. Litigation IV. IRS Appeals V. IRS Chief Counsel A. Duties B. Tax Court Practice C. Informal/Tech Advice VI. IRS Collection Division A. Duties B. Tax Lien C. Levy D. Offer in Compromise 9-2 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit A Form 2848 Power of Attorney and Declaration of Representative 9-3 Tax Conference, 28th Annual, May 21, 2015 9-4 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit B Information Document Request Response Letter 9-5 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit C Notice of Determination 30 Day Letter 9-7 Tax Conference, 28th Annual, May 21, 2015 9-8 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit D Notice of Deficiency 90 Day Letter 9-9 Tax Conference, 28th Annual, May 21, 2015 9-10 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-11 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit E Correspondence Regarding Prosecuting of Taxpayer 9-13 Tax Conference, 28th Annual, May 21, 2015 9-14 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-15 Tax Conference, 28th Annual, May 21, 2015 9-16 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit F Information Re Filing a Case in the United States Tax Court 9-17 Tax Conference, 28th Annual, May 21, 2015 9-18 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-19 Tax Conference, 28th Annual, May 21, 2015 9-20 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-21 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit G Letter Re Stipulation of Facts 9-23 Tax Conference, 28th Annual, May 21, 2015 9-24 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit H US Tax Court Decision 9-25 Tax Conference, 28th Annual, May 21, 2015 9-26 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-27 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit I Notice of Federal Tax Lien Filing and Your Right to a Hearing Under IRC 6320 9-29 Tax Conference, 28th Annual, May 21, 2015 9-30 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-31 Tax Conference, 28th Annual, May 21, 2015 9-32 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-33 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit J Form 12153 Request for a Collection Due Process or Equivalent Hearing 9-35 Tax Conference, 28th Annual, May 21, 2015 9-36 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-37 Tax Conference, 28th Annual, May 21, 2015 9-38 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit K Form 433-A Collection Information Statement for Wage Earners and Self-Employed Individuals 9-39 Tax Conference, 28th Annual, May 21, 2015 9-40 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-41 Tax Conference, 28th Annual, May 21, 2015 9-42 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-43 Tax Conference, 28th Annual, May 21, 2015 9-44 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation 9-45 Tax Conference, 28th Annual, May 21, 2015 9-46 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Exhibit L Form 656 Offer in Compromise Form 656 Department of the Treasury — Internal Revenue Service (Rev. January 2015) Offer in Compromise Did you use the Pre-Qualifier tool located on our website at www.irs.gov prior to filling out this form? Yes No Include the Application Fee and Payment (personal check, cashier's check, or money order) with your Form 656. You must also include the completed Form 433-A (OIC) and/or 433-B (OIC) and supporting documentation. Section 1 Your Information Section 1A Individual Information (Form 1040 Filers) Your First Name, Middle Initial, Last Name Social Security Number (SSN) IRS Received Date If a Joint Offer, Spouse's First Name, Middle Initial, Last Name Social Security Number (SSN) Your Physical Home Address (Street, City, State, ZIP Code) Mailing Address (if different from above or Post Office Box number) Employer Identification Number (For self-employed individuals only) Section 1B Business Information (Form 1120, 1065, etc., filers) If your business is a Corporation, Partnership, LLC, or LLP and you want to compromise those tax debts, you must complete this section. You must also include all required documentation including the Form 433-B (OIC), $186 application fee, and initial payment. Business Name Business Address (Street, City, State, ZIP Code) Employer Identification Number Name and Title of Primary Contact Telephone Number (EIN) To: Commissioner of Internal Revenue Service In the following agreement, the pronoun "we" may be assumed in place of "I" when there are joint liabilities and both parties are signing this agreement. I submit this offer to compromise the tax liabilities plus any interest, penalties, additions to tax, and additional amounts required by law for the tax type and period(s) marked below: Section 2 Tax Periods Section 2A If Your Offer is for Individual Tax Debt Only Complete this Section only if you completed Section 1A 1040 Income Tax-Year(s) Trust Fund Recovery Penalty as a responsible person of (enter corporation name) for failure to pay withholding and Federal Insurance Contributions Act taxes (Social Security taxes), for period(s) ending 941 Employer's Quarterly Federal Tax Return - Quarterly period(s) 940 Employer's Annual Federal Unemployment (FUTA) Tax Return - Year(s) Other Federal Tax(es) [specify type(s) and period(s)] Note: If you need more space, use attachment and title it “Attachment to Form 656 dated .” Make sure to sign and date the attachment. www.irs.gov Form 656 (Rev. 1-2015) 9-47 Tax Conference, 28th Annual, May 21, 2015 Page 2 of 6 Section 2 (continued) Tax Periods Section 2B If Your Offer is for Business Tax Debt Complete this Section only if you completed Section 1B 1120 Income Tax-Year(s) 941 Employer's Quarterly Federal Tax Return - Quarterly period(s) 940 Employer's Annual Federal Unemployment (FUTA) Tax Return - Year(s) Other Federal Tax(es) [specify type(s) and period(s)] Note: If you need more space, use attachment and title it “Attachment to Form 656 dated .” Make sure to sign and date the attachment. Section 3 Reason for Offer Doubt as to Collectibility - I have insufficient assets and income to pay the full amount. Exceptional Circumstances (Effective Tax Administration) - I owe this amount and have sufficient assets to pay the full amount, but due to my exceptional circumstances, requiring full payment would cause an economic hardship or would be unfair and inequitable. I am submitting a written narrative explaining my circumstances. Explanation of Circumstances (Add additional pages, if needed) – The IRS understands that there are unplanned events or special circumstances, such as serious illness, where paying the full amount or the minimum offer amount might impair your ability to provide for yourself and your family. If this is the case and you can provide documentation to prove your situation, then your offer may be accepted despite your financial profile. Describe your situation below and attach appropriate documents to this offer application. Section 4 Low-Income Certification (Individuals and Sole Proprietors Only) Do you qualify for Low-Income Certification? You qualify if your gross monthly household income is less than or equal to the amount shown in the chart below based on your family size and where you live. If you qualify, you are not required to submit any payments during the consideration of your offer. Businesses other than sole proprietorships do not qualify for the low income waiver. Check here if you qualify for Low Income Certification based on the monthly income guidelines below. Size of family unit 48 contiguous states and D.C. Hawaii Alaska 1 $2,431 $2,796 $3,038 2 $3,277 $3,769 $4,096 3 $4,123 $4,742 $5,154 4 $4,969 $5,715 $6,213 5 $5,815 $6,688 $7,271 6 $6,660 $7,660 $8,329 7 $7,506 $8,633 $9,388 8 $8,352 $9,606 $10,446 For each additional person, add $ 846 $ 973 $1,058 www.irs.gov Form 656 (Rev. 1-2015) 9-48 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Page 3 of 6 Section 5 Payment Terms Check one of the payment options below to indicate how long it will take you to pay your offer in full. You must offer more than $0. The offer amount should be in whole dollars only. Lump Sum Cash Check here if you will pay your offer in 5 or fewer payments in 5 or fewer months from the date of acceptance: Enclose a check for 20% of the offer amount (waived if you are an individual or sole proprietorship and met the requirements for Low Income Certification) and fill in the amount(s) of your future payment(s). Total Offer Amount - 20% Initial Payment = Remaining Balance $ - $ = $ 0.00 You may pay the remaining balance in one payment after acceptance of the offer or up to five payments, but cannot exceed 5 months. Amount of payment $ payable within Month after acceptance Amount of payment $ payable within Months after acceptance Amount of payment $ payable within Months after acceptance Amount of payment $ payable within Months after acceptance Amount of payment $ payable within Months after acceptance Periodic Payment Check here if you will pay your offer in full in 6 to 24 months. Enter the amount of your offer $ Note: The total amount must equal all of the proposed payments including the first and last payments. Enclose a check for the first month's installment. $ is included with this offer then $ will be sent in on the day of each month thereafter for a total of months with a final payment of $ to be paid on the day of the month. Note: The total months may not exceed a total of 24 months, including the first payment. Your first payment is considered to be month 1; therefore, the remainder of the payments must be made within 23 months for a total of 24. You must continue to make these monthly payments while the IRS is considering the offer (waived if you are an individual or sole proprietorship and met the requirements for Low Income Certification). Failure to make regular monthly payments will cause your offer to be returned with no appeal rights. IRS Use Only Attached is an addendum dated (insert date) setting forth the amended offer amount and payment terms. Section 6 Designation of Down Payment and Deposit If you want your payment to be applied to a specific tax year and a specific tax debt, please tell us the tax form and tax year/quarter . If you do not designate a preference, we will apply any money you send to the government's best interest. If you wish to designate any payments not included with this offer, you must designate a preference for each payment at the time the payment is made. However, you cannot designate the $186 application fee or any payment after the IRS accepts the offer. If you are paying more than the required payment when you submit your offer and want any part of that payment treated as a deposit, check the box below and insert the amount. Deposits will be refunded if the offer is rejected, returned, or withdrawn, unless you request it to be applied to your tax debt. My payment of $ includes the $186 application fee and $ for my initial offer payment. I am requesting the additional payment of $ be held as a deposit. CAUTION: Do NOT designate the amounts sent in with your offer to cover the down payment and application fee as “deposits.” Doing so will result in the return of your offer. www.irs.gov Form 656 (Rev. 1-2015) 9-49 Tax Conference, 28th Annual, May 21, 2015 Page 4 of 6 Section 7 Source of Funds, Making Your Payment, and Filing Requirements Source of Funds Tell us where you will obtain the funds to pay your offer. You may consider borrowing from friends and/or family, taking out a loan, or selling assets. Making Your Payment Include separate checks for the payment and application fee. Make checks payable to the “United States Treasury” and attach to the front of your Form 656, Offer in Compromise. All payments must be in U.S. dollars. Do not send cash. Send a separate application fee with each offer; do not combine it with any other tax payments, as this may delay processing of your offer. Your offer will be returned to you if the application fee and the required payment is not included, or if your check is returned for insufficient funds. Filing Requirements I certify that I have filed all required tax returns. I certify that I was not required to file a tax return for the following years: Section 8 Offer Terms By submitting this offer, I/we have read, understand and agree to the following terms and conditions: Terms, Conditions, and Legal a) I request that the IRS accept the offer amount listed in this offer application as payment of my outstanding tax Agreement debt (including interest, penalties, and any additional amounts required by law) as of the date listed on this form. I authorize the IRS to amend Section 2 on page 1 in the event I failed to list any of my assessed tax debt, or tax debt assessed before acceptance of my offer. I also authorize the IRS to amend Section 2 on page 1 by removing any tax years on which there is currently no outstanding liability. I understand that my offer will be accepted, by law, unless IRS notifies me otherwise, in writing, within 24 months of the date my offer was received by IRS. I also understand that if any tax debt that is included in the offer is in dispute in any judicial proceeding it/they will not be included in determining the expiration of the 24-month period. IRS will keep my payments, b) I voluntarily submit the payments made on this offer and understand that they are not refundable even if I fees, and some refunds. withdraw the offer or the IRS rejects or returns the offer. Unless I designate how to apply each required payment in Section 6 page 3, the IRS will apply my payment in the best interest of the government, choosing which tax years and tax debts to pay off. The IRS will also keep my application fee unless the offer is not accepted for processing. c) The IRS will keep any refund, including interest, that I might be due for tax periods extending through the calendar year in which the IRS accepts my offer. I cannot designate that the refund be applied to estimated tax payments for the following year or the accepted offer amount. If I receive a refund after I submit this offer for any tax period extending through the calendar year in which the IRS accepts my offer, I will return the refund within 30 days of notification. I understand that the amount I am offering may not include part or all of an expected or current tax refund, money already paid, funds attached by any collection action, or anticipated benefits from a capital or net operating loss. d) The IRS will keep any monies it has collected prior to this offer. The IRS may levy my assets up to the time that the IRS official signs and acknowledges my offer as pending, which is accepted for processing and the IRS may keep any proceeds arising from such a levy. No levy will be issued on individual shared responsibility payments. The IRS will keep any payments that I make related to this offer. I agree that any funds submitted with this offer will be treated as a payment unless I checked the box to treat an overpayment as a deposit. Only amounts that exceed the mandatory payments can be treated as a deposit. I also agree that any funds submitted with periodic payments made after the submission of this offer and prior to the acceptance, rejection, or return of this offer will be treated as payments, unless I identify an overpayment as a deposit on the check submitted with the corresponding periodic payment. A deposit will be refundable if the offer is rejected, returned, or withdrawn. I understand that the IRS will not pay interest on any deposit. Pending status of an offer and e) Once an authorized IRS official signs this form, my offer is considered pending as of that signature date and it right to appeal remains pending until the IRS accepts, rejects, returns, or I withdraw my offer. An offer is also considered pending for 30 days after any rejection of my offer by the IRS, and during the time that any rejection of my offer is being considered by the Appeals Office. An offer will be considered withdrawn when the IRS receives my written notification of withdrawal by personal delivery or certified mail or when I inform the IRS of my withdrawal by other means and the IRS acknowledges in writing my intent to withdraw the offer. f) I waive the right to an Appeals hearing if I do not request a hearing in writing within 30 days of the date the IRS notifies me of the decision to reject the offer. www.irs.gov Form 656 (Rev. 1-2015) 9-50 The Basics of Practice with the IRS: Audits, Appeals, and Tax Litigation Page 5 of 6 Section 8 (Continued) Offer Terms I must comply with my future g) I will comply with all provisions of the internal revenue laws, including requirements to timely file tax returns and tax obligations and understand timely pay taxes for the five year period beginning with the date of acceptance of this offer and ending through the I remain liable for the full fifth year, including any extensions to file and pay. I also agree to promptly pay any liabilities assessed after amount of my tax debt until all acceptance of this offer for tax years ending prior to acceptance of this offer that were not otherwise identified in terms and conditions of this Section 2 of this agreement. If this is an offer being submitted for joint tax debt, and one of us does not comply offer have been met. with future obligations, only the non-compliant taxpayer will be in default of this agreement. An accepted offer will not be defaulted solely due to the assessment of an individual shared responsibility payment. h) I agree that I will remain liable for the full amount of the tax liability, accrued penalties and interest, until I have met all of the terms and conditions of this offer. Penalty and interest will continue to accrue until all payment terms of the offer have been met. If I file for bankruptcy before the terms and conditions of the offer are met, I agree that the IRS may file a claim for the full amount of the tax liability, accrued penalties and interest, and that any claim the IRS files in the bankruptcy proceeding will be a tax claim. i) Once the IRS accepts my offer in writing, I have no right to challenge the tax debt(s) in court or by filing a refund claim or refund suit for any liability or period listed in Section 2, even if I default the terms of the accepted offer. I understand what will happen if j) If I fail to meet any of the terms of this offer, the IRS may levy or sue me to collect any amount ranging from the I fail to meet the terms of my unpaid balance of the offer to the original amount of the tax debt (less payments made) plus penalties and interest offer (e.g., default). that have accrued from the time the underlying tax liability arose. The IRS will continue to add interest, as Section 6601 of the Internal Revenue Code requires, on the amount the IRS determines is due after default. I agree to waive time limits k) To have my offer considered, I agree to the extension of the time limit provided by law to assess my tax debt provided by law. (statutory period of assessment). I agree that the date by which the IRS must assess my tax debt will now be the date by which my debt must currently be assessed plus the period of time my offer is pending plus one additional year if the IRS rejects, returns, or terminates my offer or I withdraw it. (Paragraph (e) of this section defines pending and withdrawal.) I understand that I have the right not to waive the statutory period of assessment or to limit the waiver to a certain length or certain periods or issues. I understand, however, that the IRS may not consider my offer if I refuse to waive the statutory period of assessment or if I provide only a limited waiver. I also understand that the statutory period for collecting my tax debt will be suspended during the time my offer is pending with the IRS, for 30 days after any rejection of my offer by the IRS, and during the time that any rejection of my offer is being considered by the Appeals Office. I understand the IRS may file a l) The IRS may file a Notice of Federal Tax Lien during the offer investigation. The IRS may file a Notice of Notice of Federal Tax Lien on Federal Tax Lien to protect the Government’s interest on offers that will be paid over time. This tax lien will be my property. released when the payment terms of the accepted offer have been satisfied. The IRS will not file a Notice of Federal Tax Lien on any individual shared responsibility debt. Correction Agreement m) I/We authorize IRS, to correct any typographical or clerical errors or make minor modifications to my/our Form 656 that I/We signed in connection to this offer. I authorize the IRS to contact n) By authorizing the IRS to contact third parties, I understand that I will not be notified of which third parties the relevant third parties in order to IRS contacts as part of the offer application process, including tax periods that have not been assessed, as stated process my offer in section 7602 (c ) of the Internal Revenue Code. In addition, I authorize the IRS to request a consumer report on me from a credit bureau. I am submitting an offer as an o) I understand if the liability sought to be compromised is the joint and individual liability of myself and my co- individual for a joint liability obligor(s) and I am submitting this offer to compromise my individual liability only, then if this offer is accepted, it does not release or discharge my co-obligor(s) from liability. The United States still reserves all rights of collection against the co-obligor(s). Shared Responsibility Payment p) If your offer includes any shared responsibility payment (SRP) amount that you owe for not having minimum (SRP) essential health coverage for you and, if applicable, your dependents per Internal Revenue Code Section 5000A – Individual shared responsibility payment, it is not subject to penalties or to lien and levy enforcement actions. However, interest will continue to accrue until you pay the total SRP balance due. We may apply your federal tax refunds to the SRP amount that you owe until it is paid in full. Section 9 Signatures Under penalties of perjury, I declare that I have examined this offer, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct and complete. Signature of Taxpayer/Corporation Name Phone Number Date (mm/dd/yyyy) Signature of Taxpayer/Authorized Corporate Officer Phone Number Date (mm/dd/yyyy) www.irs.gov Form 656 (Rev. 1-2015) 9-51 Tax Conference, 28th Annual, May 21, 2015 Page 6 of 6 Section 10 Paid Preparer Use Only Signature of Preparer Phone Number Date (mm/dd/yyyy) Name of Paid Preparer Preparer's CAF no. or PTIN Firm's Name (or yours if self-employed), Address, and ZIP Code Include a valid, signed Form 2848 or 8821 with this application, if one is not on file. Section 11 Third Party Designee Do you want to allow another person to discuss this offer with the IRS? Yes No If yes, provide designee's name Telephone Number IRS Use Only. I accept the waiver of the statutory period of limitations on assessment for the Internal Revenue Service, as described in Section 8 (k). Signature of Authorized Internal Revenue Service Official Title Date (mm/dd/yyyy) Privacy Act Statement We ask for the information on this form to carry out the internal revenue laws of the United States. Our authority to request this information is Section 7801 of the Internal Revenue Code. Our purpose for requesting the information is to determine if it is in the best interests of the IRS to accept an offer. You are not required to make an offer; however, if you choose to do so, you must provide all of the taxpayer information requested. Failure to provide all of the information may prevent us from processing your request. If you are a paid preparer and you prepared the Form 656 for the taxpayer submitting an offer, we request that you complete and sign Section 10 on Form 656, and provide identifying information. Providing this information is voluntary. This information will be used to administer and enforce the internal revenue laws of the United States and may be used to regulate practice before the Internal Revenue Service for those persons subject to Treasury Department Circular No. 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal Revenue Service. Information on this form may be disclosed to the Department of Justice for civil and criminal litigation. We may also disclose this information to cities, states and the District of Columbia for use in administering their tax laws and to combat terrorism. Providing false or fraudulent information on this form may subject you to criminal prosecution and penalties. www.irs.gov Form 656 (Rev. 1-2015) 9-52 Digital Currency: Following the Tax Consequences - Federal Income Tax Committee by Joni D. Larson Western Michigan University Thomas M. Cooley Law School Lansing Digital Currency: Following the Tax Consequences - Federal Income Tax Committee1 Joni D. Larson Western Michigan University Thomas M. Cooley Law School Lansing I. Digital Currency - Definitions ...... 10-1 II. Online, Multi-player, Video Gaming Systems ...... 10-1 III. Bitcoin - How It Works...... 10-2 IV. Tax Treatment of Virtual Currency ...... 10-4 V. The Real Problem with Bitcoin ...... 10-5 VI. Going Forward ...... 10-6 I. Digital Currency - Definitions Virtual currency: “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments, it operates like “real” currency—i.e., the coin and paper money of the United States or of any other coun- try that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance—but it does not have legal tender status in any jurisdiction.” Sec. 2, Notice 2014-21, 2014-16 I.R.B. 938. Virtual currencies have been in existence for many years, ranging from currencies used in online, multi-player, video games to barter bucks created by barter clubs to facili- tate trades. Convertible virtual currency: a “virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency.” Sec. 2, Notice 2014-21. Cryptocurrency: A subcategory of virtual currency. They “function as a unique cur- rency with [their] own free-floating exchange.” Omri Y. Marian, Are Cryptocurrencies ‘Super’ Tax Havens?, 112 Mich. L. Rev. 38, 38-39, 41 (2013), citing David D. Stewart & Stephanie Soong Johnston, Virtual Currency: A New Worry for Tax Administrators?, 68 Tax Notes Int’l 423, 423 (2012). They are virtual currencies that use peer-to-peer payment systems and rely on cryptography. Bitcoin is a cryptocurrency. Fiat currency: money a government has declared to be legal tender; the government determines the value of the currency. II. Online, Multi-player, Video Gaming Systems • May use virtual currency, some of which is convertible virtual currency. 1. Professor and Director of the Graduate Tax Program, Western Michigan University— Cooley Law School. M.S., Michigan State University; LL.M., University of Florida; J.D, Uni- versity of Montana. 10-1 Tax Conference, 28th Annual, May 21, 2015 • Players interact in a virtual world that has its own virtual economy. Virtual, and sometimes real, goods and services are bought and sold with the game’s virtual currency. A player receives currency through a payment from another game par- ticipant or from a game administrator as a reward for achieving a particular suc- cess or meeting a specific goal. • There are three types of virtual currency systems used by online, multi-player video games. • “Closed-flow” system: virtual currency can be used only within the game to purchase virtual goods or services; the currency cannot be cashed out for dollars. (While systems are referred to as “closed-flow” systems, in that the currency is not to be used outside the game, such conversions are actually possible. Moreover, even though the end-user license agreement may pro- hibit outside trading of in-game items or payment of in-game goods and ser- vices with real money, it can be done.) • “Hybrid” system: flow is in one direction; either cash can be converted to virtual currency or virtual currency can be converted to cash, but both options are not available. • “Open-flow” system: virtual currency can be used to purchase real and vir- tual goods and services and virtual cash can be exchanged for dollars and dollars for virtual currency. Virtual currency for cash exchanges are carried out by online exchange services such as PayPal. For more information on the different systems and virtual worlds, see: • Richard Heeks, Gaming for Profits: Real Money from Virtual Worlds, Scientific American (January 4, 2010) http:// www.scientificamerican.com/article/real-money-from-virtual-worlds/ • Adam S. Chodorow, Ability to Pay and the Taxation of Virtual Income, 75 Tenn. L. Rev. 695 (2008) • Bryan T. Camp, The Play’s the Thing: A Theory of Taxing Virtual Worlds, 59 Hastings L.J. 1 (2007) • Leandra Lederman, “Stranger Than Fiction”: Taxing Virtual Worlds, 82 N.Y.U. L. Rev. 1620 (2007). III. Bitcoin - How It Works A. Bitcoin Background • Bitcoin is virtual money held in a virtual account. • Each Bitcoin has its own private digital fingerprint that cannot be used again after it has been activated. • Users download software onto their computer or smart phone to create a “wallet”. The user uses the wallet to store, send, and receive Bitcoin. • There is no central bank or clearing-house or third party administrator. 10-2 Digital Currency: Following the Tax Consequences - Federal Income Tax Committee • There is no entity that issues Bitcoin. Rather, new Bitcoin enter the system through “mining.” The verification and reconciliation of Bitcoin transactions requires solving increasingly complex mathematical problems. “Miners” provide the computing power needed to complete the task and receive newly-created Bit- coin as payment for their services. • Currently-existing Bitcoin can be obtained by receiving them as a payment or gift or through an exchange that allows users to convert cash to Bitcoin and vice versa by matching buyers and sellers. • The value of Bitcoin is not tied to the value of the dollar (or any other currency) and fluctuates based on the market. Bitcoin maintains daily historical pricing. • There is a finite amount of Bitcoin available, about 21 million. The program’s designer projected that number to be reached in 2140. • Better structure than other/past virtual currencies because “double-spending” is not possible. • The decentralized system, with each transaction being verified by a miner, makes Bitcoin unique. • For more information see: Frequently Asked Questions: How Does Bitcoin Work?, Bitcoin.org, https://bitcoin.org/en/faq#how-does-bitcoin-work. B. Transactions • Made peer-to-peer, directly between sender and receiver. • Bitcoins are considered sent or received only when the transaction is logged on the blockchain. Use of the blockchain prevents each Bitcoin from being used more than once (i.e., prevents “double-spending”). Every transaction is recorded on the blockchain and time-stamped; once recorded, the transaction cannot be modified. Once recorded, ownership has moved from the transferor to the trans- feree. • Each owner has at least one “public key” (he may have multiple public keys) and a “private key”. The transfer is made to the transferee’s public key (public address). The transferor uses his “private key” to certify the transaction (i.e., approve the transfer of funds to the transferee’s public key address). • Transfers are recorded using the transferee user’s addresses (public key) and con- tains no information about the user. As long as a user address/public key is not associated with the user’s name, the user’s identity remains hidden. • Once verified, transactions are recorded and stored publicly and permanently on the network in a “block chain”. See: • https://blockchain.info • https://blockchain.info/stats • http://bitcoincharts.com/bitcoin/ 10-3 Tax Conference, 28th Annual, May 21, 2015 IV. Tax Treatment of Virtual Currency A. Functional Currency Under the Code, “functional currency” refers to the U.S. dollar. Neither Bitcoin nor other virtual currency is considered a functional currency. Describing any virtual currency as a “currency” is a non-technical, non-tax description. Sec. 4, Notice 2014-21, 2014-16 I.R.B. 938, Q/A 1. B. Notice 2014-21 In 2014 the IRS ruled that virtual convertible currencies are property for federal income tax purposes. Sec. 4, Notice 2014-21, Q/A 1. Using a convertible virtual currency, such as Bitcoin, to carry out a transaction renders the transaction a barter transaction, and the rules that apply in barter transactions apply when virtual currency is used to pay for goods or services. I.R.C. §61(a)(1); Treas. Reg. §1.61-2(d); Rev. Rul. 79-24, 1979-1 C.B. 60. • Those who are paid in virtual currency (including Bitcoin) for goods or services rendered have gross income. Compensation payments are subject to the same Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) withholding requirement as other compensation payments and the employer must satisfy the usual information reporting requirements. Sec. 4, Notice 2014-21, Q/A 11, 12, 13. • Those who “mine” Bitcoin by using their computer resources to validate Bitcoin transactions are receiving compensation for services. The income is self-employ- ment income, subject to self-employment tax. I.R.C. §1401; Sec. 4, Notice 2014- 21, Q/A 8, 9, 10. • Because virtual currency is property and its value fluctuates, use of virtual cur- rency to pay for goods or services is a disposition of property and gain or loss must be recognized. I.R.C. §1001; Sec. 4, Notice 2014-21, Q/A 1, 6. If the pay- ment constitutes a business or investment expense, presumably the taxpayer can claim a deduction equal to the amount paid. I.R.C. §§162, 212. If the payment is a salary, the employer is required to withhold FICA and FUTA tax and file a Form W-2, the same as if the employee had been paid in cash. Sec. 4, Notice 2014-21 Q/A 11, 12, 13, 14. • As with all assets sold, the character of the gain depends on how the taxpayer holds the virtual currency. I.R.C. §1221(a); Sec. 4, Notice 2014-21, Q/A 7. For taxpayers who hold Bitcoin as an investment, the character will be capital. Sec. 4, Notice 2014-21, Q/A 7; I.R.C. §1221. The net gain will be taxed at the preferen- tial rates if held for more than one year and the amount of net loss that can be rec- ognized may be limited. If virtual currency is held by the taxpayer as inventory, the gain will be ordinary. 10-4 Digital Currency: Following the Tax Consequences - Federal Income Tax Committee • When a taxpayer owns multiple Bitcoin, purchased at different prices, he will need to determine which are sold or disposed of. The Notice does not provide guidance on how to determine the order of disposition. • The fair market value of virtual currency can be determined by the exchange rate as listed on an exchange if “the exchange rate is established by market supply and demand.” Sec. 4, Notice 2014-21, Q/A 5. V. The Real Problem with Bitcoin • Transactions are peer-to-peer, anonymous, and encrypted without the use of an administrative clearing house. • Bitcoin is the currency of choice for those wanting to purchase illegal good or services anonymously. • Bitcoin is difficult to monitor for proper tax reporting and compliance purposes. A. Government Awareness of Problem • The Government Accountability Office (GAO) prepared a study on crimes that could be committed using digital currency and provided it to the Senate Commit- tee on Homeland Security and Government Affairs. In part, the report notes that policing crimes committed with digital currency would be difficult given that the transactions are anonymous. Gov’t Accountability office, GAO-14-496. Virtual Currencies: Emerging Regulatory, Law Enforcement, and Consumer Protection Challenges, (2014) http://www.gao.gov/assets/670/663678.pdf. • The European community has raised concerns about the use of virtual currency in connection with money laundering and terrorist activity. European Banking Authority, EBA Opinion on ‘Virtual Currencies,’ EBA/OP/2014/08 (July 4, 2014) http://www.eba.europa.eu/documents/10180/657547/EBA-Op-2014- 08+Opinion+on+Virtual+Currencies.pdf. • In her 2013 annual report to Congress, the Taxpayer Advocate raised issues asso- ciated with the lack of guidance on dealing with digital currencies. National Tax- payer Advocate, 2013 Annual Report to Congress, Most Serious Problems #24, p. 249–255, http://www.taxpayeradvocate.irs.gov/2013-Annual-Report/ full-2013-annual-report-to-congress.html. • The GAO published a report discussing the tax-compliance risks associated with virtual currencies and economies. Gov’t Accountability Office, GAO-13-516, Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks (2013). B. Unsavory Users • Ross Ulbricht, with an online presence as the “Dread Pirate Roberts,” operated Silk Road, an underground virtual marketplace involved in the online sale of ille- gal drugs and other unlawful goods and services. Ulbricht was able to keep the 10-5 Tax Conference, 28th Annual, May 21, 2015 sales anonymous by using a special computer setup that concealed the identity of the users. In addition, Bitcoin was used to make the purchases. The site was eventually shut down. On February 4, 2015, Ulbricht was con- victed of seven different crimes including distribution of narcotics, engaging in a continuing criminal activity, computer hacking, and conspiracy to commit money laundering. The online black market operation effectively has resurfaced under a new name, Agora. • Liberty Reserve was a Costa Rican company that offered a virtual currency ser- vice as payment processor and money transfer system. In reality, it enabled cyber- criminals to make untraceable financial transactions, facilitating over $6 billion in money laundering transactions. The co-founder, Vladimir Kats, entered a guilty plea for money laundering. • United States v. Powell: Powell operated a multimillion dollar Bitcion exchange on the Internet. He pled guilty to operating an unlicensed money service and was sentenced to four years in federal prison. Powell’s exchange business allowed individuals increased anonymity by exchanging cash anonymously for Bitcoin. He received more than $3 million from individuals during an 18-month period. • Because transfers can be made electronically, anonymously, and without the use of a third party, Bitcoin can be used to avoid complying with tax laws. Current efforts directed to finding taxpayers who have utilized offshore tax havens will not work with cryptocurrencies. While tax havens are dependent on banks or financial institutions to carry out the tax evasion techniques, cryptocurrencies, as a peer-to-peer system, do not have a third party administrator. Accordingly, there is no third-party that can be tapped for information. This fact makes use of Bit- coin very attractive to tax evaders. VI. Going Forward • Bitcoin is not the novelty it once was. It has already found a toe-hold in main- stream commerce. Bitcoin trading increased from $15 billion in 2013 to $23 bil- lion in 2014. Currently, it is the largest virtual digital currency. Crypto-Currency Market Capitalizations, http://coinmarketcap.com/. • Payment with Bitcoin is not limited to small, obscure markets. In 2014 the online retailer Overstock.com began accepting Bitcoin as payment for its products and is planning to give its employees the option of being paid in Bitcoin. On Expedia, a hotel room can be paid for with Bitcoin. Other companies embracing Bitcoin include Newegg, Dell, and Dish Network. The United Way accepts Bitcoin dona- tions, and Rand Paul is accepting Bitcoin donations to his presidential campaign. Earlier this year, a mall in Vancouver, Washington, installed a Bitcoin ATM. Business are popping up that make Bitcoin more accessible. • Venture capital investments into Bitcoin startups have increased from $96 million in 2013 to $335 million in 2014. 10-6 Digital Currency: Following the Tax Consequences - Federal Income Tax Committee The 30,000 Bitcoin seized from Ross Ulbricht were sold to venture capitalist Tim Draper. • Bitcoin has an accessibility and ubiquity unlike any previous virtual currency, effectively making it available to all taxpayers for tax avoidance purposes. It can be used for evasions of any size and is not limited to just those that require open- ing a bank account in an exotic place or advancing through a complex video game. • Awaiting guidance on the interplay between Bitcoin and the Bank Secrecy Act, FinCEN, FBAR, and FACTA. 10-7 Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee by Douglas B. Roberts, Jr. Consumers Energy Jackson Kirk A. Profit Governmental Consultant Services Inc. Lansing Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee by Douglas B. Roberts, Jr. Consumers Energy Jackson Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee Douglas B. Roberts, Jr. Consumers Energy Jackson Exhibit Exhibit A PowerPoint Presentation ...... 11-3 11-1 Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee Exhibit A PowerPoint Presentation Energy Policy Update May 21, 2015 Serving Michigan for 128 Years 2 Committed to the state’s success • We’ve supplied Michigan with affordable, reliable energy since 1886 • Michigan’s largest utility and second largest investor • Michigan’s 7th largest employer Ʌ providing 7,400 jobs plus 7,500 contractor jobs • One of the state’s largest property owners and taxpayers • Major supporter of Michigan nonprofits – donated $10 million in 2014 Generating Unit 11-3 Tax Conference, 28th Annual, May 21, 2015 Meeting Michigan’s Energy Needs 3 Creating Lasting Value Energy Efficiency Clean and Balanced Investing to improve Energy efficiency programs Portfolio reliability by upgrading reduced demand and Consumers Energy is plants and infrastructure, saved customers $575 the leading supplier including an $800 million million of renewable energy, overhaul of the Ludington meeting the 10% Pumped Storage Facility standard a full year ahead of schedule Senate Energy Committee – 10 members Republican Members John Proos, St. Joseph Majority Vice Chair Dale Zorn, Ira Township Ken Horn, Frankenmuth Tonya Schuitmaker, Lawton Joe Hune, Fowlerville C Mike Nofs Mike Shirkey, Clarklake Democratic Members David Knezek, Dearborn Heights Virgil Smith, Detroit Prior Service on Energy Committee MVC – Hoon Hopgood 11-4 Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee House Energy Committee – 25 members Republican Members Tom Barrett, Potterville Dave Maturen, Brady Township Triston Cole, Mancelona Ed McBroom, Vulcan Holly Hughes, Montague Rick Outman, Six Lakes Brad Jacobsen, Oxford Peter Pettalia, Presque Isle Andrea LaFontaine, Columbus Brett Roberts, Charlotte Pete Lucido, Wash. Township Jason Sheppard, Temperance Chair, Aric Nesbitt Michael Webber, Rochester Hills Gary Glenn, Midland, Vice Chair Democratic Members Charlie Brunner, Bay City Bob Kosowoski, Westland Wendell Byrd, Detroit Marilyn Lane, Fraser Scott Dianda, Calumet Derek Miller, Warren Latanya Garrett, Detroit Julie Plawecki, Dearborn Hts MVC Bill LaVoy John Kievela, Marquette Prior Service on Energy Committee New & Changing EPA Regulations Reshaping Energy Landscape 6 • Current EPA regulations driving shut down of nine coal plants in 2016 Projected Coal Retirements Michigan by 2016 Midwest retirements 11-16 GW projected • This includes our “Classic Seven” plants, capable of generating 950 megawatts of electricity • Electric capacity surplus will disappear in Midwest and Michigan • Regional reliability organization concerned about having enough back-up power • EPA’s Clean Power Plan will likely lead to more plant retirements after 2020, putting an additional 14 gigawatts of capacity at risk Michigan’s energy supply is hardest hit within MISO region 11-5 Tax Conference, 28th Annual, May 21, 2015 Question: 1 7 • Over the next two years, nine power plants serving one million people will be closed in Michigan due to changes in federal regulations resulting in a reduction in Michigan’s current electricity generation. Would you say the loss of these plants is: A: A crisis that must be dealt with immediately B: A concern that should be addressed over the next two years C: Something that should be studied further to understand impacts Midwest Grid Operator’s Shortfall Projections 8 The Midcontinent System Operator (MISO) is expecting capacity shortages as early as 2016 2015 2016 2017 2018 2019 2020 2021 2022 2023 • Reliability risk Starting in 2016 1 Capacity 2 GW Excess capacity gone Surplus Minimum generation requirement not met Capacity -3 GW -2 GW Shortfall -4 GW -6 GW • MISO market prices rise -10 GW • MISO market signals are -15 GW insufficient to provide long term -19 GW investments 88% -24 GW 3GW 1. A Gigawatt serves 500,000 homes, or about 1 million people. 11-6 Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee Michigan’s regulatory structure contributing to capacity shortage 9 • In 2008, the Michigan market was left partially deregulated, allowing 10% of Michigan’s electric load to be served by retail energy marketers • Today, it is clear that retail suppliers are not building power plants to supply the future needs of their customers • As Michigan utilities plan for the future, it needs to be clear whether we need to build for our existing customers or for all electric customers in Michigan • Michigan needs to address its regulatory structure to prevent a capacity shortage and support the transformation of Michigan’s generation fleet Question 2 10 State’s generally have two types of systems to deliver energy. Given these two statements which system would you prefer: A) Michigan should create a system that will focus on making sure we have the right rules and regulations to keep electricity prices stable, affordable, and creates a fair system for everyone. B) Michigan should create a system that will focus on creating competition in electricity rates, which supporters say will bring more choices, greener energy and lower prices to Michigan customers. 11-7 Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee by Kirk A. Profit Governmental Consultant Services Inc. Lansing Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee Kirk A. Profit Governmental Consultant Services Inc. Lansing I. Introduction...... 11-9 Exhibit Exhibit A Key Michigan Legislators and Government Contacts ...... 11-11 I. Introduction The following exhibit lists key Michigan legislators and government contacts. 11-9 Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee Exhibit A Key Michigan Legislators and Government Contacts Department of Treasury contacts: Nick Khouri, Michigan State Treasurer (517) 373-3223 [email protected] Howard Ryan, Legislative Liaison (517) 335-1225 [email protected] House Leadership House Republicans Speaker of the House – Kevin Cotter (R - Mt. Pleasant) (517) 373-1789, [email protected] House Majority Floor Leader – Aric Nesbitt (R - Lawton) (517) 373-0839, [email protected] Speaker Pro Tempore – Tom Leonard (R - Lansing) (517) 373-1778, [email protected] House Democrats: House Democratic Leader – Tim Greimel (D - Auburn Hills) (517) 373-0475, [email protected] House Democratic Floor Leader – Sam Singh (D - East Lansing) (517) 373-1786, [email protected] Senate Leadership Senate Republicans: Senate Majority Leader – Arlan Meekhof (R - West Olive) (517) 373-6920, [email protected] Majority Floor Leader – Mike Kowall (R - White Lake) (517) 373-1758, [email protected] President Pro Tempore – Tonya Schuitmaker (R - Lawton) (517) 373-0793, [email protected] Senate Democrats: Senate Minority Leader – Jim Ananich (D - Flint) (517) 373-0142, [email protected] Minority Floor Leader – Morris Hood (D - Detroit) (517) 373-0990, [email protected] 11-11 Tax Conference, 28th Annual, May 21, 2015 2015 - 2016 House Tax Policy Committee Jeff Farrington, Chair (R - Utica) (517) 373-7768, [email protected] David Maturen, Vice Chair (R - Vicksburg) (517) 373-1787, [email protected] Lee Chatfield (R - Levering) (517) 373-2629, [email protected] Gary Glenn (R - Midland) (517) 373-1791, [email protected] Martin Howrylak (R - Troy) (517) 373-1783, [email protected] Brandt Iden (R - Oshtemo) (517) 373-1774, [email protected] Pat Somerville (R - New Boston) (517) 373-0855, [email protected] Michael Webber (R - Rochester Hills) (517) 373-1773, [email protected] Ken Yonker (R - Caledonia) 517) 373-0840, [email protected] Jim Townsend, Minority Vice Chair (D - Royal Oak) (517) 373-3818, [email protected] Wendell Byrd (D - Detroit) (517) 373-0144, [email protected] Paul Clemente (D-Lincoln Park) (517) 373-0140, [email protected] Bill LaVoy (D-Monroe) (517) 373-1530, [email protected] 11-12 Lobbyist Roundtable - State and Local Tax Committee/Young Lawyers Committee 2015 – 2018 Senate Finance Committee Jack Brandenburg, Chair (R – Harrison Township) (517) 373-7670, [email protected] Dave Robertson, Vice Chair (R – Grand Blanc) (517) 373-1636, [email protected] Tom Casperson (R – Escanaba) (517) 373-7840, [email protected] Marty Knollenberg (R - Troy) (517) 373-2523, [email protected] John Proos (R - St. Joseph) (517) 373-6960, [email protected] Steve Bieda, Minority Vice Chair (D – Warren) (517) 373-8360, [email protected] Rebekah Warren (D-Ann Arbor) (517) 373-2406, [email protected] 11-13 Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee by Jeffrey A. DeVree Varnum LLP Grand Rapids Warren J. Widmayer Ferguson Widmayer PC Ann Arbor Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Jeffrey A. DeVree Varnum LLP Grand Rapids Warren J. Widmayer Ferguson Widmayer PC Ann Arbor I. Prudence - The Dudenhoeffer Case ...... 12-1 II. Process - The GreatBanc Settlement Agreement ...... 12-5 III. Status - The Proposed Regulation on Investment Advice ...... 12-7 Exhibits Exhibit A GreatBlanc Settlement Agreement ...... 12-9 Exhibit B Proposed Fiduciary Regulation: EBSA News Release...... 12-21 Exhibit C Proposed Fiduciary Regulation: EBSA Fact Sheet...... 12-23 Exhibit D Proposed Fiduciary Regulation: Notice of Proposed Rulemaking . . . 12-29 Exhibit E Proposed Fiduciary Regulation: Notice of Proposed Class Exemption for Best Interest Contracts ...... 12-91 I. Prudence - The Dudenhoeffer Case A. News Headlines RIA Pension & Benefits Week (June 30, 2014) Supreme Court Invalidates “Presumption of Prudence” that Protected ESOP Fidu- ciaries in Stock Drop Cases Kiplinger Tax Letter (July 3, 2014) A bit of good news for ESOP participants if the employer’s stock price falls: Plan fiduciaries are subject to a duty of prudence, the Supreme Court says. B. Litigation Background The plan was a 401(k) plan with employer matching contributions of employer stock to a part of the plan that was designated as an ESOP. The plan allowed participants to select investments, including employer stock. Stock price fell by 74% from July 2007 to September 2009. Participants claimed that the investment fiduciaries, Fifth Third and various Fifth Third officers, breached their fiduciary duties, but did not seem to have a coherent or con- sistent theory of what the fiduciaries did wrong or what they should have done instead. © 2015 The Institute of Continuing Legal Education 12-1 Tax Conference, 28th Annual, May 21, 2015 The district court dismissed the case, applying a presumption of prudence from a line of similar cases beginning with the Moench case in 1995. The court saw this as a “legal” presumption that could be applied at the pleading stage. The court of appeals agreed that the fiduciaries were entitled to a presumption in their favor, but decided that it’s an “evidentiary” presumption that applies at the trial stage. So the court sent the case back for a trial. The Supreme Court granted the petition for review because federal courts had some- what differing opinions about this presumption. C. ERISA Rules General fiduciary duties for any employee benefit plan under ERISA. • Loyalty—“solely in the interest of the participants and beneficiaries.” ERISA §404(a)(1). • Exclusive purpose—“for the exclusive purpose of providing benefits to partici- pants and their beneficiaries and defraying reasonable expenses of administering the plan.” ERISA §404(a)(1)(A) • Prudence—“with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” ERISA §404(a)(1)(B). • Diversification—“by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.” ERISA §404(a)(1)(C). • Plan documents—“in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provi- sions of this title and title IV.” ERISA §404(a)(1)(D). Special rules for ESOPs • Special purpose—“designed to invest primarily in qualifying employer securi- ties.” ERISA §407(d)(6). • Special exemption from diversification—“the diversification requirement of paragraph (1)(C) and the prudence requirement (only to the extent that it requires diversification) of paragraph (1)(B) is [sic] not violated by acquisition or holding of…qualifying employer securities.” ERISA §404(a)(2). D. Participants’ Arguments By July 2007 the handwriting was on the wall for subprime lending in the housing market, and everyone could see it. The fiduciaries knew, from inside information, that management had deceived the market by making material misstatements about the company’s financial prospects. Those misstatements had caused the market to overvalue the stock. Therefore, when buying employer stock with participants’ money, the fiduciaries were paying more for the stock than it was worth. 12-2 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee E. Fiduciaries’ Arguments ESOPs are required to invest primarily in employer stock. Fiduciaries are required to follow the terms of the plan. If they sell, and the stock price goes up instead of down, they’ll be liable for failing to follow the terms of the plan. Fiduciaries would violate federal securities law if they were to buy or sell on the basis of inside information. If they sell, and the stock price crashes, participants will be even worse off. F. Court’s Analysis Section 1104(a)(1)(C) requires ERISA fiduciaries to diversify plan assets. And §1104(a)(2) establishes the extent to which those duties are loosened in the ESOP con- text to ensure that employers are permitted and encouraged to offer ESOPs. Section 1104(a)(2) makes no reference to a special “presumption” in favor of ESOP fiducia- ries…. Instead, §1104(a)(2) simply modifies the duties imposed by §1104(a)(1) in a pre- cisely delineated way: It provides that an ESOP fiduciary is exempt from §1104(a)(1)(C)’s diversification requirement and also from §1104(a)(1)(B)’s duty of prudence, but “only to the extent that it requires diversification.” (Court’s emphasis). We cannot accept the claim that underlies this argument, namely, that the content of ERISA’s duty of prudence varies depending upon the specific nonpecuniary goal set out in an ERISA plan, such as what petitioners [i.e., the fiduciaries] claim is the nonpecuni- ary goal here [i.e., employee ownership of employer stock]. This concern [i.e., federal securities law] is a legitimate one. But an ESOP-specific rule that a fiduciary does not act imprudently in buying or holding company stock unless the company is on the brink of collapse (or the like) is an ill-fitting means of addressing it. While ESOP fiduciaries may be more likely to have insider information about a com- pany that the fund is investing in than are other ERISA fiduciaries, the potential for con- flict with the securities laws would be the same for a non-ESOP fiduciary who had relevant inside information about a potential investment. Petitioners are basically seeking relief from what they believe are meritless, economi- cally burdensome lawsuits. We agree that Congress sought to encourage the creation of ESOPs.… At the same time, we do not believe that the presumption at issue here is an appropriate way to weed out meritless lawsuits or to provide the requisite “balancing.” The proposed presumption makes it impossible for a plaintiff to state a duty-of-prudence claim, no matter how meritorious, unless the employer is in very bad economic circum- stances. Such a rule does not readily divide the plausible sheep from the meritless goats. That important task can be better accomplished through careful, context-sensitive scru- tiny of a complaint’s allegations. G. New Pleading Standard Court puts a heavy, and perhaps even heavier, burden on participants with procedural requirements for pleading their case in the complaint. We consider more fully one important mechanism for weeding out meritless claims, the motion to dismiss for failure to state a claim. That mechanism, which gave rise to the lower court decisions at issue here, requires careful judicial consideration of whether the complaint states a claim that the defendant has acted imprudently. © 2015 The Institute of Continuing Legal Education 12-3 Tax Conference, 28th Annual, May 21, 2015 In our view, where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances.… Many investors take the view that they have little hope of outperform- ing the market in the long run based solely on their analysis of publicly available infor- mation, and accordingly they rely on the security’s market price as an unbiased assessment of the security’s value in light of all public information.… In other words, a fiduciary usually is not imprudent to assume that a major stock market…provides the best estimate of the value of the stocks traded on it that is available to him. To state a claim for breach of the duty of prudence on the basis of inside information, a plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it. The following three points inform the requisite analysis. First, in deciding whether the complaint states a claim upon which relief can be granted, courts must bear in mind that the duty of prudence, under ERISA as under the common law of trusts, does not require a fiduciary to break the law.… Second, where a complaint faults fiduciaries for failing to decide, on the basis of the inside information, to refrain from making additional stock purchases or for failing to disclose that information to the public so that the stock would no longer be overvalued, additional considerations arise. The courts should con- sider the extent to which an ERISA-based obligation either to refrain on the basis of inside information from making a planned trade or to disclose inside information to the public could conflict with the complex insider trading and corporate disclosure requirements imposed by the federal securities laws or with the objectives of those laws.… Third, lower courts faced with such claims should also consider whether the complaint has plausibly alleged that a prudent fiduciary in the defendant’s position could not have concluded that stopping purchases—which the market might take as a sign that insider fiduciaries viewed the employer’s stock as a bad investment—or publicly disclosing negative information would do more harm than good to the fund by causing a drop in the stock price and a concom- itant drop in the value of the stock already held by the fund. H. Remand We leave it to the courts below to apply the foregoing to the complaint in this case in the first instance. I. Limited Application? Any application to fiduciaries of an ESOP with employer stock that is not publicly traded? 12-4 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee II. Process - The GreatBanc Settlement Agreement A. Press Releases GreatBanc Trust Company (June 2, 2014) (excerpts) GreatBanc Trust Company is pleased to announce that it has settled the lawsuit relating to the 2006 Sierra Aluminum employee stockownership plan (ESOP) transaction, the only lawsuit brought against GreatBanc by the U.S. Department of Labor (DoL). GreatBanc Trust is also pleased to announce that as a product of constructive and collab- orative discussions with top DoL officials in Washington D.C., GreatBanc Trust and the DoL have agreed on a process to be followed when GreatBanc Trust, as trustee, pur- chases or sells stock on behalf of an ESOP. In a series of meetings with the DoL officials, GreatBanc Trust informed them about the excellent policies and procedures that GreatBanc Trust has had in place for many years. The DoL contributed its ideas, and mutually agreed that it would be helpful to spell these out in a written document. EBSA News Release (June 3, 2014) (excerpts) The U.S. Department of Labor has reached a $5.25 million settlement with GreatBanc Trust Co. resolving department allegations that the Lisle, Illinois-based company vio- lated the Employee Retirement Income Security Act. In 2006, GreatBanc, as trustee to the Sierra Aluminum Co. Employee Stock Ownership Plan, allegedly allowed the plan to purchase stock from Sierra Aluminum’s co-founders and top executives for more than fair market value. “The benefit of this settlement is two-fold: The Sierra Aluminum plan will recoup a sig- nificant amount of money, and perhaps more importantly, safeguards will be put in place to protect ESOPs involved in any future GreatBanc transactions,” said U.S. Secretary of Labor Thomas E. Perez. “Others in the industry would do well to take notice of the protections put in place by this agreement,” said Assistant Secretary of Labor for Employee Benefits Security Phyllis C. Borzi. “ESOPs are an important tool to promote employee ownership, not a way to create big cash-outs for owners and top executives.” B. Regulation Projects In 1988, EBSA proposes regulations on “adequate consideration” and does little or nothing further. In 2010, EBSA proposes regulations on “investment advice” that would have included ESOP appraisers and, in response to criticism, goes back to the drawing board. C. Highlights of the Agreement Conflicts of interest. The agreement prohibits the use of a valuation advisor who has ever performed work, including an ESOP feasibility study, for— • The plan sponsor; © 2015 The Institute of Continuing Legal Education 12-5 Tax Conference, 28th Annual, May 21, 2015 • The seller (if the ESOP is the buyer) or the buyer (if the ESOP is the seller). • The investment bank or other consultant who is involved in structuring the trans- action. Selection process. The agreement requires a written analysis of— • The reason for selecting the particular valuation advisor; • A list of all valuation advisors that the trustee considered; • The qualifications of the valuation advisors that the trustee considered; • A list of references checked and a discussion of their views on the valuation advi- sors; • Whether the valuation advisor was the subject of prior criminal or civil proceed- ings; and • A full explanation of the bases for concluding that the selection of the valuation advisor was prudent. Projections. The agreement requires the valuation advisor or the trustee to provide a written analysis of the reasonableness of the projections, including— • The identity of the individuals who are responsible for providing the projections and potential conflicts of interest; and • An opinion on the reasonableness of the projections, with comparison to five- year history of the company and comparable companies in a variety of metrics, estimates of future repurchase liability, review of various fairness issues, and an explanation of the reasons for the opinion. Financial statements. The agreement requires the trustee to request audited and unqualified financial statements for the five previous fiscal years and the current year-to- date. If the company provides unaudited or qualified financial statements, the agreement requires the trustee to explain why it is prudent to rely on this despite the risk. Review and analysis of valuation report. The agreement requires a written review and analysis of the valuation report, including a conclusion and explanation of the bases for conclusion in 16 different areas. The agreement also requires documentation of the review process, including identification of the people involved, issues of disagreement, the reasons for disagreement, and whether anyone ever expressed a conclusion or belief that the valuation report was inconsistent with the data. Committee process. The agreement requires a record of name, business address, phone number, and email address of each committee member and each member’s vote on the transaction. The agreement also requires a written certification from each committee member that the member read the valuation report, etc. The agreement also requires pres- ervation of each member’s notes and each member’s communications with others involved in the transaction. Claw-back provisions. The agreement requires the trustee to consider claw-back arrangements or other price adjustments to protect the ESOP against the possibility of 12-6 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee adverse consequences in the event of significant corporate events or changed circum- stances, and to explain in writing the trustee’s conclusions regarding the appropriateness of claw-back arrangements or other price adjustments. III. Status - The Proposed Regulation on Investment Advice A. Headlines and Press Release EBSA Fact Sheet Headline Department of Labor Proposes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle-Class Families Billions of Dollars Every Year EBSA Press Release (April 14, 2015) (excerpts) The U.S. Department of Labor has released a proposed rule that will protect 401(k) and IRA investors by mitigating the effect of conflicts of interest in the retirement invest- ment marketplace. A White House Council of Economic Advisers analysis found that these conflicts of interest result in annual losses of about 1 percentage point for affected investors—or about $17 billion per year in total. Under the proposals, retirement advisers will be required to put their clients’ best inter- ests before their own profits. Those who wish to receive payments from companies sell- ing products they recommend and forms of compensation that create conflicts of interest will need to rely on one of several proposed prohibited transaction exemptions. Today’s announcement includes a proposed rule that would update and close loopholes in a nearly 40-year-old regulation. The proposal would expand the number of persons who are subject to fiduciary best interest standards when they provide retirement invest- ment advice. It also includes a package of proposed exemptions allowing advisers to continue to receive payments that could create conflicts of interest if the conditions of the exemption are met. In addition, the announcement includes a comprehensive eco- nomic analysis of the proposals’ expected gains to investors and costs. Finally, the proposal carves out general investment education from fiduciary status. Sales pitches to large plan fiduciaries who are financial experts, and appraisals or valua- tions of the stock held by employee-stock ownership plans, are also carved out. B. Current Regulation Five basic requirements (in addition to fee or other compensation) for fiduciary sta- tus— • Render advice on value or make recommendations on advisability • On a regular basis • Pursuant to a mutual agreement, arrangement, or understanding that the advice— • Will be individualized based on the particular needs of the plan, and • Will serve as the primary basis for investment decisions. C. Proposed Regulation Broad definition of investment advice. Two basic requirements (again, in addition to fee or other compensation) for fiduciary status— © 2015 The Institute of Continuing Legal Education 12-7 Tax Conference, 28th Annual, May 21, 2015 • Types of advice • Nature of relationship • Representation or acknowledgment of fiduciary status, or • Agreement, arrangement, or understanding that the advice is individualized or specifically directed to the recipient for consideration in making invest- ment decisions. Exceptions. Six exceptions (“carve outs”)— • Counterparties in transactions with sophisticated fiduciaries • Employees of plan sponsor who receive only normal compensation • Platform providers • Benchmarking services • Financial reports and valuations • Investment education Prohibited transaction exemptions. Proposed prohibited transaction exemptions, including a “best interest contract” exemption for advice provided pursuant to a written contract that includes— • Acknowledgment of fiduciary status • Standards of impartial conduct, e.g., best interest of the retirement investor, unreasonable compensation, misleading statements • Warranty of compliance with all applicable federal and state laws • Warranty of policies and procedures designed to mitigate conflicts of interest and ensure adherence to standards of impartial conduct • Disclosures 12-8 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Exhibit A GreatBlanc Settlement Agreement AGREEMENT CONCERNING FIDUCIARY ENGAGEMENTS AND PROCESS REQUIREMENTS FOR EMPLOYER STOCK TRANSACTIONS The Secretary of the United States Department of Labor (the “Secretary”) and GreatBanc Trust Company (“the Trustee"), by and through their attorneys, have agreed that the policies and procedures described below apply whenever the Trustee serves as a trustee or other fiduciary of any employee stock ownership plan subject to Title I of ERISA ("ESOP") in connection with transactions in which the ESOP is purchasing or selling, is contemplating purchasing or selling, or receives an offer to purchase or sell, employer securities that are not publicly traded. A. Selection and Use of Valuation Advisor – General. In all transactions involving the purchase or sale of employer securities that are not publicly traded, the Trustee will hire a qualified valuation advisor, and will do the following: 1. prudently investigate the valuation advisor's qualifications; 2. take reasonable steps to determine that the valuation advisor receives complete, accurate and current information necessary to value the employer securities; and 3. prudently determine that its reliance on the valuation advisor's advice is reasonable before entering into any transaction in reliance on the advice. B. Selection of Valuation Advisor – Conflicts of Interest. The Trustee will not use a valuation advisor for a transaction that has previously performed work – including but not limited to a "preliminary valuation" – for or on behalf of the ESOP sponsor (as distinguished from the ESOP), any counterparty to the ESOP involved in the transaction, or any other entity that is structuring the transaction (such as an investment bank) for any party other than the ESOP or its trustee. The Trustee will not use a valuation advisor for a transaction that has a familial or corporate relationship (such as a parent-subsidiary relationship) to any of the aforementioned persons or entities. The Trustee will obtain written confirmation from the valuation advisor selected that none of the above-referenced relations exist. C. Selection of Valuation Advisor – Process. In selecting a valuation advisor for a transaction involving the purchase or sale of employer securities, the Trustee will prepare a written analysis addressing the following topics: © 2015 The Institute of Continuing Legal Education 12-9 Tax Conference, 28th Annual, May 21, 2015 1. The reason for selecting the particular valuation advisor; 2. A list of all the valuation advisors that the Trustee considered; 3. A discussion of the qualifications of the valuation advisors that the Trustee considered; 4. A list of references checked and discussion of the references' views on the valuation advisors; 5. Whether the valuation advisor was the subject of prior criminal or civil proceedings; and 6. A full explanation of the bases for concluding that the Trustee’s selection of the valuation advisor was prudent. If the Trustee selects a valuation advisor from a roster of valuation advisors that it has previously used, the Trustee need not undertake anew the analysis outlined above if the following conditions are satisfied: (a) the Trustee previously performed the analysis in connection with a prior engagement of the valuation advisor; (b) the previous analysis was completed within the 15 month period immediately preceding the valuation advisor’s selection for a specific transaction; (c) the Trustee documents in writing that it previously performed the analysis, the date(s) on which the Trustee performed the analysis, and the results of the analysis; and (d) the valuation advisor certifies that the information it previously provided pursuant to item (5) above is still accurate. D. Oversight of Valuation Advisor – Required Analysis. In connection with any purchase or sale of employer securities that are not publicly traded, the Trustee will request that the valuation advisor document the following items in its valuation report,1 and if the valuation advisor does not so document properly, the Trustee will prepare supplemental documentation of the following items to the extent they were not documented by the valuation advisor: 1 As used herein, "valuation report" means the final valuation report as opposed to previous versions or drafts. 12-10 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee 1. Identify in writing the individuals responsible for providing any projections reflected in the valuation report, and as to those individuals, conduct reasonable inquiry as to: (a) whether those individuals have or reasonably may be determined to have any conflicts of interest in regard to the ESOP (including but not limited to any interest in the purchase or sale of the employer securities being considered); (b) whether those individuals serve as agents or employees of persons with such conflicts, and the precise nature of any such conflicts: and (c) record in writing how the Trustee and the valuation advisor considered such conflicts in determining the value of employer securities; 2. Document in writing an opinion as to the reasonableness of any projections considered in connection with the proposed transaction and explain in writing why and to what extent the projections are or are not reasonable. At a minimum, the analysis shall consider how the projections compare to, and whether they are reasonable in light of, the company's five-year historical averages and/or medians and the five-year historical averages and/or medians of a group of comparable public companies (if any exist) for the following metrics, unless five-year data are unavailable (in which case, the analyses shall use averages extending as far back as possible): a. Return on assets b. Return on equity c. EBIT margins d. EBITDA margins e. Ratio of capital expenditures to sales f. Revenue growth rate g. Ratio of free cash flows (of the enterprise) to sales 3. If it is determined that any of these metrics should be disregarded in assessing the reasonableness of the projections, document in writing both the calculations of the metric (unless calculation is impossible) and the basis for the conclusion that the © 2015 The Institute of Continuing Legal Education 12-11 Tax Conference, 28th Annual, May 21, 2015 metric should be disregarded. The use of additional metrics to evaluate the reasonableness of projections other than those listed in section D(2)(a)-(g) above is not precluded as long as the appropriateness of those metrics is documented in writing. If comparable companies are used for any part of a valuation – whether as part of a Guideline Public Company method, to gauge the reasonableness of projections, or for any other purpose – explain in writing the bases for concluding that the comparable companies are actually comparable to the company being valued, including on the basis of size, customer concentration (if such information is publicly available), and volatility of earnings. If a Guideline Public Company analysis is performed, explain in writing any discounts applied to the multiples selected, and if no discount is applied to any given multiple, explain in significant detail the reasons. 4. If the company is projected to meet or exceed its historical performance or the historical performance of the group of comparable public companies on any of the metrics described in paragraph D(2) above, document in writing all material assumptions supporting such projections and why those assumptions are reasonable. 5. To the extent that the Trustee or its valuation advisor considers any of the projections provided by the ESOP sponsor to be unreasonable, document in writing any adjustments made to the projections. 6. If adjustments are applied to the company's historical or projected financial metrics in a valuation analysis, determine and explain in writing why such adjustments are reasonable. 7. If greater weight is assigned to some valuation methods than to others, explain in writing the weighting assigned to each valuation method and the basis for the weightings assigned. 8. Consider, as appropriate, how the plan document provisions regarding stock distributions, the duration of the ESOP loan, and the age and tenure of the ESOP participants, may affect the ESOP sponsor’s prospective repurchase obligation, the prudence of the stock purchase, or the fair market value of the stock. 12-12 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee 9. Analyze and document in writing (a) whether the ESOP sponsor will be able to service the debt taken on in connection with the transaction (including the ability to service the debt in the event that the ESOP sponsor fails to meet the projections relied upon in valuing the stock); (b) whether the transaction is fair to the ESOP from a financial point of view; (c) whether the transaction is fair to the ESOP relative to all the other parties to the proposed transaction; (d) whether the terms of the financing of the proposed transaction are market-based, commercially reasonable, and in the best interests of the ESOP; and (e) the financial impact of the proposed transaction on the ESOP sponsor, and document in writing the factors considered in such analysis and conclusions drawn therefrom. E. Financial Statements. 1. The Trustee will request that the company provide the Trustee and its valuation advisor with audited unqualified financial statements prepared by a CPA for the preceding five fiscal years, unless financial statements extending back five years are unavailable (in which case, the Trustee will request audited unqualified financial statement extending as far back as possible). 2. If the ESOP Sponsor provides to the Trustee or its valuation advisor unaudited or qualified financial statements prepared by a CPA for any of the preceding five fiscal years (including interim financial statements that update or supplement the last available audited statements), the Trustee will determine whether it is prudent to rely on the unaudited or qualified financial statements notwithstanding the risk posed by using unaudited or qualified financial statements. 3. If the Trustee proceeds with the transaction notwithstanding the lack of audited unqualified financial statements prepared by a CPA (including interim financial statements that update or supplement the last available audited statements), the Trustee will document the bases for the Trustee’s reasonable belief that it is prudent to rely on the financial statements, and explain in writing how it accounted for any risk posed by using qualified or unaudited statements. If the Trustee does not believe that it can reasonably © 2015 The Institute of Continuing Legal Education 12-13 Tax Conference, 28th Annual, May 21, 2015 conclude that it would be prudent to rely on the financial statements used in the valuation report, the Trustee will not proceed with the transaction. While the Trustee need not audit the financial statements itself, it must carefully consider the reliability of those statements in the manner set forth herein. F. Fiduciary Review Process – General. In connection with any transaction involving the purchase or sale of employer securities that are not publicly traded, the Trustee agrees to do the following: 1. Take reasonable steps necessary to determine the prudence of relying on the ESOP sponsor's financial statements provided to the valuation advisor, as set out more fully in paragraph E above; 2. Critically assess the reasonableness of any projections (particularly management projections), and if the valuation report does not document in writing the reasonableness of such projections to the Trustee’s satisfaction, the Trustee will prepare supplemental documentation explaining why and to what extent the projections are or are not reasonable; 3. Document in writing its bases for concluding that the information supplied to the valuation advisor, whether directly from the ESOP sponsor or otherwise, was current, complete, and accurate. G. Fiduciary Review Process – Documentation of Valuation Analysis. The Trustee will document in writing its analysis of any final valuation report relating to a transaction involving the purchase or sale of employer securities. The Trustee’s documentation will specifically address each of the following topics and will include the Trustee’s conclusions regarding the final valuation report's treatment of each topic and explain in writing the bases for its conclusions: 1. Marketability discounts; 2. Minority interests and control premiums; 3. Projections of the company's future economic performance and the reasonableness or unreasonableness of such projections, including, if applicable, the bases for assuming 12-14 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee that the company's future financial performance will meet or exceed historical performance or the expected performance of the relevant industry generally; 4. Analysis of the company's strengths and weaknesses, which may include, as appropriate, personnel, plant and equipment, capacity, research and development, marketing strategy, business planning, financial condition, and any other factors that reasonably could be expected to affect future performance; 5. Specific discount rates chosen, including whether any Weighted Average Cost of Capital used by the valuation advisor was based on the company's actual capital structure or that of the relevant industry and why the chosen capital structure weighting was reasonable; 6. All adjustments to the company's historical financial statements; 7. Consistency of the general economic and industry-specific narrative in the valuation report with the quantitative aspects of the valuation report; 8. Reliability and timeliness of the historical financial data considered, including a discussion of whether the financial statements used by the valuation advisor were the subject of unqualified audit opinions, and if not, why it would nevertheless be prudent to rely on them; 9. The comparability of the companies chosen as part of any analysis based on comparable companies; 10. Material assumptions underlying the valuation report and any testing and analyses of these assumptions; 11. Where the valuation report made choices between averages, medians, and outliers (e.g., in determining the multiple(s) used under the “guideline company method” of valuation), the reasons for the choices; 12. Treatment of corporate debt; 13. Whether the methodologies employed were standard and accepted methodologies and the bases for any departures from standard and accepted methodologies; © 2015 The Institute of Continuing Legal Education 12-15 Tax Conference, 28th Annual, May 21, 2015 14. The ESOP sponsor's ability to service any debt or liabilities to be taken on in connection with the proposed transaction; 15. The proposed transaction's reasonably foreseeable risks as of the date of the transaction; 16. Any other material considerations or variables that could have a significant effect on the price of the employer securities. H. Fiduciary Review Process – Reliance on Valuation Report. 1. The Trustee, through its personnel who are responsible for the proposed transaction, will do the following, and document in writing its work with respect to each: a. Read and understand the valuation report; b. Identify and question the valuation report's underlying assumptions; c. Make reasonable inquiry as to whether the information in the valuation report is materially consistent with information in the Trustee's possession; d. Analyze whether the valuation report's conclusions are consistent with the data and analyses; and e. Analyze whether the valuation report is internally consistent in material aspects. 2. The Trustee will document in writing the following: (a) the identities of its personnel who were primarily responsible for the proposed transaction, including any person who participated in decisions on whether to proceed with the transaction or the price of the transaction; (b) any material points as to which such personnel disagreed and why; and (c) whether any such personnel concluded or expressed the belief prior to the Trustee’s approval of the transaction that the valuation report's conclusions were inconsistent with the data and analysis therein or that the valuation report was internally inconsistent in material aspects. 3. If the individuals responsible for performing the analysis believe that the valuation report's conclusions are not consistent with the data and analysis or that the valuation report is internally inconsistent in material respects, the Trustee will not proceed with the transaction. 12-16 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee I. Preservation of Documents. In connection with any transaction completed by the Trustee through its committee or otherwise, the Trustee will create and preserve, for at least six (6) years, notes and records that document in writing the following: 1. The full name, business address, telephone number and email address at the time of the Trustee’s consideration of the proposed transaction of each member of the Trustee’s Fiduciary Committee (whether or not he or she voted on the transaction) and any other Trustee personnel who made any material decision(s) on behalf of the Trustee in connection with the proposed transaction, including any of the persons identified pursuant to H(2) above; 2. The vote (yes or no) of each member of the Trustee’s Fiduciary Committee who voted on the proposed transaction and a signed certification by each of the voting committee members and any other Trustee personnel who made any material decision(s) on behalf of the Trustee in connection with the proposed transaction that they have read the valuation report, identified its underlying assumptions, and considered the reasonableness of the valuation report’s assumptions and conclusions; 3. All notes and records created by the Trustee in connection with its consideration of the proposed transaction, including all documentation required by this Agreement; 4. All documents the Trustee and the persons identified in 1 above relied on in making their decisions; 5. All electronic or other written communications the Trustee and the persons identified in 1 above had with service providers (including any valuation advisor), the ESOP sponsor, any non-ESOP counterparties, and any advisors retained by the ESOP sponsor or non-ESOP counterparties. J. Fair Market Value. The Trustee will not cause an ESOP to purchase employer securities for more than their fair market value or sell employer securities for less than their fair market value. The DOL states that the principal amount of the debt financing the transaction, irrespective of the interest rate, cannot exceed the securities' fair market value. Accordingly, the Trustee will not cause an ESOP to engage in a leveraged stock purchase transaction in which the © 2015 The Institute of Continuing Legal Education 12-17 Tax Conference, 28th Annual, May 21, 2015 principal amount of the debt financing the transaction exceeds the fair market value of the stock acquired with that debt, irrespective of the interest rate or other terms of the debt used to finance the transaction. K. Consideration of Claw-Back. In evaluating proposed stock transactions, the Trustee will consider whether it is appropriate to request a claw-back arrangement or other purchase price adjustment(s) to protect the ESOP against the possibility of adverse consequences in the event of significant corporate events or changed circumstances. The Trustee will document in writing its consideration of the appropriateness of a claw-back or other purchase price adjustment(s). L. Other Professionals. The Trustee may, consistent with its fiduciary responsibilities under ERISA, employ, or delegate fiduciary authority to, qualified professionals to aid the Trustee in the exercise of its powers, duties, and responsibilities as long as it is prudent to do so. M. This Agreement is not intended to specify all of the Trustee’s obligations as an ERISA fiduciary with respect to the purchase or sale of employer stock under ERISA, and in no way supersedes any of the Trustee’s obligations under ERISA or its implementing regulations. 12-18 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee © 2015 The Institute of Continuing Legal Education 12-19 Tax Conference, 28th Annual, May 21, 2015 12-20 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Exhibit B Proposed Fiduciary Regulation: EBSA News Release !" # !$ %&'()*'++ !$ *'* , -./ 0 !"# $ %&' ( # ') * + , ' ( ! -!. ( / 0 1 ( ( ( 2 3 ( 4 ( / #( /3 ( ,5 63' ( / 2 # # 7 / ( / ( 1 3 (1 ( 8( 8 2 9 ( ( % # 2 ( 2 % / ( 1 2 3 2 3 2 / 2 / 8 % # /%&' % 0 ( # ( ( 1 # % ( ( / ( 2 / / / ( ( ( / / !: 8! % (/ ( ( ( / ( 2 % 2 / 2 2 ( ; 2 / 2 % / # 3 8 2 3 ( 8 © 2015 The Institute of Continuing Legal Education 12-21 Tax Conference, 28th Annual, May 21, 2015 / 0 2 ; (/ ( 2 / # ( ( 8 # / # ( / 2 / ( <5 = 12-22 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Exhibit C Proposed Fiduciary Regulation: EBSA Fact Sheet EMPLOYEE BENEFITS SECURITY ADMINISTRATION <50;,+:;(;,:+,7(9;4,5;6-3()69 FACTSHEET www.dol.gov/protectyoursavings/FactSheetCOI Department of Labor Proposes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle-Class Families Billions of Dollars Every Year “Today, I’m calling on the Department of Labor to update the rules and requirements that retirement advisors put the best interests of their clients above their own financial interests. It’s a very simple principle: You want to give financial advice, you’ve got to put your client’s interests first.” – President Barack Obama, February 23, 2015 Middle class economics means that Americans should [OLPYV^UWYVÄ[Z(UK[VKH`[OL+LWHY[TLU[VM3HIVY be able to retire with dignity after a lifetime of hard is taking the next step toward making that a reality, by work. But loopholes in the retirement advice rules have issuing a Notice of Proposed Rulemaking (NPRM) to allowed some brokers and other advisers to recommend require that best interest standard across a broader WYVK\J[Z[OH[W\[[OLPYV^UWYVÄ[ZHOLHKVM[OLPYJSPLU[Z» range of retirement advice to protect more investors. ILZ[PU[LYLZ[O\Y[PUNTPSSPVUZVM(TLYPJH»Z^VYRLYZHUK ;VKH`»ZWYVWVZHSPZ[OLYLZ\S[VM`LHYZVM^VYRHUK their families. YLÅLJ[ZMLLKIHJRMYVTHIYVHKYHUNLVMZ[HRLOVSKLYZ· (Z`Z[LT^OLYLÄYTZJHUILULÄ[MYVTIHJRKVVY PUJS\KPUNPUK\Z[Y`JVUZ\TLYHK]VJH[LZ*VUNYLZZ WH`TLU[ZHUKOPKKLUMLLZVM[LUI\YPLKPUÄULWYPU[ retirement groups, academia, and the American public. if they talk responsible Americans into buying bad ;OLWYVWVZHSPUJS\KLZIYVHKÅL_PISLL_LTW[PVUZMYVT retirement investments—with high costs and low JLY[HPUVISPNH[PVUZHZZVJPH[LK^P[OHÄK\JPHY`Z[HUKHYK returns—instead of recommending quality investments that will help streamline compliance while still requiring PZU»[MHPY(>OP[L/V\ZL*V\UJPSVM,JVUVTPJ(K]PZLYZ advisers to serve the best interest of their clients. HUHS`ZPZMV\UK[OH[[OLZLJVUÅPJ[ZVMPU[LYLZ[YLZ\S[PU In the coming months, the Administration welcomes HUU\HSSVZZLZVMHIV\[WLYJLU[HNLWVPU[MVYHɈLJ[LK comments on the proposal and looks forward to working investors—or about $17 billion per year in total. To with all stakeholders to achieve the commonsense goals KLTVUZ[YH[LOV^ZTHSSKPɈLYLUJLZJHUHKK\W!( of the rule while minimizing disruptions to the many percentage point lower return could reduce your savings good practices in industry. Many advisers already put by more than a quarter over 35 years. In other words, [OLPYJ\Z[VTLYZ»ILZ[PU[LYLZ[ÄYZ[;OL`HYLOHYK^VYRPUN instead of a $10,000 retirement investment growing to men and women who got into this work to help families more than $38,000 over that period after adjusting for achieve retirement security. They deserve a level playing PUÅH[PVUP[^V\SKILQ\Z[V]LY ÄLSKHUK[OLPYJSPLU[ZKLZLY]L[OLX\HSP[`HK]PJL[OH[[OPZ In February, the President directed the Department of rule will ensure. Labor to move forward with a proposed rulemaking to YLX\PYLYL[PYLTLU[HK]PZLYZ[VHIPKLI`H¸ÄK\JPHY`¹ Z[HUKHYK·W\[[PUN[OLPYJSPLU[Z»ILZ[PU[LYLZ[ILMVYL Page 1 © 2015 The Institute of Continuing Legal Education 12-23 Tax Conference, 28th Annual, May 21, 2015 FACTSHEET: Department of Labor Proposes Rule Updating Our Outdated Retirement SUMMARY OF TODAY’S ACTION TO PROTECT Protections RETIREMENT SAVERS BY THE DEPARTMENT :PUJL [OL,TWSV`LL9L[PYLTLU[0UJVTL:LJ\YP[` OF LABOR (J[,90:(OHZWYV]PKLK[OL+LWHY[TLU[VM3HIVY +63^P[OH\[OVYP[`[VWYV[LJ[(TLYPJH»Z[H_WYLMLYYLK Today, the Department of Labor issued a proposed retirement savings, recognizing the importance of rulemaking to protect investors from backdoor consumer protections for a basic retirement nest egg payments and hidden fees in retirement investment HUK[OLZPNUPÄJHU[[H_PUJLU[P]LZWYV]PKLK[VLUJV\YHNL advice. Americans to save for retirement. But the basic rules governing retirement investment advice have not been • Backdoor Payments & Hidden Fees Often TLHUPUNM\SS`JOHUNLKZPUJL KLZWP[L[OLKYHTH[PJ Buried in Fine Print Are Hurting the Middle ZOPM[PUV\YWYP]H[LYL[PYLTLU[Z`Z[LTH^H`MYVTKLÄULK Class: Conflicts of interest cost middle-class ILULÄ[WSHUZHUKPU[VZLSMKPYLJ[LK09(ZHUKR families who receive conflicted advice huge s. That shift means good investment advice is more amounts of their hard-earned savings. Conflicts PTWVY[HU[[OHUL]LY;VKH`+63PZWYVWVZPUNHUL^Y\SL lead, on average, to about 1 percentage point lower [OH[^PSSZLLR[V! annual returns on retirement savings and $17 billion Require more retirement investment advisers to of losses every year. W\[[OLPYJSPLU[»ZILZ[PU[LYLZ[ÄYZ[I`L_WHUKPUN • The Department of Labor is protecting [OL[`WLZVMYL[PYLTLU[PU]LZ[TLU[HK]PJL families from conflicted retirement advice. The JV]LYLKI`ÄK\JPHY`WYV[LJ[PVUZ Today large Department issued a proposed rule and related SVVWOVSLZPU[OLKLÄUP[PVUVMYL[PYLTLU[PU]LZ[TLU[ exemptions that would require retirement advisers HK]PJL\UKLYV\[KH[LK+63Y\SLZL_WVZLTHU` to abide by a “fiduciary” standard—putting their TPKKSLJSHZZMHTPSPLZHUKLZWLJPHSS`09(V^ULYZ clients’ best interest before their own profits. to advice that may not be in their best interest. Page 2 www.dol.gov/protectyoursavings/FactSheetCOI 12-24 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee FACTSHEET: Department of Labor Proposes Rule sponsors can continue to provide general education Complying with the Proposed Rule VUYL[PYLTLU[ZH]PUNHJYVZZLTWSV`TLU[IHZLK WSHUZHUK09(Z^P[OV\[[YPNNLYPUNÄK\JPHY`K\[PLZ ([WYLZLU[PUKP]PK\HSZWYV]PKPUNÄK\JPHY`PU]LZ[TLU[ As an example, education could consist of general HK]PJL[VLTWSV`LYIHZLKWSHUZWVUZVYZHUKWSHU information about the mix of assets (e.g., stocks and participants are required to act impartially and provide bonds) an average person should have based on HK]PJL[OH[PZPU[OLPYJSPLU[Z»ILZ[PU[LYLZ[ Page 3 www.dol.gov/protectyoursavings/FactSheetCOI © 2015 The Institute of Continuing Legal Education 12-25 Tax Conference, 28th Annual, May 21, 2015 FACTSHEET: Department of Labor Proposes Rule *SLHYS`HUKWYVTPULU[S`KPZJSVZLZHU`JVUÅPJ[ZVM advice regarding IRA investments because otherwise PU[LYLZ[SPRLOPKKLUMLLZVM[LUI\YPLKPU[OLÄUL ULP[OLY+63UVY[OLZH]LY^OVPZOHYTLKJHUOVSK WYPU[VYIHJRKVVYWH`TLU[Z[OH[TPNO[WYL]LU[ the adviser accountable for the losses the saver [OLHK]PZLYMYVTWYV]PKPUNHK]PJLPU[OLJSPLU[»Z Z\ɈLYLK;OLJVU[YHJ[JHUYLX\PYL[OH[PUKP]PK\HS ILZ[PU[LYLZ[ The contract must also direct the disputes be handled through arbitration but must customer to a webpage disclosing the compensation give clients the right to bring class action lawsuits in HYYHUNLTLU[ZLU[LYLKPU[VI`[OLHK]PZLYHUKÄYT court if a group of people are harmed. This feature of and make customers aware of their right to complete the best interest contract exemption is modeled on information on the fees charged. [OLY\SLZ\UKLY-059(^OPJOPZHUVUNV]LYUTLU[HS In addition to the new best interest contract exemption, organization that regulates advice by brokers to [OLWYVWVZHSWYVWVZLZHUL^WYPUJPWSLZIHZLK invest in securities but not other types of retirement exemption for principal transactions and maintains or ZH]PUNZJV]LYLKI`,90:( revises many existing administrative exemptions. The ;OL09:JHUPTWVZLHUL_JPZL[H_VU[YHUZHJ[PVUZ principal transactions exemption would allow advisers IHZLKVUJVUÅPJ[LKHK]PJL that is not eligible [VYLJVTTLUKJLY[HPUÄ_LKPUJVTLZLJ\YP[PLZHUK for one of the many proposed exemptions. As ZLSS[OLT[V[OLPU]LZ[VYKPYLJ[S`MYVT[OLHK]PZLY»Z \UKLYJ\YYLU[SH^[OL0U[LYUHS9L]LU\L*VKL own inventory, as long as the adviser adhered to the imposes an excise tax and can require correction L_LTW[PVU»ZJVUZ\TLYWYV[LJ[P]LJVUKP[PVUZ of such transactions involving plan sponsors, plan Finally, the proposal asks for comment on whether WHY[PJPWHU[ZHUKILULÄJPHYPLZHUK09(V^ULYZ [OLÄUHSL_LTW[PVUZZOV\SKPUJS\KLHUL^¸SV^MLL L_LTW[PVU¹[OH[^V\SKHSSV^ÄYTZ[VHJJLW[WH`TLU[Z Process Going Forward [OH[^V\SKV[OLY^PZLILKLLTLK¸JVUÅPJ[LK¹^OLU The Administration invites stakeholders from all YLJVTTLUKPUN[OLSV^LZ[MLLWYVK\J[ZPUHNP]LU WLYZWLJ[P]LZ[VZ\ITP[JVTTLU[ZK\YPUN[OL KH` product class, with even fewer requirements than the notice and comment period or through the public hearing best interest contract exemption. to be scheduled shortly after the close of the initial public comment hearing. The public record will be reopened Strengthening Enforcement of Consumer MVYJVTTLU[HM[LY[OLW\ISPJOLHYPUNPZOLSK6US`HM[LY reviewing all the comments will the Administration Protections KLJPKL^OH[[VPUJS\KLPUHÄUHSY\SL·HUKL]LUVUJL[OL ,_PZ[PUNSVVWOVSLZTLHU[OH[THU`YL[PYLTLU[HK]PZLYZ +LWHY[TLU[VM3HIVY\S[PTH[LS`PZZ\LZHÄUHSY\SLP[^PSS KVUV[JVUZPKLY[OLTZLS]LZÄK\JPHYPLZ(ZHYLZ\S[ UV[NVPU[VLɈLJ[PTTLKPH[LS` JVUZ\TLYZOH]LSPTP[LKPMHU`YLJV\YZL\UKLY,90:( HUK[OL0U[LYUHS9L]LU\L*VKLPM[OLPYYL[PYLTLU[HK]PZLY How Is This Rule Different from the YLJVTTLUKZWYVK\J[Z[OH[HYLPU[OLHK]PZLY»ZPU[LYLZ[ YH[OLY[OHU[OLJVUZ\TLY»Z;OLWYVWVZHS^PSSUV[VUS` Proposal in 2010? THRLTVYLHK]PZLYZÄK\JPHYPLZI\[HSZVLUZ\YL[OL`HYL 0U+63W\[MVY^HYKHWYVWVZHS[VYLX\PYLTVYL held accountable to their clients if they provide advice YL[PYLTLU[PU]LZ[TLU[HK]PJL[VILPU[OLJSPLU[»ZILZ[ [OH[PZUV[PU[OLPYJSPLU[Z»ILZ[PU[LYLZ[ILJH\ZL! PU[LYLZ[>OPSLTHU`JOHTWPVULK[OLNVHSZVM[OL +63J\YYLU[S`OHZ[OLYPNO[[VIYPUNLUMVYJLTLU[ proposal, some stakeholders expressed concerns during HJ[PVUZHNHPUZ[ÄK\JPHY`HK]PZLYZ[VWSHU the notice and comment period and at a public hearing. ZWVUZVYZHUKWHY[PJPWHU[Z^OVKVUV[WYV]PKL Mindful of these criticisms, and wanting to arrive at HK]PJLPU[OLPYJSPLU[Z»ILZ[PU[LYLZ[ As under [OLYPNO[HUZ^LY+63KLJPKLK[V^P[OKYH^[OLY\SL current law, the plan sponsor or plan participant HUKNVIHJR[V[OLKYH^PUNIVHYK:PUJLIV[O harmed by the bad advice can also bring their own +63HUK[OL>OP[L/V\ZLOH]LLUNHNLKL_[LUZP]LS` action. with stakeholders, meeting with industry, advocates, HJHKLTPJZ·HU`VUL^OVJHUOLSW\ZÄN\YLV\[[OLILZ[ ;OL¸ILZ[PU[LYLZ[JVU[YHJ[L_LTW[PVU¹HSSV^Z way to craft a rule that adequately protects consumers J\Z[VTLYZ[VOVSKÄK\JPHY`HK]PZLYZHJJV\U[HISL HUKSL]LSZ[OLWSH`PUNÄLSKMVY[OLTHU`HK]PZLYZKVPUN MVYWYV]PKPUNHK]PJLPU[OLPYILZ[PU[LYLZ[ through right by their clients, while minimizing compliance a private right of action for breach of contract. In burdens. V[OLY^VYKZPMHUHK]PZLYPZU»[W\[[PUN[OLPYJSPLU[»Z PU[LYLZ[ÄYZ[[OLJSPLU[JHU[HRLHJ[PVU[VOVSK[OLT accountable. This option is especially important for Page 4 www.dol.gov/protectyoursavings/FactSheetCOI 12-26 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee FACTSHEET: Department of Labor Proposes Rule The proposal released today has improved upon the products in a given product class, that is even ]LYZPVUPUHU\TILYVM^H`ZIV[OPUWYVJLZZHUK more streamlined than the best interest contract Z\IZ[HUJL! exemption. DOL has improved the process to better — 0UJS\KLZHJHY]LV\[MYVTÄK\JPHY`Z[H[\ZMVYWYV]PKPUN PUJVYWVYH[LZ[HRLOVSKLYMLLKIHJR investment education to IRA owners, and not just to — DOL is issuing proposed exemptions simultaneous plan sponsors and plan participants as under with the proposed rule. Responding to comments [OLWYVWVZHS0[HSZV\WKH[LZ[OLKLÄUP[PVU YLJLP]LKPU+63PZW\ISPZOPUN[OLWYVWVZLK of education to include retirement planning and exemptions alongside the rule so interested lifetime income information. In addition, the WHY[PLZOH]LHIL[[LYZLUZLVMOV^[OLÄK\JPHY` proposal strengthens consumer protections requirements and exemptions work together. I`JSHZZPM`PUNTH[LYPHSZ[OH[YLMLYLUJLZWLJPÄJ products that the consumer should consider — DOL has consulted extensively with the Securities buying as advice. and Exchange Commission (SEC) and other federal stakeholders. :LJYL[HY`7LYLaHUK*OHPY>OP[L — +L[LYTPULZ^OVPZHÄK\JPHY`IHZLKUV[VU[P[SLI\[ have had numerous meetings and conversations, rather the advice rendered.;OLY\SLWYVWVZLK HUK:,*Z[HɈOHZWYV]PKLK[LJOUPJHSHZZPZ[HUJL [OH[HU`VUL^OV^HZHSYLHK`HÄK\JPHY` and will continue these discussions. \UKLY,90:(MVYV[OLYYLHZVUZVY^OV^HZHU investment adviser under federal securities — DOL is releasing a more rigorous analysis of the SH^Z^V\SKILHUPU]LZ[TLU[HK]PJLÄK\JPHY` anticipated gains to investors and costs of the rule. *VUZPZ[LU[^P[O[OLM\UJ[PVUHS[LZ[MVYKL[LYTPUPUN :PUJL[OLIVK`VMPUKLWLUKLU[YLZLHYJO ÄK\JPHY`Z[H[\Z\UKLY,90:([OLWYVWVZHSSVVRZ VU[OLJVZ[ZHUKJVUZLX\LUJLZVMJVUÅPJ[ZVM not at the title but rather whether the person is interests in retirement investment advice has providing retirement investment advice. NYV^UZPNUPÄJHU[S`;VKH`+63PZYLSLHZPUNH Regulatory Impact Analysis (RIA) alongside the — Limits the seller’s carve-out to sales pitches to Y\SL[OH[YLÅLJ[Z[OH[Z\IZ[HU[PHSIVK`VMYLZLHYJO SHYNLWSHUÄK\JPHYPLZ^P[OÄUHUJPHSL_WLY[PZLThis and estimates the gains to investors and costs of YLZWVUKZ[VJVTTLU[Z[OH[KPɈLYLU[PH[PUN the proposed rule. investment advice from sales pitches in the JVU[L_[VMPU]LZ[TLU[WYVK\J[ZPZ]LY`KPɉJ\S[ ;OLY\SL»ZZ\IZ[HUJLOHZJOHUNLKIHZLKVU HUK\USLZZ[OLHK]PJLYLJPWPLU[PZHÄUHUJPHS JVTTLU[ZYLJLP]LKZPUJL:WLJPÄJHSS`[OL L_WLY[[OLJHY]LV\[^V\SKJYLH[LHSVVWOVSL proposal: that would fail to protect investors. — Provides a new, broad, principles-based exemption — Excludes valuations or appraisals of the stock held that can accommodate and adapt to the broad range of by employee stock ownership plans (ESOPs) from [OL evolving business practices. Industry commenters KLMPUP[PVUVMMPK\JPHY`PU]LZ[TLU[HK]PJL The emphasized that the existing exemptions are too WYVWVZLKY\SLJSHYPÄLZ[OH[Z\JOHWWYHPZHSZKV rigid and prescriptive, leading to a patchwork of not constitute retirement investment advice L_LTW[PVUZUHYYV^S`[HPSVYLK[VTLL[ZWLJPÄJ Z\IQLJ[[VHÄK\JPHY`Z[HUKHYK+63TH`W\[ business practices and unable to adapt to forth a separate regulatory proposal to clarify the changing conditions. Drawing on these and other HWWSPJHISLSH^MVY,:67HWWYHPZHSZ comments, the best interest contract exemption represents an unprecedented departure from the +LWHY[TLU[»ZHWWYVHJO[V7;,ZV]LY[OLWHZ[ `LHYZ0[ZIYVHKHUKWYPUJPWSLZIHZLKHWWYVHJO is intended to streamline compliance and give PUK\Z[Y`[OLÅL_PIPSP[`[VÄN\YLV\[OV^[VZLY]L [OLPYJSPLU[Z»ILZ[PU[LYLZ[ — Includes other new, broad exemptions. For example, the new principal transactions exemption also HKVW[ZHWYPUJPWSLZIHZLKHWWYVHJO(UK +63PZHZRPUNMVYJVTTLU[ZVU^OL[OLY[OL ÄUHSYLN\SH[VY`WHJRHNLZOV\SKPUJS\KLHUL^ L_LTW[PVUMVYHK]PJL[VPU]LZ[PU[OLSV^LZ[MLL Page 5 www.dol.gov/protectyoursavings/FactSheetCOI © 2015 The Institute of Continuing Legal Education 12-27 Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Exhibit D Proposed Fiduciary Regulation: Notice of Proposed Rulemaking Vol. 80 Monday, No. 75 April 20, 2015 Part III Department of Labor Employee Benefits Security Administration 29 CFR Parts 2509 and 2510 Definition of the Term ‘‘Fiduciary’’; Conflict of Interest Rule—Retirement Investment Advice; Proposed Rule © 2015 The Institute of Continuing Legal Education 12-29 Tax Conference, 28th Annual, May 21, 2015 21928 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules DEPARTMENT OF LABOR on the proposed regulation, EBSA rendering ‘‘investment advice for a fee encourages interested persons to submit or other compensation, direct or Employee Benefits Security their comments electronically. You may indirect, with respect to any moneys or Administration submit comments, identified by RIN other property of such plan . . . ’’ 1210–AB32, by any of the following ERISA safeguards plan participants by 29 CFR Parts 2509 and 2510 methods: imposing trust law standards of care and Federal eRulemaking Portal: http:// undivided loyalty on plan fiduciaries, RIN 1210–AB32 www.regulations.gov. Follow and by holding fiduciaries accountable Definition of the Term ‘‘Fiduciary’’; instructions for submitting comments. when they breach those obligations. In Conflict of Interest Rule—Retirement Email: [email protected]. Include RIN addition, fiduciaries to plans and IRAs Investment Advice 1210–AB32 in the subject line of the are not permitted to engage in message. ‘‘prohibited transactions,’’ which pose AGENCY: Employee Benefits Security Mail: Office of Regulations and special dangers to the security of Administration, Department of Labor. Interpretations, Employee Benefits retirement, health, and other benefit ACTION: Notice of proposed rulemaking Security Administration, Attn: Conflict plans because of fiduciaries’ conflicts of and withdrawal of previous proposed of Interest Rule, Room N–5655, U.S. interest with respect to the transactions. rule. Department of Labor, 200 Constitution Under this regulatory structure, Avenue NW., Washington, DC 20210. fiduciary status and responsibilities are SUMMARY: This document contains a Hand Delivery/Courier: Office of central to protecting the public interest proposed regulation defining who is a Regulations and Interpretations, in the integrity of retirement and other ‘‘fiduciary’’ of an employee benefit plan Employee Benefits Security important benefits, many of which are under the Employee Retirement Income Administration, Attn: Conflict of tax-favored. Security Act of 1974 (ERISA) as a result Interest Rule, Room N–5655, U.S. In 1975, the Department issued of giving investment advice to a plan or Department of Labor, 200 Constitution regulations that significantly narrowed its participants or beneficiaries. The Avenue NW., Washington, DC 20210. the breadth of the statutory definition of proposal also applies to the definition of Instructions: All comments received fiduciary investment advice by creating a ‘‘fiduciary’’ of a plan (including an must include the agency name and a five-part test that must, in each individual retirement account (IRA)) Regulatory Identifier Number (RIN) for instance, be satisfied before a person under section 4975 of the Internal this rulemaking (RIN 1210–AB32). can be treated as a fiduciary adviser. Revenue Code of 1986 (Code). If Persons submitting comments This regulatory definition applies to adopted, the proposal would treat electronically are encouraged not to both ERISA and the Code. The persons who provide investment advice submit paper copies. All comments Department created the test in a very or recommendations to an employee received will be made available to the different context, prior to the existence benefit plan, plan fiduciary, plan public, posted without change to of participant-directed 401(k) plans, participant or beneficiary, IRA, or IRA http://www.regulations.gov and http:// widespread investments in IRAs, and owner as fiduciaries under ERISA and www.dol.gov/ebsa, and made available the now commonplace rollover of plan the Code in a wider array of advice for public inspection at the Public assets from fiduciary-protected plans to relationships than the existing ERISA Disclosure Room, N–1513, Employee IRAs. Today, as a result of the five-part and Code regulations, which would be Benefits Security Administration, U.S. test, many investment professionals, replaced. The proposed rule, and related Department of Labor, 200 Constitution consultants, and advisers 1 have no exemptions, would increase consumer Avenue NW., Washington, DC 20210, obligation to adhere to ERISA’s protection for plan sponsors, fiduciaries, including any personal information fiduciary standards or to the prohibited participants, beneficiaries and IRA provided. transaction rules, despite the critical owners. This document also withdraws FOR FURTHER INFORMATION CONTACT: role they play in guiding plan and IRA a prior proposed regulation published in For Questions Regarding the Proposed investments. Under ERISA and the 2010 (2010 Proposal) concerning this Rule: Contact Luisa Grillo-Chope or Code, if these advisers are not same subject matter. In connection with Fred Wong, Office of Regulations and fiduciaries, they may operate with this proposal, elsewhere in this issue of Interpretations, Employee Benefits conflicts of interest that they need not the Federal Register, the Department is Security Administration (EBSA), (202) disclose and have limited liability under proposing new exemptions and 693–8825. federal pension law for any harms amendments to existing exemptions For Questions Regarding the Proposed resulting from the advice they provide. from the prohibited transaction rules Prohibited Transaction Exemptions: Non-fiduciaries may give imprudent applicable to fiduciaries under ERISA Contact Karen Lloyd, Office of and disloyal advice; steer plans and IRA and the Code that would allow certain Exemption Determinations, EBSA, 202– owners to investments based on their broker-dealers, insurance agents and 693–8824. own, rather than their customers’ others that act as investment advice For Questions Regarding the financial interests; and act on conflicts fiduciaries to continue to receive a Regulatory Impact Analysis: Contact G. of interest in ways that would be variety of common forms of Christopher Cosby, Office of Policy and prohibited if the same persons were compensation that otherwise would be Research, EBSA, 202–693–8425. (These fiduciaries. In light of the breadth and prohibited as conflicts of interest. are not toll-free numbers). intent of ERISA and the Code’s statutory DATES: As of April 20, 2015, the SUPPLEMENTARY INFORMATION: proposed rule published October 22, 1 By using the term ‘‘adviser,’’ the Department I. Executive Summary does not intend to limit its use to investment 2010 (75 FR 65263) is withdrawn. advisers registered under the Investment Advisers Submit written comments on the A. Purpose of the Regulatory Action Act of 1940 or under state law. For example, as proposed regulation on or before July 6, Under ERISA and the Code, a person used herein, an adviser can be an individual or 2015. entity who can be, among other things, a is a fiduciary to a plan or IRA to the representative of a registered investment adviser, a ADDRESSES: To facilitate the receipt and extent that he or she engages in bank or similar financial institution, an insurance processing of written comment letters specified plan activities, including company, or a broker-dealer. 12-30 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21929 definition, the growth of participant- their advice. Central to the exemption is recommendations or appraisals to an directed investment arrangements and the adviser and firm’s agreement to meet employee benefit plan, a plan fiduciary, IRAs, and the need for plans and IRA fundamental obligations of fair dealing participant or beneficiary, or an IRA owners to seek out and rely on and fiduciary conduct—to give advice owner or fiduciary, and (2) either (a) sophisticated financial advisers to make that is in the customer’s best interest; acknowledging the fiduciary nature of critical investment decisions in an avoid misleading statements; receive no the advice, or (b) acting pursuant to an increasingly complex financial more than reasonable compensation; agreement, arrangement, or marketplace, the Department believes it and comply with applicable federal and understanding with the advice recipient is appropriate to revisit its 1975 state laws governing advice. This that the advice is individualized to, or regulatory definition as well as the principles-based approach aligns the specifically directed to, the recipient for Code’s virtually identical regulation. adviser’s interests with those of the plan consideration in making investment or With this regulatory action, the participant or IRA owner, while leaving management decisions regarding plan Department proposes to replace the the adviser and employing firm with the assets. When such advice is provided 1975 regulations with a definition of flexibility and discretion necessary to for a fee or other compensation, direct fiduciary investment advice that better determine how best to satisfy these or indirect, the person giving the advice reflects the broad scope of the statutory basic standards in light of the unique is a fiduciary. text and its purposes and better protects attributes of their business. The plans, participants, beneficiaries, and Department is similarly proposing to Although the new general definition IRA owners from conflicts of interest, amend existing exemptions for a wide of investment advice avoids the imprudence, and disloyalty. range of fiduciary advisers to ensure weaknesses of the current regulation, The Department has also sought to adherence to these basic standards of standing alone it could sweep in some preserve beneficial business models for fiduciary conduct. In addition, the relationships that are not appropriately delivery of investment advice by Department is proposing a new regarded as fiduciary in nature and that separately proposing new exemptions exemption for ‘‘principal transactions’’ the Department does not believe from ERISA’s prohibited transaction in which advisers sell certain debt Congress intended to cover as fiduciary rules that would broadly permit firms to securities to plans and IRAs out of their relationships. Accordingly, the continue common fee and compensation own inventory, as well as an proposed regulation includes a number practices, as long as they are willing to amendment to an existing exemption of specific carve-outs to the general adhere to basic standards aimed at that would permit advisers to receive definition. For example, the regulation ensuring that their advice is in the best compensation for extending credit to draws an important distinction between interest of their customers. Rather than plans or IRAs to avoid failed securities fiduciary investment advice and non- create a highly prescriptive set of transactions. In addition to the Best fiduciary investment or retirement transaction-specific exemptions, the Interest Contract Exemption, the education. Similarly, under the ‘‘seller’s Department instead is proposing a set of Department is also seeking public carve-out,’’ 3 the proposal would not exemptions that flexibly accommodate a comment on whether it should issue a treat as fiduciary advice wide range of current business separate streamlined exemption that recommendations made to a plan in an practices, while minimizing the harmful would allow advisers to receive arm’s length transaction where there is impact of conflicts of interest on the otherwise prohibited compensation in generally no expectation of fiduciary quality of advice. connection with plan, participant and investment advice, provided that the In particular, the Department is beneficiary accounts, and IRA carve-out’s specific conditions are met. proposing a new exemption (the ‘‘Best investments in certain high-quality low- In addition, the proposal includes Interest Contract Exemption’’) that fee investments, subject to fewer specific carve-outs for advice rendered would provide conditional relief for conditions. This is discussed in greater by employees of the plan sponsor, common compensation, such as detail in the Federal Register notice platform providers, and persons who commissions and revenue sharing, that related to the proposed Best Interest offer or enter into swaps or security- an adviser and the adviser’s employing Contract Exemption. based swaps with plans. All of the rule’s firm might receive in connection with This broad regulatory package aims to carve-outs are subject to conditions investment advice to retail retirement enable advisers and their firms to give designed to draw an appropriate line investors.2 In order to protect the advice that is in the best interest of their between fiduciary and non-fiduciary interests of plans, participants and customers, without disrupting common communications, consistent with the compensation arrangements under beneficiaries, and IRA owners, the text and purpose of the statutory conditions designed to ensure the exemption requires the firm and the provisions. adviser to contractually acknowledge adviser is acting in the best interest of the advice recipient. The proposed new Finally, in addition to the new fiduciary status, commit to adhere to exemptions and amendments to existing proposal in this Notice, the Department basic standards of impartial conduct, exemptions are published elsewhere in is simultaneously proposing a new Best adopt policies and procedures today’s edition of the Federal Register. Interest Contract Exemption, revising reasonably designed to minimize the other exemptions from the prohibited harmful impact of conflicts of interest, B. Summary of the Major Provisions of transaction rules of ERISA and the Code and disclose basic information on their the Proposed Rule and is exploring through a request for conflicts of interest and on the cost of The proposed rule clarifies and comments the concept of an additional rationalizes the definition of fiduciary low-fee exemption. 2 For purposes of the exemption, retail investors include (1) the participants and beneficiaries of investment advice subject to specific participant-directed plans, (2) IRA owners, and (3) carve-outs for particular types of 3 Although referred to herein as the ‘‘seller’s the sponsors (including employees, officers, or communications that are best carve-out,’’ we note that the carve-out provided in directors thereof) of non participant-directed plans understood as non-fiduciary in nature. paragraph (b)(1)(i) of the proposal is not limited to with fewer than 100 participants to the extent the sales and would apply to incidental advice sponsors (including employees, officers, or Under the definition, a person renders provided in connection with an arm’s length sale, directors thereof) act as a fiduciary with respect to investment advice by (1) providing purchase, loan, or bilateral contract between a plan plan investment decisions. investment or investment management investor with financial expertise and the adviser. © 2015 The Institute of Continuing Legal Education 12-31 Tax Conference, 28th Annual, May 21, 2015 21930 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules C. Gains to Investors and Compliance receiving conflicted investment advice that these gains alone would far exceed Costs can expect their investments to the proposal’s compliance cost. For underperform by an average of 100 basis When the Department promulgated example, if only 75 percent of points per year over the next 20 years. the 1975 rule, 401(k) plans did not exist, anticipated gains were realized, the The underperformance associated with IRAs had only just been authorized, and quantified subset of such gains— conflicts of interest—in the mutual the majority of retirement plan assets specific to the front-load mutual fund funds segment alone—could cost IRA were managed by professionals, rather segment of the IRA market—would investors more than $210 billion over than directed by individual investors. amount to between $30 billion and $33 the next 10 years and nearly $500 Today, individual retirement investors billion over 10 years. If only 50 percent billion over the next 20 years. Some have much greater responsibility for were realized, this subset of expected studies suggest that the directing their own investments, but gains would total between $20 billion underperformance of broker-sold they seldom have the training or and $22 billion over 10 years, or several mutual funds may be even higher than times the proposal’s estimated specialized expertise necessary to 100 basis points, possibly due to loads prudently manage retirement assets on compliance cost of $2.4 billion to 5.7 that are taken off the top and/or poor billion over the same 10 years. These their own. As a result, they often timing of broker sold investments. If the depend on investment advice for gain estimates also exclude additional true underperformance of broker-sold potential gains to investors resulting guidance on how to manage their funds is 200 basis points, IRA mutual savings to achieve a secure retirement. from reducing or eliminating the effects fund holders could suffer from of conflicts in financial products other In the current marketplace for underperformance amounting to $430 retirement investment advice, however, than front-end-load mutual funds. The billion over 10 years and nearly $1 Department invites input that would advisers commonly have direct and trillion across the next 20 years. While substantial conflicts of interest, which make it possible to quantify the the estimates based on the mutual fund magnitude of the rule’s effectiveness encourage investment recommendations market are large, the total market impact that generate higher fees for the advisers and of any additional, not-yet-quantified could be much larger. Insurance gains for investors. at the expense of their customers and products, Exchange Traded Funds These estimates account for only a often result in lower returns for (ETFs), individual stocks and bonds, fraction of potential conflicts, associated customers even before fees. and other products are all sold by agents losses, and affected retirement assets. A wide body of economic evidence and brokers with conflicts of interest. supports a finding that the impact of The Department expects the proposal The total gains to IRA investors these conflicts of interest on retirement would deliver large gains for retirement attributable to the rule may be much investment outcomes is large and, from investors. Because of data constraints, higher than these quantified gains alone the perspective of advice recipients, only some of these gains can be for several reasons. The Department negative. As detailed in the quantified with confidence. Focusing expects the proposal to yield large, Department’s Regulatory Impact only on how load shares paid to brokers additional gains for IRA investors, Analysis (available at www.dol.gov/ affect the size of loads paid by IRA including potential reductions in ebsa/pdf/conflictsofinterestria.pdf), the investors holding load funds and the excessive trading and associated supporting evidence includes, among returns they achieve, the Department transaction costs and timing errors (such other things, statistical analyses of estimates the proposal would deliver to as might be associated with return conflicted investment channels, IRA investors gains of between $40 chasing), improvements in the experimental studies, government billion and $44 billion over 10 years and performance of IRA investments other reports documenting abuse, and basic between $88 billion and $100 billion than front-load mutual funds, and economic theory on the dangers posed over 20 years. These estimates assume improvements in the performance of by conflicts of interest and by the that the rule would eliminate (rather defined contribution (DC) plan asymmetries of information and than just reduce) underperformance investments. As noted above, under expertise that characterize interactions associated with the practice of current rules, adviser conflicts could between ordinary retirement investors incentivizing broker recommendations cost IRA investors as much as $410 and conflicted advisers. This evidence through variable front-end-load sharing; billion over 10 years and $1 trillion over takes into account existing protections if the rule’s effectiveness in this area is 20 years, so the potential additional under ERISA as well as other federal substantially below 100 percent, these gains to IRA investors from this and state laws. A review of this data, estimates may overstate these particular proposal could be very large. which consistently points to substantial gains to investors in the front-load The following accounting table failures in the market for retirement mutual fund segment of the IRA market. summarizes the Department’s advice, suggests that IRA holders The Department nonetheless believes conclusions: TABLE 1—PARTIAL GAINS TO INVESTORS AND COMPLIANCE COSTS ACCOUNTING TABLE Primary Discount rate Period Category estimate Low estimate High estimate Year dollar (9%) covered Partial Gains to Investors Annualized, Monetized ($millions/year) ...... $4,243 $3,830 ...... 2015 7 2017–2026 $5,170 4,666 ...... 2015 3 2017–2026 12-32 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21931 TABLE 1—PARTIAL GAINS TO INVESTORS AND COMPLIANCE COSTS ACCOUNTING TABLE—Continued Primary Discount rate Period Category estimate Low estimate High estimate Year dollar (9%) covered Notes: The proposal is expected to deliver large gains for retirement investors. Because of limitations of the literature and other available evi- dence, only some of these gains can be quantified. The estimates in this table focus only on how load shares paid to brokers affect the size of loads IRA investors holding load funds pay and the returns they achieve. These estimates assume that the rule will eliminate (rather than just reduce) underperformance associated with the practice of incentivizing broker recommendations through variable front-end-load sharing. If, however, the rule’s effectiveness in reducing underperformance is substantially below 100 percent, these estimates may overstate these particular gains to investors in the front-end-load mutual fund segment of the IRA market. However, these estimates account for only a frac- tion of potential conflicts, associated losses, and affected retirement assets. The total gains to IRA investors attributable to the rule may be higher than the quantified gains alone for several reasons. For example, the proposal is expected to yield additional gains for IRA investors, including potential reductions in excessive trading and associated transaction costs and timing errors (such as might be associated with return chasing), improvements in the performance of IRA investments other than front-load mutual funds, and improvements in the performance of DC plan investments. The partial-gains-to-investors estimates include both economic efficiency benefits and transfers from the financial services industry to IRA hold- ers. The partial gains estimates are discounted to December 31, 2015. Compliance Costs Annualized, Monetized ($millions/year) ...... $348 ...... $706 2015 7 2016–2025 328 ...... 664 2015 3 2016–2025 Notes: The compliance costs of the current proposal including the cost of compliance reviews, comprehensive compliance and supervisory sys- tem changes, policies and procedures and training programs updates, insurance increases, disclosure preparation and distribution, and some costs of changes in other business practices. Compliance costs incurred by mutual funds or other asset providers have not been estimated. Insurance Premium Transfers Annualized Monetized ($millions/year) ...... $63 ...... 2015 7 2016–2025 63 ...... 2015 3 2016–2025 From/To ...... From: Service providers facing increased in- To: Plans, participants, beneficiaries, and IRA surance premiums due to increased liability investors through the payment of recov- risk eries—funded from a portion of the in- creased insurance premiums OMB Circular A–4 requires the incentivizing broker recommendations assume the gains to investors arise presentation of a social welfare through variable front-end-load sharing. gradually as the fraction of wealth accounting table that summarizes a If, however, the rule’s effectiveness is invested based on conflicted investment regulation’s benefits, costs and transfers substantially below 100 percent, these advice slowly declines over time based (monetized, where possible). A estimates would overstate these partial on historical patterns of asset turnover. summary of this type would differ from gains to investors in the front-load However, the estimates do not account and expand upon Table I in several mutual fund segment of the IRA market. for potential transition costs associated ways: The estimates in Table I also exclude with a shift of investments to higher- • In the language of social welfare additional potential gains to investors performing vehicles. These transition economics as reflected in Circular A–4, resulting from reducing or eliminating costs have not been quantified due to investor gains comprise two parts: the effects of conflicts in financial lack of granularity in the literature or Social welfare ‘‘benefits’’ attributable to products other than front-end-load availability of other evidence on both improvements in economic efficiency mutual funds in the IRA market, and all the portion of investor gains that and ‘‘transfers’’ of welfare to retirement potential gains to investors in the plan consists of resource savings, as opposed investors from the financial services market. The Department invites input to transfers, and the amount of industry. Due to limitations of the that would make it possible to quantify transitional cost that would be incurred literature and other available evidence, the magnitude of the rule’s effectiveness per unit of resource savings. the investor gains estimates presented in and of any additional, not-yet-quantified • Other categories of costs not yet Table I have not been broken down into gains for investors. • quantified include compliance costs benefits and transfer components, but Generally, the gains to investors incurred by mutual funds or other asset making the distinction between these consist of multiple parts: Transfers to providers. Enforcement costs or other categories of impacts is key for a social IRA investors from advisers and others costs borne by the government are also welfare accounting statement. in the supply chain, benefits to the not quantified. • The estimates in Table I reflect only overall economy from a shift in the a subset of the gains to investors allocation of investment dollars to The Department requests detailed resulting from the rule, but may projects that have higher returns, and comment, data, and analysis on all of overstate this subset. As noted in Table resource savings associated with, for the issues outlined above for I, the Department’s estimates of partial example, reductions in excessive incorporation into the social welfare gains to investors reflect an assumption turnover and wasteful and unsuccessful analysis at the finalization stage of the that the rule will eliminate, rather than efforts to outperform the market. Some rulemaking process. just reduce, underperformance of these gains are partially quantified in For a detailed discussion of the gains associated with the practice of Table I. Also, the estimates in Table I to investors and compliance costs of the © 2015 The Institute of Continuing Legal Education 12-33 Tax Conference, 28th Annual, May 21, 2015 21932 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules current proposal, please see Section J. available for additional public comment in nature, appraisals or valuations of Regulatory Impact Analysis, below. and the Department received over 60 employer securities provided to ESOPs additional comment letters. In addition, or to certain collective investment funds II. Overview the Department has held many meetings holding assets of plan investors. On a A. Rulemaking Background with interested parties. more technical point, the Department The market for retirement advice has A number of commenters urged also followed recommendations that it changed dramatically since the consideration of other means to attain not automatically assign fiduciary status Department first promulgated the 1975 the objectives of the 2010 Proposal and to investment advisers under the regulation. Individuals, rather than large of additional analysis of the proposal’s Advisers Act, but instead follow an employers and professional money expected costs and benefits. In light of entirely functional approach to these comments and because of the managers, have become increasingly fiduciary status. In light of public significance of this rule, the Department responsible for managing retirement comments, the new proposal also makes decided to issue a new proposed assets as IRAs and participant-directed a number of other changes to the regulation. On September 19, 2011 the plans, such as 401(k) plans, have regulatory proposal. For example, the Department announced that it would supplanted defined benefit pensions. At Department has addressed concerns that withdraw the 2010 Proposal and the same time, the variety and it could be misread to extend fiduciary propose a new rule defining the term complexity of financial products have status to persons that prepare ‘‘fiduciary’’ for purposes of section newsletters, television commentaries, or increased, widening the information gap 3(21)(A)(ii) of ERISA. This document conference speeches that contain between advisers and their clients. Plan fulfills that announcement in publishing recommendations made to the general fiduciaries, plan participants and IRA both a new proposed regulation and public. Similarly, the rule makes clear investors must often rely on experts for withdrawing the 2010 Proposal. that fiduciary status does not extend to advice, but are unable to assess the Consistent with the President’s internal company personnel who give quality of the expert’s advice or Executive Orders 12866 and 13563, advice on behalf of their plan sponsor effectively guard against the adviser’s extending the rulemaking process will as part of their duties, but receive no conflicts of interest. This challenge is give the public a full opportunity to compensation beyond their salary for especially true of small retail investors evaluate and comment on the revised the provision of advice. The Department who typically do not have financial proposal and updated economic is appreciative of the comments it expertise and can ill-afford lower analysis. In addition, we are received to the 2010 Proposal, and more returns to their retirement savings simultaneously publishing proposed fully discusses a number of the caused by conflicts. As baby boomers new and amended exemptions from comments that influenced change in the retire, they are increasingly moving ERISA and the Code’s prohibited sections that follow. In addition, the money from ERISA-covered plans, transaction rules designed to allow Department is eager to receive where their employer has both the certain broker-dealers, insurance agents comments on the new proposal in incentive and the fiduciary duty to and others that act as investment advice general, and requests public comment facilitate sound investment choices, to fiduciaries to nevertheless continue to on a number of specific aspects of the IRAs where both good and bad receive common forms of compensation package as indicated below. investment choices are myriad and that would otherwise be prohibited, The following discussion summarizes advice that is conflicted is subject to appropriate safeguards. The the 2010 Proposal, describes some of the commonplace. Such ‘‘rollovers’’ will existing class exemptions will otherwise concerns and issues raised by total more than $2 trillion over the next remain in place, affording flexibility to commenters, and explains the new 5 years. These trends were not apparent fiduciaries who currently use the proposed regulation, which is published when the Department promulgated the exemptions or who wish to use the with this notice. 1975 rule. At that time, 401(k) plans did exemptions in the future. The proposed B. The Statute and Existing Regulation not yet exist and IRAs had only just new regulatory package takes into been authorized. These changes in the account robust public comment and ERISA (or the ‘‘Act’’) is a marketplace, as well as the input and represents a substantial comprehensive statute designed to Department’s experience with the rule change from the 2010 Proposal, protect the interests of plan participants since 1975, support the Department’s balancing long overdue consumer and beneficiaries, the integrity of efforts to reevaluate and revise the rule protections with flexibility for the employee benefit plans, and the security through a public process of notice and industry in order to minimize of retirement, health, and other critical comment rulemaking. disruptions to current business models. benefits. The broad public interest in On October 22, 2010, the Department In crafting the current regulatory ERISA-covered plans is reflected in the published a proposed rule in the package, the Department has benefitted Act’s imposition of stringent fiduciary Federal Register (75 FR 65263) (2010 from the views and perspectives responsibilities on parties engaging in Proposal) proposing to amend 29 CFR expressed in public comments to the important plan activities, as well as in 2510.3–21(c) (40 FR 50843, Oct. 31, 2010 Proposal. For example, the the tax-favored status of plan assets and 1975), which defines when a person Department has responded to concerns investments. One of the chief ways in renders investment advice to an about the impact of the prohibited which ERISA protects employee benefit employee benefit plan, and transaction rules on the marketplace for plans is by requiring that plan consequently acts as a fiduciary under retail advice by proposing a broad fiduciaries comply with fundamental ERISA section 3(21)(A)(ii) (29 U.S.C. package of exemptions that are intended obligations rooted in the law of trusts. 1002(21)(A)(ii)). In response to this to ensure that advisers and their firms In particular, plan fiduciaries must proposal, the Department received over make recommendations that are in the manage plan assets prudently and with 300 comment letters. A public hearing best interest of plan participants and undivided loyalty to the plans and their on the 2010 Proposal was held in IRA owners, without disrupting participants and beneficiaries.4 In Washington, DC on March 1 and 2, common fee arrangements. In response addition, they must refrain from 2011, at which 38 speakers testified. to commenters, the Department has also The transcript of the hearing was made determined not to include, as fiduciary 4 ERISA section 404(a). 12-34 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21933 engaging in ‘‘prohibited transactions,’’ responsibility with respect to plan investment advice for a fee. Under the which the Act does not permit because assets. Thus, ‘‘any authority or control’’ regulation, for advice to constitute of the dangers to the interests of the over plan assets is sufficient to confer ‘‘investment advice,’’ an adviser who is plan and IRA posed by the fiduciary status, and any person who not a fiduciary under another provision transactions.5 When fiduciaries violate renders ‘‘investment advice for a fee or of the statute must—(1) render advice as ERISA’s fiduciary duties or the other compensation, direct or indirect’’ to the value of securities or other prohibited transaction rules, they may is an investment advice fiduciary, property, or make recommendations as be held personally liable for any losses regardless of whether they have direct to the advisability of investing in, to the investor resulting from the control over the plan’s assets, and purchasing or selling securities or other breach.6 In addition, violations of the regardless of their status as an property (2) on a regular basis (3) prohibited transaction rules are subject investment adviser and/or broker under pursuant to a mutual agreement, to excise taxes under the Code. the federal securities laws. The statutory arrangement or understanding, with the The Code also protects individuals definition and associated fiduciary plan or a plan fiduciary that (4) the who save for retirement through tax- responsibilities were enacted to ensure advice will serve as a primary basis for favored accounts that are not generally that plans can depend on persons who investment decisions with respect to covered by ERISA, such as IRAs, provide investment advice for a fee to plan assets, and that (5) the advice will through a more limited regulation of make recommendations that are be individualized based on the fiduciary conduct. Although ERISA’s prudent, loyal, and untainted by particular needs of the plan or IRA. The general fiduciary obligations of conflicts of interest. In the absence of regulation provides that an adviser is a prudence and loyalty do not govern the fiduciary status, persons who provide fiduciary with respect to any particular fiduciaries of IRAs and other plans not investment advice would neither be instance of advice only if he or she covered by ERISA, these fiduciaries are subject to ERISA’s fundamental meets each and every element of the subject to the prohibited transaction fiduciary standards, nor accountable five-part test with respect to the rules of the Code. In this context, under ERISA or the Code for imprudent, particular advice recipient or plan at however, the sole statutory sanction for disloyal, or tainted advice, no matter issue. engaging in the illegal transactions is how egregious the misconduct or how As the marketplace for financial the assessment of an excise tax enforced substantial the losses. Plans, individual services has developed in the years by the Internal Revenue Service (IRS). participants and beneficiaries, and IRA since 1975, the five-part test may now Thus, unlike participants in plans owners often are not financial experts undermine, rather than promote, the covered by Title I of ERISA, IRA owners and consequently must rely on statutes’ text and purposes. The do not have a statutory right to bring professional advice to make critical narrowness of the 1975 regulation suit against fiduciaries under ERISA for investment decisions. The statutory allows advisers, brokers, consultants violation of the prohibited transaction definition, prohibitions on conflicts of and valuation firms to play a central rules and fiduciaries are not personally interest, and core fiduciary obligations role in shaping plan and IRA liable to IRA owners for the losses of prudence and loyalty, all reflect investments, without ensuring the caused by their misconduct. Congress’ recognition in 1974 of the accountability that Congress intended Under this statutory framework, the fundamental importance of such advice for persons having such influence and determination of who is a ‘‘fiduciary’’ is to protect savers’ retirement nest eggs. responsibility. Even when plan of central importance. Many of ERISA’s In the years since then, the significance sponsors, participants, beneficiaries, and IRA owners clearly rely on paid and the Code’s protections, duties, and of financial advice has become still advisers for impartial guidance, the liabilities hinge on fiduciary status. In greater with increased reliance on regulation allows many advisers to relevant part, section 3(21)(A) of ERISA participant-directed plans and self- avoid fiduciary status and disregard provides that a person is a fiduciary directed IRAs for the provision of ERISA’s fiduciary obligations of care with respect to a plan to the extent he retirement benefits. and prohibitions on disloyal and or she (i) exercises any discretionary In 1975, the Department issued a conflicted transactions. As a authority or discretionary control with regulation, at 29 CFR 2510.3–21(c) consequence, these advisers can steer respect to management of such plan or defining the circumstances under which customers to investments based on their exercises any authority or control with a person is treated as providing own self-interest (e.g., products that respect to management or disposition of ‘‘investment advice’’ to an employee generate higher fees for the adviser even its assets; (ii) renders investment advice benefit plan within the meaning of for a fee or other compensation, direct if there are identical lower-fee products section 3(21)(A)(ii) of ERISA (the ‘‘1975 available), give imprudent advice, and or indirect, with respect to any moneys regulation’’), and the Department of the or other property of such plan, or has engage in transactions that would Treasury issued a virtually identical otherwise not be permitted by ERISA any authority or responsibility to do so; 7 regulation under the Code. The and the Code without fear of or, (iii) has any discretionary authority regulation narrowed the scope of the or discretionary responsibility in the accountability under either ERISA or statutory definition of fiduciary the Code. administration of such plan. Section investment advice by creating a five-part Instead of ensuring that trusted 4975(e)(3) of the IRC identically defines test that must be satisfied before a advisers give prudent and unbiased ‘‘fiduciary’’ for purposes of the person can be treated as rendering advice in accordance with fiduciary prohibited transaction rules set forth in norms, the current regulation erects a Code section 4975. 7 See 26 CFR 54.4975–9(c), which interprets Code multi-part series of technical The statutory definition contained in section 4975(e)(3). 40 FR 50840 (Oct. 31, 1975). impediments to fiduciary responsibility. section 3(21)(A) deliberately casts a Under section 102 of Reorganization Plan No. 4 of The Department is concerned that the wide net in assigning fiduciary 1978, the authority of the Secretary of the Treasury to interpret section 4975 of the Code has been specific elements of the five-part test— transferred, with certain exceptions not here which are not found in the text of the 5 ERISA section 406. The Act also prohibits relevant, to the Secretary of Labor. References in certain transactions between a plan and a ‘‘party in this document to sections of ERISA should be read Act or Code—now work to frustrate interest.’’ to refer also to the corresponding sections of the statutory goals and defeat advice 6 ERISA section 409; see also ERISA section 405. Code. recipients’ legitimate expectations. In © 2015 The Institute of Continuing Legal Education 12-35 Tax Conference, 28th Annual, May 21, 2015 21934 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules light of the importance of the proper individual, the ‘‘regular basis’’ particular consultant’s advice as management of plan and IRA assets, it requirement also deprives individual primary, secondary, or tertiary. is critical that the regulation defining participants and IRA owners of statutory Presumably, paid consultants make investment advice draws appropriate protection when they seek specialized recommendations—and retirement distinctions between the sorts of advice advice on a one-time basis, even if the investors pay for them—with the hope relationships that should be treated as advice concerns the investment of all or or expectation that the fiduciary in nature and those that substantially all of the assets held in recommendations could, in fact, be should not. In practice, the current their account (e.g., as in the case of an relied upon in making important regulation appears not to do so. Instead, annuity purchase or a roll-over from a decisions. When a plan, participant, the lines drawn by the five-part test plan to an IRA or from one IRA to beneficiary, or IRA owner directly or frequently permit evasion of fiduciary another). indirectly pays for advice upon which it status and responsibility in ways that Under the five-part test, fiduciary can rely, there appears to be little undermine the statutory text and status can also be defeated by arguing statutory basis for drawing distinctions purposes. that the parties did not have a mutual based on a subjective characterization of One example of the five-part test’s agreement, arrangement, or the advice as ‘‘primary,’’ ‘‘secondary,’’ shortcomings is the requirement that understanding that the advice would or other. advice be furnished on a ‘‘regular serve as a primary basis for investment In other respects, the current basis.’’ As a result of the requirement, if decisions. Investment professionals in regulatory definition could also benefit a small plan hires an investment today’s marketplace frequently market from clarification. For example, a professional or appraiser on a one-time retirement investment services in ways number of parties have argued that the basis for an investment recommendation that clearly suggest the provision of regulation, as currently drafted, does not or valuation opinion on a large, complex tailored or individualized advice, while encompass advice as to the selection of investment, the adviser has no fiduciary at the same time disclaiming in fine money managers or mutual funds. obligation to the plan under ERISA. print the requisite ‘‘mutual’’ Similarly, they have argued that the Even if the plan is considering investing understanding that the advice will be regulation does not cover advice given all or substantially all of the plan’s used as a primary basis for investment to the managers of pooled investment assets, lacks the specialized expertise decisions. vehicles that hold plan assets necessary to evaluate the complex Similarly, there appears to be a contributed by many plans, as opposed transaction on its own, and the widespread belief among broker-dealers to advice given to particular plans. consultant fully understands the plan’s that they are not fiduciaries with respect Parties have even argued that advice dependence on his professional to plans or IRAs because they do not was insufficiently ‘‘individualized’’ to judgment, the consultant is not a hold themselves out as registered fall within the scope of the regulation fiduciary because he does not advise the investment advisers, even though they because the advice provider had failed plan on a ‘‘regular basis.’’ The plan often market their services as financial to prudently consider the ‘‘particular could be investing hundreds of millions or retirement planners. The import of needs of the plan,’’ notwithstanding the of dollars in plan assets, and it could be such disclaimers—and of the fine legal fact that both the advice provider and the most critical investment decision distinctions between brokers and the plan agreed that individualized the plan ever makes, but the adviser registered investment advisers—is often advice based on the plan’s needs would would have no fiduciary responsibility completely lost on plan participants and be provided, and the adviser actually under the 1975 regulation. While a IRA owners who receive investment made specific investment consultant who regularly makes less advice. As shown in a study conducted recommendations to the plan. Although significant investment by the RAND Institute for Civil Justice the Department disagrees with each of recommendations to the plan would be for the Securities and Exchange these interpretations of the current a fiduciary if he satisfies the other four Commission (SEC), consumers often do regulation, the arguments nevertheless prongs of the regulatory test, the one- not read the legal documents and do not suggest that clarifying regulatory text time consultant on an enormous understand the difference between could be helpful. transaction has no fiduciary brokers and registered investment Changes in the financial marketplace responsibility. advisers particularly when brokers have enlarged the gap between the 1975 In such cases, the ‘‘regular basis’’ adopt such titles as ‘‘financial adviser’’ regulation’s effect and the Congressional requirement, which is not found in the and ‘‘financial manager.’’ 8 intent of the statutory definition. The text of ERISA or the Code, fails to draw Even in the absence of boilerplate fine greatest change is the predominance of a sensible line between fiduciary and print disclaimers, however, it is far from individual account plans, many of non-fiduciary conduct, and undermines evident how the ‘‘primary basis’’ which require participants to make the law’s protective purposes. A specific element of the five-part test promotes investment decisions for their own example is the one-time purchase of a the statutory text or purposes of ERISA accounts. In 1975, private-sector defined group annuity to cover all of the benefits and the Code. If, for example, a plan benefit pensions—mostly large, promised to substantially all of a plan’s hires multiple specialized advisers for professionally managed funds—covered participants for the rest of their lives an especially complex transaction, it over 27 million active participants and when a defined benefit plan terminates should be able to rely upon all of the held assets totaling almost $186 billion. or a plan’s expenditure of hundreds of consultants’ advice, regardless of This compared with just 11 million millions of dollars on a single real estate whether one could characterize any active participants in individual transaction with the assistance of a account defined contribution plans with financial adviser hired for purposes of 8 Angela A. Hung, Noreen Clancy, Jeff Dominitz, assets of just $74 billion.9 Moreover, the that one transaction. Despite the clear Eric Talley, Claude Berrebi, Farrukh Suvankulov, great majority of defined contribution importance of the decisions and the Investor and Industry Perspectives on Investment plans at that time were professionally clear reliance on paid advisers, the Advisers and Broker-Dealers, RAND Institute for Civil Justice, commissioned by the U.S. Securities advisers would not be plan fiduciaries. and Exchange Commission, 2008, at http:// 9 U.S. Department of Labor, Private Pension Plan On a smaller scale that is still www.sec.gov/news/press/2008/2008-1_ Bulletin Historical Tables and Graphs, (Dec. 2014), immensely important for the affected randiabdreport.pdf at http://www.dol.gov/ebsa/pdf/historicaltables.pdf. 12-36 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21935 managed, not participant-directed. In information between advisers and the ERISA fiduciary to the plan by virtue of 1975, 401(k) plans did not yet exist and customers who depend upon them for having control over the management or IRAs had just been authorized as part of guidance; and the advisers’ significant disposition of plan assets, or by having ERISA’s enactment the prior year. In conflicts of interest. discretionary authority over the contrast, by 2012 defined benefit plans When Congress enacted ERISA in administration of the plan; (3) was covered just under 16 million active 1974, it made a judgment that plan already an investment adviser under the participants, while individual account- advisers should be subject to ERISA’s Investment Advisers Act of 1940 based defined contribution plans fiduciary regime and that plan (Advisers Act); or (4) provided the covered over 68 million active participants, beneficiaries and IRA advice pursuant to an agreement or participants— including 63 million owners should be protected from understanding that the advice may be participants in 401(k)-type plans that conflicted transactions by the prohibited considered in connection with plan are participant-directed.10 transaction rules. More fundamentally, investment or asset management With this transformation, plan however, the statutory language was decisions and would be individualized participants, beneficiaries and IRA designed to cover a much broader to the needs of the plan, plan owners have become major consumers category of persons who provide participant or beneficiary, or IRA owner. of investment advice that is paid for fiduciary investment advice based on The 2010 Proposal also provided that, directly or indirectly. By 2012, 97 their functions and to limit their ability for purposes of the fiduciary definition, percent of 401(k) participants were to engage in self-dealing and other relevant fees included any direct or responsible for directing the investment conflicts of interest than is currently indirect fees received by the adviser or of all or part of their own account, up reflected in the five-part test. While an affiliate from any source. Direct fees from 86 percent as recently as 1999.11 many advisers are committed to are payments made by the advice Also, in 2013, more than 34 million providing high-quality advice and recipient to the adviser including households owned IRAs.12 always put their customers’ best transaction-based fees, such as Many of the consultants and advisers interests first, the 1975 regulation makes brokerage, mutual fund or insurance who provide investment-related advice it far too easy for advisers in today’s sales commissions. Indirect fees are and recommendations receive marketplace not to do so and to avoid payments to the adviser from any source compensation from the financial fiduciary responsibility even when they other than the advice recipient such as institutions whose investment products clearly purport to give individualized revenue sharing payments from a they recommend. This gives the advice and to act in the client’s best mutual fund. consultants and advisers a strong bias, interest, rather than their own. The 2010 Proposal included specific carve-outs for the following actions that conscious or unconscious, to favor C. The 2010 Proposal investments that provide them greater the Department believed should not compensation rather than those that In 2010, the Department proposed a result in fiduciary status. In particular, may be most appropriate for the new regulation that would have a person would not have become a participants. Unless they are fiduciaries, replaced the five-part test with a new fiduciary by— however, these consultants and advisers definition of what counted as fiduciary 1. Providing recommendations as a are free under ERISA and the Code, not investment advice for a fee. At that time, seller or purchaser with interests only to receive such conflicted the Department did not propose any adverse to the plan, its participants, or compensation, but also to act on their new prohibited transaction exemptions IRA owners, if the advice recipient conflicts of interest to the detriment of and acknowledged uncertainty reasonably should have known that the their customers. In addition, plans, regarding whether existing exemptions adviser was not providing impartial participants, beneficiaries, and IRA would be available, but specifically investment advice and the adviser had owners now have a much greater variety invited comments on whether new or not acknowledged fiduciary status. of investments to choose from, creating amended exemptions should be 2. Providing investment education a greater need for expert advice. proposed. The proposal also provided information and materials in connection Consolidation of the financial services carve-outs for conduct that would not with an individual account plan. 3. Marketing or making available a industry and innovations in result in fiduciary status. The general menu of investment alternatives that a compensation arrangements have definition included the following types of advice: (1) Appraisals or fairness plan fiduciary could choose from, and multiplied the opportunities for self- opinions concerning the value of providing general financial information dealing and reduced the transparency of securities or other property; (2) to assist in selecting and monitoring fees. The absence of adequate fiduciary recommendations as to the advisability those investments, if these activities include a written disclosure that the protections and safeguards is especially of investing in, purchasing, holding or adviser was not providing impartial problematic in light of the growth of selling securities or other property; and (3) recommendations as to the investment advice. participant-directed plans and self- 4. Preparing reports necessary to directed IRAs; the gap in expertise and management of securities or other property. Reflecting the Department’s comply with ERISA, the Code, or regulations or forms issued thereunder, 10 U.S. Department of Labor, Private Pension Plan longstanding interpretation of the 1975 Bulletin Abstract of 2012 Form 5500 Annual regulations, the 2010 Proposal made unless the report valued assets that lack Reports, (Jan. 2015), at http://www.dol.gov/ebsa/ clear that investment advice under the a generally recognized market, or served PDF/2012pensionplanbulletin.PDF. proposal includes advice provided to as a basis for making plan distributions. 11 U.S. Department of Labor, Private Pension Plan plan participants, beneficiaries and IRA The 2010 Proposal applied to the Bulletin Abstract of 1999 Form 5500 Annual Reports, Number 12, Summer 2004 (Apr. 2008), at owners as well as to plan fiduciaries. definition of an ‘‘investment advice http://www.dol.gov/ebsa/PDF/ Under the 2010 Proposal, a paid fiduciary’’ in section 4975(e)(3)(B) of the 1999pensionplanbulletin.PDF. adviser would have been treated as a Code as well as to the parallel ERISA 12 Brien, Michael J., and Constantijn W.A. Panis. fiduciary if the adviser provided one of definition. These provisions apply to Analysis of Financial Asset Holdings of Households on the United States: 2013 Update. Advanced the above types of advice and either: (1) both certain ERISA covered plans, and Analytic Consulting Group and Deloitte, Report Represented that he or she was acting as certain non-ERISA plans such as Prepared for the U.S. Department of Labor, 2014. an ERISA fiduciary; (2) was already an individual retirement accounts. © 2015 The Institute of Continuing Legal Education 12-37 Tax Conference, 28th Annual, May 21, 2015 21936 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules In the preamble to the 2010 Proposal, arrangement, or understanding that the Many of the differences between the the Department also noted that it had advice is individualized or specifically new proposal and the 2010 Proposal previously interpreted the 1975 directed to the recipient for reflect the input of commenters on the regulation as providing that a consideration in making investment or 2010 Proposal as part of the public recommendation to a plan participant investment management decisions notice and comment process. For on how to invest the proceeds of a regarding plan assets. example, some commenters argued that contemplated plan distribution was not The new proposal includes several the 2010 Proposal swept too broadly by fiduciary investment advice. Advisory carve-outs for persons who do not making investment recommendations Opinion 2005–23A (Dec. 7, 2005). The represent that they are acting as ERISA fiduciary in nature simply because the Department specifically asked for fiduciaries, some of which were adviser was a plan fiduciary for comments as to whether the final rule included in some form in the 2010 purposes unconnected with the advice should include such recommendations Proposal but many of which were not. or an investment adviser under the as fiduciary advice. Subject to specified conditions, these Advisers Act. In their view, such status- The 2010 Proposal prompted a large carve-outs cover— based criteria were in tension with the number of comments and a vigorous (1) Statements or recommendations Act’s functional approach to fiduciary debate. As noted above, the Department made to a ‘‘large plan investor with status and would have resulted in made special efforts to encourage the financial expertise’’ by a counterparty unwarranted and unintended regulated community’s participation in acting in an arm’s length transaction; compliance issues and costs. Other this rulemaking. In addition to an (2) offers or recommendations to plan commenters objected to the lack of a extended comment period, the fiduciaries of ERISA plans to enter into requirement for these status-based Department held a two-day public a swap or security-based swap that is categories that the advice be hearing. Additional time for comments regulated under the Securities Exchange individualized to the needs of the was allowed following the hearing and Act or the Commodity Exchange Act; advice recipient. The new proposal publication of the hearing transcript on (3) statements or recommendations incorporates these suggestions: An the Department’s Web site and provided to a plan fiduciary of an adviser’s status as an investment adviser Department representatives held ERISA plan by an employee of the plan under the Advisers Act or as an ERISA numerous meetings with interested sponsor if the employee receives no fee fiduciary for reasons unrelated to advice parties. Many of the comments beyond his or her normal compensation; are no longer factors in the definition. concerned the Department’s conclusions (4) marketing or making available a In addition, unless the adviser regarding the likely economic impact of platform of investment alternatives to be represents that he or she is a fiduciary the proposal, if adopted. A number of selected by a plan fiduciary for an with respect to advice, the advice must commenters urged the Department to ERISA participant-directed individual be provided pursuant to an agreement, undertake additional analysis of account plan; arrangement, or understanding that the expected costs and benefits particularly (5) the identification of investment advice is individualized or specifically with regard to the 2010 Proposal’s alternatives that meet objective criteria directed to the recipient to be treated as coverage of IRAs. After consideration of specified by a plan fiduciary of an fiduciary advice. these comments and in light of the ERISA plan or the provision of objective Furthermore, the carve-outs that treat significance of this rulemaking to the financial data to such fiduciary; certain conduct as non-fiduciary in retirement plan service provider (6) the provision of an appraisal, nature have been modified, clarified, industry, plan sponsors and fairness opinion or a statement of value and expanded in response to comments. participants, beneficiaries and IRA to an ESOP regarding employer For example, the carve-out for certain owners, the Department decided to take securities, to a collective investment valuations from the definition of more time for review and to issue a new vehicle holding plan assets, or to a plan fiduciary investment advice has been proposed regulation for comment. for meeting reporting and disclosure modified and expanded. Under the 2010 D. The New Proposal requirements; and Proposal, appraisals and valuations for (7) information and materials that compliance with certain reporting and The new proposed rule makes many constitute ‘‘investment education’’ or disclosure requirements were not revisions to the 2010 Proposal, although ‘‘retirement education.’’ treated as fiduciary advice. The new it also retains aspects of that proposal’s The new proposal applies the same proposal additionally provides a carve- essential framework. The new proposal definition of ‘‘investment advice’’ to the out from fiduciary treatment for broadly updates the definition of definition of ‘‘fiduciary’’ in section appraisal and fairness opinions for fiduciary investment advice, and also 4975(e)(3) of the Code and thus applies ESOPs regarding employer securities. provides a series of carve-outs from the to investment advice rendered to IRAs. Although, the Department remains fiduciary investment advice definition ‘‘Plan’’ is defined in the new proposal concerned about valuation advice for communications that should not be to mean any employee benefit plan concerning an ESOP’s purchase of viewed as fiduciary in nature. The described in section 3(3) of the Act and employer stock and about a plan’s definition generally covers the following any plan described in section reliance on that advice, the Department categories of advice: (1) Investment 4975(e)(1)(A) of the Code. For ease of has concluded that the concerns recommendations, (2) investment reference in this proposal, the term regarding valuations of closely held management recommendations, (3) ‘‘IRA’’ has been inclusively defined to employer stock in ESOP transactions appraisals of investments, or (4) mean any account described in Code raise unique issues that are more recommendations of persons to provide section 4975(e)(1)(B) through (F), such investment advice for a fee or to manage as a true individual retirement account differences among the various types of non-ERISA plan assets. Persons who provide such described under Code section 408(a) plan arrangements described in Code section advice fall within the general definition and a health savings account described 4975(e)(1)(B) through (F), the Department solicits of a fiduciary if they either (a) represent 13 comments on whether it is appropriate for the in section 223(d) of the Code. regulation to cover the full range of these that they are acting as a fiduciary under arrangements. These non-ERISA plan arrangements ERISA or the Code or (b) provide the 13 As discussed below in Section E. Coverage of are tax favored vehicles under the Code like IRAs, advice pursuant to an agreement, IRAs and Other Non-ERISA Plans, in recognition of but are not intended for retirement savings. 12-38 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21937 appropriately addressed in a separate and responsibilities. As the Department laws, and to take the effects of those regulatory initiative. Additionally, the moves forward with this project in laws into account so as to appropriately carve-out for valuations conducted for accordance with the specific provisions calibrate the impact of the rule on those reporting and disclosure purposes has of ERISA and the Code, it will continue firms. The proposed regulation reflects been expanded to include reporting and to consult with staff of the SEC and these efforts. In the Department’s view, disclosure obligations outside of ERISA other regulators on its proposals and it neither undermines, nor contradicts, and the Code, and is applicable to both their impact on retail investors and the provisions or purposes of the ERISA plans and IRAs. Many other other regulatory regimes. One result of securities laws, but instead works in modifications to the other carve-outs these discussions, particularly with staff harmony with them. The Department from fiduciary status, as well as new of the CFTC and SEC, is the new has coordinated—and will continue to carve-outs and prohibited transaction provision at paragraph (b)(1)(ii) of the coordinate—its efforts with other federal exemptions, are described below in proposed regulations concerning agencies to ensure that the various legal Section IV—‘‘The Provisions of the New counterparty transactions with swap regimes are harmonized to the fullest Proposal.’’ dealers, major swap participants, extent possible. security-based swap dealers, and major The Department has also consulted III. Coordination With Other Federal security-based swap participants. Under with the Department of the Treasury Agencies the terms of that paragraph, such and the IRS, particularly on the subject Many comments to the 2010 persons would not be treated as ERISA of IRAs. Although the Department has rulemaking emphasized the need to fiduciaries merely because, when acting responsibility for issuing regulations harmonize the Department’s efforts with as counterparties to swap or security- and prohibited transaction exemptions rulemaking activities under the Dodd- based swap transactions, they give under section 4975 of the Code, which Frank Wall Street Reform and Consumer information and perform actions applies to IRAs, the IRS maintains Protection Act, Pub. Law No. 111–203, required for compliance with the general responsibility for enforcing the 124 Stat. 1376 (2010), (Dodd-Frank Act), requirements of the business conduct tax laws. The IRS’ responsibilities in particular, the Security and Exchange standards of the Dodd-Frank Act and its extend to the imposition of excise taxes Commission’s (SEC) standards of care implementing regulations. on fiduciaries who participate in for providing investment advice and the In pursuing these consultations, the prohibited transactions.14 As a result, Commodity Futures Trading Department has aimed to coordinate and the Department and the IRS share Commission’s (CFTC) business conduct minimize conflicting or duplicative responsibility for combating self-dealing standards for swap dealers. While the provisions between ERISA, the Code by fiduciary investment advisers to tax- 2010 Proposal discussed statutes over and federal securities laws, to the extent qualified plans and IRAs. Paragraph (e) which the SEC and CFTC have possible. However, the governing of the proposed regulation, in particular, jurisdiction, it did not specifically statutes do not permit the Department to recognizes this jurisdictional describe inter-agency coordination make the obligations of fiduciary intersection. efforts. In addition, commenters investment advisers under ERISA and When the Department announced that questioned the adequacy of the Code identical to the duties of it would issue a new proposal, it stated coordination with other agencies advice providers under the securities that it would consider proposing new regarding IRA products and services. laws. ERISA and the Code establish and/or amended prohibited transaction They argued that subjecting SEC- consumer protections for some exemptions to address the concerns of regulated investment advisers and investment advice that does not fall commenters about the broader scope of broker-dealers to a special set of ERISA within the ambit of federal securities the fiduciary definition and its impact rules for plans and IRAs could lead to laws, and vice versa. Even if each of the on the fee practices of brokers and other additional costs and complexities for relevant agencies were to adopt an advisers. Commenters had expressed individuals who may have several identical definition of ‘‘fiduciary’’, the concern about whether longstanding different types of accounts at the same legal consequences of the fiduciary exemptions granted by the Department financial institution some of which may designation would vary between allowing advisers, despite their be subject only to the SEC rules, and agencies because of differences in the fiduciary status under ERISA, to receive others of which may be subject to both specific duties and remedies established commissions in connection with mutual SEC rules and new regulatory by the different federal laws at issue. funds, securities and insurance products requirements under ERISA. ERISA and the Code place special would remain applicable under the new In the course of developing the new emphasis on the elimination or rule. As explained more fully below, the proposal and the related proposed mitigation of conflicts of interest and Department is simultaneously prohibited transaction exemptions, the adherence to substantive standards of publishing in the notice section of Department has consulted with staff of conduct, as reflected in the prohibited today’s Federal Register proposed the SEC and other regulators on an transaction rules and ERISA’s standards prohibited transaction class exemptions ongoing basis regarding whether the of fiduciary conduct. The specific duties to address these concerns. The proposals would subject investment imposed on fiduciaries by ERISA and Department believes that existing advisers and broker-dealers who the Code stem from legislative exemptions and these new proposed provide investment advice to judgments on the best way to protect the exemptions would preserve the ability requirements that create an undue public interest in tax-preferred benefit to engage in common fee arrangements, compliance burden or conflict with arrangements that are critical to while protecting plan participants, their obligations under other federal workers’ financial and physical health. beneficiaries and IRA owners from laws. As part of this consultative The Department has taken great care to abusive practices that may result from process, SEC staff has provided honor ERISA and the Code’s specific conflicts of interest. technical assistance and information text and purposes. The terms of these new exemptions with respect to retail investors, the At the same time, the Department has are discussed in more detail below and marketplace for investment advice and worked hard to understand the impact in the preambles to the proposed coordinating, to the extent possible, the of the proposed rule on firms subject to agencies’ separate regulatory provisions the securities laws and other federal 14 Reorganization Plan No. 4 of 1978. © 2015 The Institute of Continuing Legal Education 12-39 Tax Conference, 28th Annual, May 21, 2015 21938 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules exemptions. While the exemptions to replace the restrictive five-part test Except for the prong of the definition differ in terms and coverage, each with a new definition that better concerning appraisals and valuations imposes a ‘‘best interest’’ standard on comports with the statutory language in discussed below, the proposal is fiduciary investment advisers. Thus, for ERISA and the Code.15 As explained structured so that communications must example, the Best Interest Contract below, the proposal accomplishes this constitute a ‘‘recommendation’’ to fall Exemption requires the investment by first describing the kinds of within the scope of fiduciary investment advice fiduciary and associated communications and relationships that advice. In that regard, as stated earlier financial institution to expressly agree would generally constitute fiduciary in Section III concerning coordination to provide advice that is in the ‘‘best investment advice if the adviser receives with other Federal Agencies, the interest’’ of the advice recipient. As a fee or other compensation. Rather than Department has consulted with staff of proposed, the best interest standard is add additional elements that must be other agencies with rulemaking intended to mirror the duties of met in all instances, as under the authority over investment advisers and prudence and loyalty, as applied in the current regulation, the proposal broker-dealers. FINRA Policy Statement context of fiduciary investment advice describes several specific types of 01–23 sets forth guidelines to assist under sections 404(a)(1)(A) and (B) of advice or communications that would brokers in evaluating whether a ERISA. Thus, the ‘‘best interest’’ not be treated as investment advice. In particular communication could be standard is rooted in the longstanding the Department’s view, this structure is viewed as a recommendation, thereby trust-law duties of prudence and loyalty faithful to the remedial purpose of the triggering application of FINRA’s Rule adopted in section 404 of ERISA and in statute, but avoids burdening activities 2111 that requires that a firm or the cases interpreting those standards. that do not implicate relationships of associated person have a reasonable Accordingly, the Best Interest trust and expectations of impartiality. basis to believe that a recommended Contract Exemption provides: transaction or investment strategy A. Categories of Advice or involving a security or securities is Investment advice is in the ‘‘Best Interest’’ Recommendations 16 of the Retirement Investor when the Adviser suitable for the customer. Although and Financial Institution providing the Paragraph (a)(1) of the proposal sets the regulatory context for the FINRA advice act with the care, skill, prudence, and forth the following types of advice, guidance is somewhat different, the diligence under the circumstances then which, when provided in exchange for Department believes that it provides prevailing that a prudent person would a fee or other compensation, whether useful standards and guideposts for exercise based on the investment objectives, directly or indirectly, and given under distinguishing investment education risk tolerance, financial circumstances and circumstances described in paragraph from investment advice under ERISA. needs of the Retirement Investor, without (a)(2), would be ‘‘investment advice’’ Accordingly, the Department regard to the financial or other interests of specifically solicits comments on the Adviser, Financial Institution, any unless one of the carve-outs in Affiliate, Related Entity, or other party. paragraph (b) applies. The listed types whether it should adopt some or all of of advice are— the standards developed by FINRA in This ‘‘best interest’’ standard is not (i) A recommendation as to the defining communications that rise to the intended to add to or expand the ERISA advisability of acquiring, holding, level of a recommendation for purposes section 404 standards of prudence and disposing of or exchanging securities or of distinguishing between investment loyalty as they apply to the provision of other property, including a education and investment advice under investment advice to ERISA covered recommendation to take a distribution ERISA. plans. Advisers to ERISA-covered plans of benefits or a recommendation as to Additionally, as paragraph (d) of the are already required to adhere to the the investment of securities or other proposal makes clear, the regulation fundamental standards of prudence and property to be rolled over or otherwise does not treat the mere execution of a loyalty, and can be held accountable for distributed from the plan or IRA; securities transaction at the direction of violations of the standards. Rather, the (ii) A recommendation as to the primary impact of the ‘‘best interest’’ 16 management of securities or other See also FINRA’s Regulatory Notice 11–02, 12– standard is on the IRA market. Under 25 and 12–55. Regulatory Notice 11–02 includes the property, including recommendations as the Code, advisers to IRAs are subject following discussion: to the management of securities or other For instance, a communication’s content, context only to the prohibited transaction rules. property to be rolled over or otherwise and presentation are important aspects of the Incorporating the best interest standard distributed from the plan or IRA; inquiry. The determination of whether a in the proposed Best Interest Contract ‘‘recommendation’’ has been made, moreover, is an (iii) An appraisal, fairness opinion, or Exemption effectively requires advisers objective rather than subjective inquiry. An similar statement whether verbal or important factor in this regard is whether—given its to comply with these basic fiduciary written concerning the value of content, context and manner of presentation—a standards as a condition of engaging in particular communication from a firm or associated securities or other property if provided transactions that would otherwise be person to a customer reasonably would be viewed in connection with a specific prohibited because of the conflicts of as a suggestion that the customer take action or transaction or transactions involving the refrain from taking action regarding a security or interest they create. Additionally, the acquisition, disposition, or exchange, of investment strategy. In addition, the more exemption ensures that IRA owners and individually tailored the communication is to a such securities or other property by the investors have a contract-based claim to particular customer or customers about a specific plan or IRA; or security or investment strategy, the more likely the hold their fiduciary advisers (iv) A recommendation of a person communication will be viewed as a accountable if they violate these basic who is also going to receive a fee or recommendation. Furthermore, a series of actions obligations of prudence and loyalty. As that may not constitute recommendations when other compensation to provide any of under current law, no private right of viewed individually may amount to a the types of advice described in recommendation when considered in the aggregate. action under ERISA is available to IRA paragraphs (i) through (iii) above. It also makes no difference whether the owners. communication was initiated by a person or a computer software program. These guiding IV. The Provisions of the New Proposal 15 For purposes of readability, this proposed principles, together with numerous litigated The new proposal would amend the rulemaking republishes 29 CFR 2510.3–21 in its decisions and the facts and circumstances of any entirety, as revised, rather than only the specific particular case, inform the determination of definition of investment advice in 29 amendments to this section. See 29 CFR 2510.3– whether the communication is a recommendation CFR 2510.3–21 (1975) of the regulation 21(d)—Execution of securities transactions. for purposes of FINRA’s suitability rule. 12-40 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21939 a plan or IRA owner as fiduciary proposal’s treatment of such non- Responding to comments, the proposal activity. This paragraph remains fiduciary educational and informational in paragraph (a)(1)(iii) covers only unchanged from the 1975 regulation materials adequately covers the appraisals, fairness opinions, or similar other than to update references to the common types of distribution-related statements that relate to a particular proposal’s structure. The definition’s information that participants find transaction. The Department also scope remains limited to advice useful, including information relating to expanded the 2010 Proposal’s carve-out relationships, as delineated in its text annuitizations and other forms of for general reports or statements of and does not impact merely lifetime income payment options, but value provided to satisfy required administrative or ministerial activities welcomes input on other types of reporting and disclosure rules under necessary for a plan or IRA’s information that would help clarify the ERISA or the Code. The carve-out in the functioning. It also does not apply to line between advice and education in 2010 proposal covered general reports order taking where no advice is this context. or statements of value that merely provided. (2) Recommendations as to the reflected the value of an investment of (1) Recommendations To Distribute Plan Management of Plan Investments a plan or a participant or beneficiary, and provided for purposes of Assets The preamble to the 2010 Proposal compliance with the reporting and Paragraph (a)(1)(i) specifically stated that the ‘‘management of disclosure requirements of ERISA, the includes recommendations concerning securities or other property’’ would Code, and the regulations, forms and the investment of securities to be rolled include advice and recommendations as schedules issued thereunder, unless the over or otherwise distributed from the to the exercise of rights appurtenant to plan or IRA. Noting the Department’s shares of stock (e.g., voting proxies). 75 reports involved assets for which there position in Advisory Opinion 2005–23A FR 65266 (Oct. 22, 2010). The was not a generally recognized market that it is not fiduciary advice to make Department has long viewed the and served as a basis on which a plan a recommendation as to distribution exercise of ownership rights as a could make distributions to plan options even if that is accompanied by fiduciary responsibility because of its participants and beneficiaries. The a recommendation as to where the material effect on plan investment goals. carve-out was broadened in this distribution would be invested, (Dec. 7, 29 CFR 2509.08–2 (2008). Consequently, proposal to includes valuations 2005), the 2010 Proposal did not individualized or specifically directed provided solely for purposes of include this type of advice, but the advice and recommendations on the compliance with the reporting and Department requested comments on exercise of proxy or other ownership disclosure provisions under the Act, the whether it should be included in a final rights are appropriately treated as Code, and the regulations, forms and regulation. Some commenters stated fiduciary in nature. Accordingly, the schedules issued thereunder, or any that exclusion of this advice from the proposed regulation’s provision on applicable reporting or disclosure final rule would fail to protect advice regarding the management of requirement under a Federal or state participant accounts from conflicted securities or other property would law, or rule or regulation or self- advice in connection with one of the continue to cover individualized advice regulatory organization (e.g., FINRA) most significant financial decisions that or recommendations as to proxy voting without regard to the type of asset participants make concerning retirement and the management of retirement involved. In this manner, the new savings. Other commenters argued that assets in paragraph (a)(1)(ii). proposal focuses on instances where the including this advice would give rise to We received comments on the 2010 plan or IRA owner is looking to the prohibited transactions that could proposal seeking some clarification appraiser for advice on the market value disrupt the routine process that occurs regarding its application to certain of an asset that the investor is when a worker leaves a job, contacts a practices. In this regard, it is the considering to acquire, dispose, or financial services firm for help rolling Department’s view that guidelines or exchange. In many cases the most over a 401(k) balance, and the firm other information on voting policies for important investment advice that an explains the investments it offers and proxies that are provided to a broad investor receives is advice as to how the benefits of a rollover. class of investors without regard to a much it can or should pay for hard-to- The proposed regulation, if finalized, client’s individual interests or value assets. In response to comments, would supersede Advisory Opinion investment policy, and which are not the proposal also contains an entirely 2005–23A. Thus, recommendations to directed or presented as a recommended new carve-out at paragraph (b)(5)(ii) take distributions (and thereby policy for the plan or IRA to adopt, specifically addressing valuations or withdraw assets from existing plan or would not rise to the level of fiduciary appraisals provided to an investment IRA investments or roll over into a plan investment advice under the proposal. fund (e.g., collective investment fund or or IRA) or to entrust plan or IRA assets Additionally, a recommendation pooled separate account) holding assets to particular money managers, advisers, addressed to all shareholders in a proxy of various investors in addition to at or investments would fall within the statement would not result in fiduciary least one plan or IRA. Also, as scope of covered advice. However, as status on the part of the issuer of the mentioned, the Department has decided the proposal’s text makes clear, one statement or the person who distributes not to extend fiduciary coverage to does not act as a fiduciary merely by the proxy statement. These positions are valuations or appraisals for ESOPs providing participants with information clarified in the proposed regulation. relating to employer securities at this about plan or IRA distribution options, time because the Department has including the consequences associated (3) Appraisals concluded that its concerns in this with the available types of benefit The new proposal, like the current space raise unique issues that are more distributions. In this regard, the new regulation which includes ‘‘advice as to appropriately addressed in a separate proposal draws an important distinction the value of securities or other regulatory initiative. The proposal’s between fiduciary investment advice property,’’ continues to cover certain carve-outs do not apply, however, if the and non-fiduciary investment appraisals and valuation reports. provider of the valuation represents or information and educational materials. However, it is considerably more acknowledges that it is acting as a The Department believes that the focused than the 2010 Proposal. fiduciary with respect to the advice. © 2015 The Institute of Continuing Legal Education 12-41 Tax Conference, 28th Annual, May 21, 2015 21940 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules Some representatives of the appraisal such advice should be treated as solely on their or an affiliate’s status as industry submitted comments on the fiduciary in nature if provided under an investment adviser under the 2010 Proposal arguing that ERISA’s the circumstances in paragraph (a)(1)(iv) Advisers Act. Instead, their fiduciary fiduciary duty to act solely in the and for direct or indirect compensation. status would be determined by reference interest of the plan and its participants Covered advice would include to the same functional test that applies and beneficiaries is inconsistent with recommendations of persons to perform to all persons under the regulation. the duty of appraisers to provide asset management services or to make Paragraph (a)(2)(ii) of the proposal objective, independent value investment recommendations. Advice as avoids treating recommendations made determinations. The Department to the identity of the person entrusted to the general public, or to no one in disagrees. A biased or inaccurate with investment authority over particular, as investment advice and appraisal does not help a plan, a retirement assets is often critical to the thus addresses concerns that the general participant or a beneficiary make proper management and investment of circulation of newsletters, television prudent investment decisions. Like those assets. On the other hand, general talk show commentary, or remarks in other forms of investment advice, an advice as to the types of qualitative and speeches and presentations at financial appraisal is a tool for plan fiduciaries, quantitative criteria to consider in industry educational conferences would participants, beneficiaries, and IRA hiring an investment manager would result in the person being treated as a owners to use in deciding what price to not rise to the level of a fiduciary. This paragraph requires an pay for assets and whether to accept or recommendation of a person to manage agreement, arrangement, or decline proposed transactions. An plan investments nor would a trade understanding that advice is directed to, appraiser complies with his or her journal’s endorsement of an investment a specific recipient for consideration in obligations as an appraiser—and as a manager. Similarly, the proposed making investment decisions. The loyal fiduciary—by giving plan regulation would not cover parties need not have a meeting of the fiduciaries or participants an impartial recommendations of administrative minds on the extent to which the advice and accurate assessment of the value of service providers, property managers, or recipient will actually rely on the an asset in accordance with appraisers’ other service providers who do not advice, but they must agree or professional standard of care. Nothing provide investment services. understand that the advice is in ERISA or this regulation should be individualized or specifically directed B. The Circumstances Under Which to the particular advice recipient for read as compelling an appraiser to slant Advice Is Provided valuation opinions to reflect what the consideration in making investment plan wishes the asset were worth rather As provided in paragraph (a)(2) of the decisions. In this respect, paragraph than what it is really worth. As stated proposal, unless a carve-out applies, a (a)(2)(ii) differs significantly from its in the preamble to the 2010 Proposal, category of advice listed in the proposal counterpart in the 2010 Proposal. In the Department would expect a would constitute ‘‘investment advice’’ if particular, and in response to fiduciary appraiser’s determination of the person providing the advice, either comments, the proposal does not value to be unbiased, fair and objective directly or indirectly (e.g., through or require that advice be individualized to and to be made in good faith based on together with any affiliate)— the needs of the plan, participant or a prudent investigation under the (i) Represents or acknowledges that it beneficiary or IRA owner if the advice prevailing circumstances then known to is acting as a fiduciary within the is specifically directed to such recipient. the appraiser. In the Department’s view, meaning of the Act or Code with respect Under the proposal, advisers could not these fiduciary standards are fully to the advice described in paragraph specifically direct investment consistent with professional standards, (a)(1); or recommendations to individual persons, (ii) Renders the advice pursuant to a such as the Uniform Standards of but then deny fiduciary responsibility written or verbal agreement, Professional Appraisal Practice on the basis that they did not, in fact, arrangement or understanding that the (USPAP).17 consider the advice recipient’s advice is individualized to, or that such individual needs or intend that the (4) Recommendations of a Person To advice is specifically directed to, the recipient base investment decisions on Provide Investment Advice or advice recipient for consideration in their recommendations. Nor could they Management Services making investment or management continue the practice of advertising The proposal would treat decisions with respect to securities or advice or counseling that is one-on-one recommendations on the selection of other property of the plan or IRA. or that a reasonable person would investment managers or advisers as Under paragraph (a)(2)(i), advisers believe would be tailored to their fiduciary investment advice. In the who claim fiduciary status under ERISA individual needs and then disclaim that Department’s view, the current or the Code in providing advice would the recommendations are fiduciary regulation already covers such advice. be taken at their word. They may not investment advice in boilerplate The proposal simply revises the later argue that the advice was not language in the advertisement or in the regulation’s text to remove any possible fiduciary in nature. Nor may they rely paperwork provided to the client. ambiguity. The Department believes that upon the carve-outs described in Like the 2010 Proposal, and unlike paragraph (b) on the scope of the the 1975 regulation, the new proposal 17 A number of commenters also pointed to such definition of fiduciary investment does not require that advice be provided professional standards as alternatives to fiduciary advice. on a regular basis. Investment advice treatment under ERISA. While the Department The 2010 Proposal provided that that meets the requirements of the believes that such professional standards are fully investment recommendations provided proposal, even if provided only once, consistent with the fiduciary duties, the rights, remedies and sanctions under both ERISA and the by an investment adviser under the can be critical to important investment Code importantly turn on fiduciary status, and Advisers Act would, in the absence of decisions. If the adviser received a advice on the value of an asset is often the most a carve-out, automatically be treated as direct or indirect fee in connection with critical investment advice a plan receives. As a investment advice. In response to its advice, the advice recipients should result, treating appraisals as fiduciary advice provides an additional layer of protection for comments, the new proposal drops this reasonably expect adherence to consumers without conflicting with the duties of provision. Thus, the proposal avoids fiduciary standards on the same terms appraisers. making such persons fiduciaries based as other retirement investors who get 12-42 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21941 recommendations from the adviser on a in connection with an offer to enter into plans, a person may rely on more routine basis. such a transaction or when the person representations from the independent providing the advice is acting as a plan fiduciary regarding the value of C. Carve-Outs From the General representative, such as an agent, for the employee benefit plan assets under Definition plan’s counterparty. This carve-out is management). In that circumstance, the The Department recognizes that in subject to the following conditions. adviser need not obtain written many circumstances, plan fiduciaries, First, the person must provide advice representations from its counterparty to participants, beneficiaries, and IRA to an ERISA plan fiduciary who is avail itself of the carve-out, but must owners may receive recommendations independent of such person and who fairly inform the independent plan or appraisals that, notwithstanding the exercises authority or control respecting fiduciary that the adviser is not general definition set forth in paragraph the management or disposition of the undertaking to provide impartial (a) of the proposal, should not be treated plan’s assets, with respect to an arm’s investment advice, or to give advice in as fiduciary investment advice. length sale, purchase, loan or bilateral a fiduciary capacity; and cannot receive Accordingly, paragraph (b) contains a contract between the plan and the a fee or other compensation directly number of specific carve-outs from the counterparty, or with respect to a from the plan, or plan fiduciary, for the scope of the general definition. The proposal to enter into such a sale, provision of investment advice in carve-out at paragraph (b)(5) of the purchase, loan or bilateral contract. connection with the transaction. In that proposal concerning financial reports Second, either of two alternative sets circumstance, the adviser must also and valuations was discussed above in of conditions must be met. Under reasonably believe that the independent connection with appraisals. The carve- alternative one, prior to providing any plan fiduciary has sufficient expertise to out in paragraph (b)(5)(iii) covers recommendation with respect to the prudently evaluate the transaction. communications to a plan, a plan transaction, such person: The overall purpose of this carve-out fiduciary, a plan participant or (1) Obtains a written representation is to avoid imposing ERISA fiduciary beneficiary, an IRA or IRA owner solely from the plan fiduciary that he/she is a obligations on sales pitches that are part for purposes of compliance with the fiduciary who exercises authority or of arm’s length transactions where reporting and disclosure provisions control with respect to the management neither side assumes that the under the Act, the Code, and the or disposition of the employee benefit counterparty to the plan is acting as an regulations, forms and schedules issued plan’s assets (as described in section impartial trusted adviser, but the seller thereunder, or any applicable reporting 3(21)(A)(i) of the Act), that the employee is making representations about the or disclosure requirement under a benefit plan has 100 or more value and benefits of proposed deals. Federal or state law, rule or regulation participants covered under the plan, Under appropriate circumstances, or self-regulatory organization rule or and that the fiduciary will not rely on reflected in the conditions to this carve- regulation. The carve-out in paragraph the person to act in the best interests of out, these counterparties to the plan do (b)(6) covers education. The other carve- the plan, to provide impartial not suggest that they are an impartial outs are limited to communications investment advice, or to give advice in fiduciary and plans do not expect a with plans and plan fiduciaries and do a fiduciary capacity; relationship of undivided loyalty or not cover communications to (2) fairly informs the plan fiduciary of trust. Both sides of such transactions participants, beneficiaries or IRA the existence and nature of the person’s understand that they are acting at arm’s owners. These more limited carve-outs financial interests in the transaction; length, and neither party expects that are described more fully below. In each (3) does not receive a fee or other recommendations will necessarily be instance, the proposed carve-outs are for compensation directly from the plan, or based on the buyer’s best interests. In communications that the Department plan fiduciary, for the provision of such a sales transaction, the buyer believes Congress did not intend to investment advice in connection with understands that it is buying an cover as fiduciary ‘‘investment advice’’ the transaction (this does not preclude investment product, not advice about and that parties would not ordinarily a person from receiving a fee or whether it is a good product, from a view as communications characterized compensation for other services); seller who has opposing financial by a relationship of trust or impartiality. (4) knows or reasonably believes that interests. The seller’s invitation to buy None of the carve-outs apply where the the independent plan fiduciary has the product is understood as a sales adviser represents or acknowledges that sufficient expertise to evaluate the pitch, not a recommendation. Also, a it is acting as a fiduciary under ERISA transaction and to determine whether representative for the plan’s with respect to the advice. the transaction is prudent and in the counterparty, such as a broker, in such best interest of the plan participants a transaction, would be able to use the (1) Seller’s and Swap Carve-Outs (such person may rely on written carve-out if the conditions are met. (a) The ‘‘Seller’s Carve-Out’’ 18 representations from the plan or the Although the 2010 Proposal also had Paragraph (b)(1)(i) of the proposed plan fiduciary to satisfy this condition). a carve-out for sellers and other The second alternative applies if the regulation provides a carve-out from the counterparties, the carve-out in the new person knows or reasonably believes general definition for incidental advice proposal is significantly different. The that the independent plan fiduciary has provided in connection with an arm’s changes are designed to ensure that the responsibility for managing at least $100 length sale, purchase, loan, or bilateral carve-out appropriately distinguishes million in employee benefit plan assets contract between an expert plan incidental advice as part of an arm’s (for purposes of this condition, when investor and the adviser. It also applies length transactions with no expectation dealing with an individual employee of trust or acting in the customer’s best 18 Although the preamble uses the shorthand benefit plan, a person may rely on the interest, from those instances of advice expression ‘‘seller’s carve-out,’’ we note that the information on the most recent Form where customers may be expecting carve-out provided in paragraph (b)(1)(i) of the 5500 Annual Return/Report filed by the unbiased investment advice that is in proposal is not limited to sales but rather would plan to determine the value of plan their best interest. For example, the apply to incidental advice provided in connection with an arm’s length sale, purchase, loan, or assets, and, in the case of an seller’s carve-out is unavailable to an bilateral contract between a plan investor with independent fiduciary acting as an asset adviser if the plan directly pays a fee for financial expertise and an adviser. manager for multiple employee benefit investment advice. If a plan expressly © 2015 The Institute of Continuing Legal Education 12-43 Tax Conference, 28th Annual, May 21, 2015 21942 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules pays a fee for advice, the essence of the put the interests of the investors they comments on whether the proposed relationship is advisory, and the statute serve ahead of their own. The seller’s carve-out should be available for clearly contemplates fiduciary status. Department has addressed legitimate advice given directly to plan Thus, a service provider may not charge concerns about preserving existing fee participants, beneficiaries, and IRA the plan a direct fee to act as an adviser, practices and minimizing market owners. Further, the Department invites and then disclaim responsibility as a disruptions through proposed comments on the scope of the seller’s fiduciary adviser by asserting that he or prohibited transaction exemptions carve-out and whether the plan size she is merely an arm’s length detailed below, rather than through a limitation of 100 plan participants and counterparty. blanket carve-out from fiduciary status. 100 million dollar asset requirement in Commenters on the 2010 Proposal Moreover, excluding retail investors the proposal are appropriate conditions differed on whether the carve-out from the seller’s carve-out is consistent or whether other conditions would be should apply to transactions involving with recent congressional action, the more appropriate proxies for identifying plan participants, beneficiaries or IRA Pension Protection Act of 2006 (PPA). persons with sufficient investment- owners. After carefully considering the Specifically, the PPA created a new related expertise to be included in a issue and the public comments, the statutory exemption that allows seller’s carve-out.20 The Department is Department does not believe such a fiduciaries giving investment advice to also interested in whether existing and carve-out can or should be crafted to individuals (pension plan participants, proposed prohibited transaction cover recommendations to retail beneficiaries and IRA owners) to receive exemptions eliminate or mitigate the investors, including small plans, IRA compensation from investment vehicles need for any seller’s carve-out. owners and plan participants and that they recommend in certain circumstances. 29 U.S.C. 1108(b)(14); 26 (b) Swap and Security-Based Swap beneficiaries. As a rule, investment Transactions recommendations to such retail U.S.C. 4975(d)(17). Recognizing the customers do not fit the ‘‘arm’s length’’ risks presented when advisers receive Paragraph (b)(1)(ii) of the proposal characteristics that the seller’s carve-out fees from the investments they specifically addresses advice and other is designed to preserve. recommend to individuals, Congress communications by counterparties in Recommendations to retail investors placed important constraints on such connection with certain swap or and small plan providers are routinely advice arrangements that are calculated security-based swap transactions under presented as advice, consulting, or to limit the potential for abuse and self- the Commodity Exchange Act or the financial planning services. In the dealing, including requirements for fee- Securities Exchange Act. This broad class of financial transactions is defined securities markets, brokers’ suitability leveling or the use of independently and regulated under amendments to the obligations generally require a certified computer models. The Commodity Exchange Act and the significant degree of individualization. Department has issued regulations Securities Exchange Act by the Dodd- Research has shown that disclaimers are implementing this provision at 29 CFR Frank Act. Section 4s(h) of the ineffective in alerting retail investors to 2550.408g–1 and 408g–2. Including Commodity Exchange Act (7 U.S.C. the potential costs imposed by conflicts retail investors in the seller’s carve-out 6s(h)), and section 15F of the Securities of interest, or the fact that advice is not would undermine the protections for necessarily in their best interest, and retail investors that Congress required 20 The proposed thresholds of 100 or more may even exacerbate these costs.19 Most under this PPA provision. Although the seller’s carve-out may participants and assets of $100 million are retail investors and many small plan consistent with thresholds used for similar not be available in the retail market, the sponsors are not financial experts, are purposes under existing rules and practices. For proposal is intended to ensure that unaware of the magnitude and impact of example, administrators of plans with 100 or more small plan fiduciaries, plan participants, participants, unlike smaller plans, generally are conflicts of interest, and are unable beneficiaries and IRA owners would be required to report to the Department details on the identity, function, and compensation of their effectively to assess the quality of the able to obtain essential information advice they receive. IRA owners are services providers; file a schedule of assets held for regarding important decisions they investments; and submit audit reports to the especially at risk because they lack the make regarding their investments Department. Smaller plans are not subject to these protection of having a menu of without the providers of that same filing requirements that are imposed on large plans. The vast majority of plans with fewer than investment options chosen by a plan information crossing the line into fiduciary who is charged to protect the 100 participants have 10 or less participants. They fiduciary status. Under the platform are much more similar to individual retail investors interests of the IRA owner. Similarly, provider carve-out under paragraph than to large financially sophisticated institutional small plan sponsors are typically (b)(3), platform providers (i.e., persons investors, who employ lawyers and have the time experts in the day-to-day business of and expertise to scrutinize advice they receive for that provide access to securities or other bias. Similarly, Congress established a $100 million running an operating company, not in property through a platform or similar asset threshold in enacting the PPA statutory cross- managing financial investments for mechanism) and persons that help plan trading exemption under ERISA section 408(b)(19). others. In this retail market, a seller’s fiduciaries select or monitor investment In the transactions covered by 408(b)(19), an carve-out would run the risk of creating investment manager has discretion with respect to alternatives for their plans can perform separate client accounts that are on opposite sides a loophole that would result in the rule those services without incurring of the trade. The cross trade can create efficiencies failing to improve consumer protections fiduciary status. Similarly, under the for both clients, but it also gives rise to a prohibited by permitting the same type of investment education carve-out of transaction under ERISA § 406(b)(2) because the boilerplate disclaimers that some adviser or manager is ‘‘representing’’ both sides of paragraph (b)(6), general plan the transaction and, therefore, has a conflict of advisers now use to avoid fiduciary information, financial, investment and interest. The exemption generally allows an status under the current ‘‘five-part test’’ retirement information, and information investment manager to effect cash purchases and regulation. Persons making investment and education regarding asset allocation sales of securities for which market quotations are recommendations should be required to readily available between large sophisticated plans models would all be available to a plan, with at least $100 million in assets and another plan fiduciary, participant, beneficiary account under management by the investment 19 Loewenstein, George, Daylian Cain, Sunita Sah, or IRA owner and would not constitute manager, subject to certain conditions. In this The Limits of Transparence: Pitfalls and Potential the provision of investment advice, context, the $100 million threshold serves as a of Disclosing Conflicts of Interest, American proxy for identifying institutional fiduciaries that Economic Review: Papers and Proceedings 101, no. irrespective of who receives that can be expected to have the expertise to protect 3 (2011). information. The Department invites their own interests in the conflicted transaction. 12-44 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21943 Exchange Act of 1934 (15 U.S.C. 78o– under ERISA. Commenters also argued persons would not act as investment 10(h) establishes similar business that their obligations under the business advice fiduciaries simply by marketing conduct standards for dealers and major conduct standards could effectively or making available such investment participants in swaps or security-based preclude them from relying on the vehicles, without regard to the swaps. Special rules apply for carve-out for counterparties in the 2010 individualized needs of the plan or its transactions involving ‘‘special Proposal. Although the Department does participants and beneficiaries, as long as entities,’’ a term that includes employee not agree that the carve-out in the 2010 they disclose in writing that they are not benefit plans under ERISA, but not IRAs Proposal would have been unavailable undertaking to provide impartial and other non-ERISA plans. to plan’s swap counterparty (see letter investment advice or to give advice in In outline, paragraph (b)(1)(ii) of the dated April 28, 2011, to CFTC Chairman a fiduciary capacity. proposal would allow swap dealers, Gary Gensler from EBSA’s Assistant Similarly, a separate provision at security-based swap dealers, major swap Secretary Phyllis Borzi), the separate paragraph (b)(4) carves out certain participants and security-based major proposed carve-out for swap and common activities that platform swap participants who make security-based swap transactions in the providers may carry out to assist plan recommendations to plans to avoid proposal should avoid any fiduciaries in selecting and monitoring becoming ERISA investment advice uncertainty.21 The Department will the investment alternatives that they fiduciaries when acting as continue to coordinate its efforts with make available to plan participants. counterparties to a swap or security- staff of the SEC and CFTC to ensure that Under paragraph (b)(4), merely based swap transaction. Under the swap any final regulation is consistent with identifying offered investment carve out, if the person providing the agencies’ work in connection with alternatives meeting objective criteria recommendations is a swap dealer or the Dodd-Frank Act’s business conduct specified by the plan fiduciary or security-based swap dealer, it must not standards. providing objective financial data be acting as an adviser to the plan, regarding available alternatives to the within the meaning of the applicable (2) Employees of the Plan Sponsor plan fiduciary would not cause a business conduct standards regulations The proposal at paragraph (b)(2) platform provider to be a fiduciary of the CFTC or the SEC. In addition, provides that employees of a plan investment adviser. These two carve- before providing any recommendations sponsor of an ERISA plan would not be outs are clarifying modifications to the with respect to the transaction, the treated as investment advice fiduciaries corresponding provisions of the 2010 person providing recommendations with respect to advice they provide to Proposal. They address certain common must obtain a written representation the fiduciaries of the sponsor’s plan as practices that have developed with the from the independent plan fiduciary, long as they receive no compensation growth of participant-directed that the fiduciary will not rely on for the advice beyond their normal individual account plans and recognize recommendations provided by the compensation as employees of the plan circumstances where the platform person. sponsor. This carve-out from the scope provider and the plan fiduciary clearly Under the Commodity Exchange Act, of the fiduciary investment advice understand that the provider has swap dealers or major swap participants definition recognizes that internal financial or other relationships with the that act as counterparties to ERISA employees, such as members of a offered investments and is not plans, must have a reasonable basis to company’s human resources purporting to provide impartial believe that the plans have independent department, routinely develop reports investment advice. It also representatives who are fiduciaries and recommendations for investment accommodates the fact that platform under ERISA. 7 U.S.C. 6s(h)(5). Similar committees and other named fiduciaries providers often provide general requirements apply for security-based of the sponsors’ plans, without acting as financial information that falls short of swap transactions. 15 U.S.C 78o– paid fiduciary advisers. The carve-out constituting actual investment advice or 10(h)(4) and (5). The CFTC has issued responds to and addresses the concerns recommendations, such as information a final rule to implement these of commenters who said that these on the historic performance of asset requirements and the SEC has issued a personnel should not be treated as classes and of the investments available proposed rule that would cover fiduciaries because their advice is through the provider. The carve-outs security-based swaps. 17 CFR 23.400 to largely incidental to their duties on also reflect the Department’s agreement 23.451 (2012). behalf of the plan sponsor and they with commenters that a platform Paragraph (b)(1)(ii) reflects the receive no compensation for these provider who merely identifies Department’s coordination of its efforts advice-related functions. investment alternatives using objective with staff of the SEC and CFTC, and is third-party criteria (e.g., expense ratios, (3) Platform Providers/Selection and intended to provide a clear road-map for fund size, or asset type specified by the Monitoring Assistance swap counterparties to avoid ERISA plan fiduciary) to assist in selecting and fiduciary status in arm’s length The carve-out at paragraph (b)(3) of monitoring investment alternatives transactions with plans. The provision the proposal is directed to service should not be considered to be addresses commenters’ concerns that providers, such as recordkeepers and rendering investment advice. the conduct required for compliance third party administrators, that offer a While recognizing the utility of the with the Dodd-Frank Act’s business ‘‘platform’’ or selection of investment provisions in paragraphs (b)(3) and conduct standards could constitute vehicles to participant-directed (b)(4) for the effective and efficient fiduciary investment advice under individual account plans under ERISA. operation of plans by plan sponsors, ERISA even in connection with arm’s Under the terms of the carve-out, the plan fiduciaries and plan service length transactions with plans that are plan fiduciaries must choose the providers, the Department reiterates its separately represented by independent specific investment alternatives that longstanding view, recently codified in fiduciaries who are not looking to their will be made available to participants 29 CFR 2550.404a–5(f) and 2550.404c– counterparties for disinterested advice. for investing their individual accounts. 1(d)(2)(iv) (2010), that a fiduciary is If that were the case, swaps and The carve-out merely makes clear that always responsible for prudently security-based swaps with plans would selecting and monitoring providers of often constitute prohibited transactions 21 http://www.dol.gov/ebsa/pdf/cftc20110428.pdf. services to the plan or designated © 2015 The Institute of Continuing Legal Education 12-45 Tax Conference, 28th Annual, May 21, 2015 21944 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules investment alternatives offered under operative text, but with the important distinction between non-fiduciary the plan. exceptions explained below. Paragraph education and fiduciary advice applies Several commenters also asked the (b)(6) of the proposed regulation, if equally to information provided to plan Department to clarify that the platform finalized, would supersede IB 96–1. fiduciaries as well as information provider carve-out is available in the Consistent with IB 96–1, paragraph provided to plan participants and 403(b) plan marketplace. In the (b)(6) makes clear that furnishing or beneficiaries and IRA owners, and that Department’s view, a 403(b) plan that is making available the specified it applies equally to participant-directed subject to Title I of ERISA would be an categories of information and materials plans and other plans. In addition, the individual account plan within the to a plan, plan fiduciary, participant, provision applies without regard to meaning of ERISA section 3(34) of the beneficiary or IRA owner will not whether the information is provided by Act for purposes of the proposed constitute the rendering of investment a plan sponsor, fiduciary, or service regulation, so the platform provider advice, irrespective of who provides the provider. carve-out would be available with information (e.g., plan sponsor, Based on public input received in respect to such plans. fiduciary or service provider), the connection with its joint examination of Other commenters asked that the frequency with which the information is lifetime income issues with the platform provider provision be generally shared, the form in which the Department of the Treasury, the extended to apply to IRAs. In the IRA information and materials are provided Department is persuaded that additional context, however, there typically is no (e.g., on an individual or group basis, in guidance may help improve retirement separate independent ‘‘plan fiduciary’’ writing or orally, via a call center, or by security by facilitating the provision of who interacts with the platform way of video or computer software), or information and education relating to provider to protect the interests of the whether an identified category of retirement needs that extend beyond a account owners. As a result, it is much information and materials is furnished participant’s or beneficiary’s date of more difficult to conclude that the or made available alone or in retirement. Accordingly, paragraph transaction is truly arm’s length or to combination with other categories of (b)(6) of the proposal includes specific draw a bright line between fiduciary investment or retirement information language to make clear that the and non-fiduciary communications on and materials identified in paragraph provision of certain general information investment options. Consequently, the (b)(6), or the type of plan or IRA that helps an individual assess and proposed regulation declines to extend involved. As a departure from IB 96–1, understand retirement income needs application of this carve-out to IRAs and a new condition of the carve-out for past retirement and associated risks other non-ERISA plans. As the investment education is that the (e.g., longevity and inflation risk), or Department continues its work on this information and materials not include explains general methods for the regulatory project, however, it requests advice or recommendations as to individual to manage those risks both specific comment as to the types of specific investment products, specific within and outside the plan, would not platforms and options that may be investment managers, or the value of result in fiduciary status under the offered to IRA owners, how they may be particular securities or other property. proposal.22 similar to or different from platforms The paragraph reflects the Department’s offered in connection with participant- view that the statutory reference to 22 Although the proposal would formally remove directed individual account plans, and ‘‘investment advice’’ is not meant to IB 96–1 from the CFR, the Department notes that whether it would be appropriate for encompass general investment paragraph (e) of IB 96–1 provides generalized service providers not to be treated as information and educational materials, guidance under section 405 and 404(c) of ERISA fiduciaries under this carve-out when with respect to the selection by employers and plan but rather is targeted at more specific fiduciaries of investment educators and the lack of marketing such platforms to IRA recommendations and advice on the responsibility of employers and fiduciaries with owners. We also invite comments, investment of plan and IRA assets. respect to investment educators selected by alternatively, on whether the scope of Similar to IB 96–1, paragraph (b)(6) of participants. Specifically, paragraph (e) states: this carve-out should be limited to large the proposed regulation divides As with any designation of a service provider to a plan, the designation of a person(s) to provide plans, similar to the scope of the investment education information and investment educational services or investment ‘‘Seller’s Carve-out’’ discussed above. materials into four general categories: (i) advice to plan participants and beneficiaries is an As a corollary to the proposal’s Plan information; (ii) general financial, exercise of discretionary authority or control with restriction of the applicability of the investment and retirement information; respect to management of the plan; therefore, persons making the designation must act prudently platform provider carve-out to only (iii) asset allocation models; and (iv) and solely in the interest of the plan participants ERISA plans, the selection and interactive investment materials. The and beneficiaries, both in making the designation(s) monitoring assistance carve-out is proposed regulation in paragraph and in continuing such designation(s). See ERISA similarly not available in the IRA and (b)(6)(v) also adopts the provision from sections 3(21)(A)(i) and 404(a), 29 U.S.C. 1002 (21)(A)(i) and 1104(a). In addition, the designation other non-ERISA plans context. IB 96–1 stating that there may be other of an investment advisor to serve as a fiduciary may Commenters on the platform provider examples of information, materials and give rise to co-fiduciary liability if the person restriction are encouraged to offer their educational services which, if making and continuing such designation in doing views on the effect of this restriction in furnished, would not constitute so fails to act prudently and solely in the interest investment advice or recommendations of plan participants and beneficiaries; or knowingly the non-ERISA plan marketplace. participates in, conceals or fails to make reasonable within the meaning of the proposed (4) Investment Education efforts to correct a known breach by the investment regulation and that no inference should advisor. See ERISA section 405(a), 29 U.S.C. Paragraph (b)(6) of the proposed be drawn regarding materials or 1105(a). The Department notes, however, that, in regulation is similar to a carve-out in the information which are not specifically the context of an ERISA section 404(c) plan, neither the designation of a person to provide education 2010 Proposal for the provision of included in paragraph (b)(6)(i) through nor the designation of a fiduciary to provide investment education information and (iv). investment advice to participants and beneficiaries materials within the meaning of an Although paragraph (b)(6) would, in itself, give rise to fiduciary liability for earlier Interpretive Bulletin issued by incorporates most of the relevant text of loss, or with respect to any breach of part 4 of title I of ERISA, that is the direct and necessary result the Department in 1996. 29 CFR IB 96–1, there are important changes. of a participant’s or beneficiary’s exercise of 2509.96–1 (IB 96–1). Paragraph (b)(6) One change from IB 96–1 is that independent control. 29 CFR 2550.404c–1(d). The incorporates much of IB 96–1’s paragraph (b)(6) makes clear that the Department also notes that a plan sponsor or 12-46 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21945 As noted, another change is that the recommendations, regardless of caveats. but is not limited to, brokerage fees, Department is not incorporating the Accordingly, paragraphs (b)(6)(iii) and mutual fund sales, and insurance sales provisions at paragraph (d)(3)(iii) and (iv) relating to asset allocation models commissions. (4)(iv) of IB 96–1. Those provisions of IB and interactive investment materials Paragraph (c)(3) of the 2010 Proposal 96–1 permit the use of asset allocation preclude the identification of specific used similar language, but it also models that refer to specific investment investment alternatives available under provided that the term included fees products available under the plan or the plan or IRA in order for the and compensation based on multiple IRA, as long as those references to materials described in those paragraphs transactions involving different parties. specific products are accompanied by a to be considered investment education. Commenters found this provision statement that other investment Thus, for example, we would not treat confusing and it does not appear in the alternatives having similar risk and an asset allocation model as mere new proposal. The provision was return characteristics may be available. education if it called for a certain intended to confirm the Department’s Based on its experience with the IB 96– percentage of the investor’s assets to be position that fees charged on a so-called 1 since publication, as well as views invested in large cap mutual funds, and ‘‘omnibus’’ basis (e.g., compensation expressed by commenters to the 2010 accompanied that proposed allocation paid based on business placed or Proposal, the Department now believes with the identity of a specific fund or retained that includes plan or IRA that, even when accompanied by a provider. In that circumstance, the business) would constitute fees and statement as to the availability of other adviser has made a specific investment compensation for purposes of the rule. investment alternatives, these types of recommendation that should be treated Direct or indirect compensation also specific asset allocations that identify as fiduciary advice and adhere to includes any compensation received by specific investment alternatives fiduciary standards. Further, materials affiliates of the adviser that is connected function as tailored, individualized that identify specific plan investment to the transaction in which the advice investment recommendations, and can alternatives also appear to fall within was provided. For example, when a effectively steer recipients to particular the definition of ‘‘recommendation’’ in fiduciary adviser recommends that a investments, but without adequate paragraph (f)(1) of the proposal, and participant or IRA owner invest in a protections against potential abuse.23 could result in fiduciary status on the mutual fund, it is not unusual for an In particular, the Department agrees part of a provider if the other provisions affiliated adviser to the mutual fund to with those commenters to the 2010 of the proposal are met. The Department receive a fee. The receipt by the affiliate Proposal who argued that cautionary believes that effective and useful asset of advisory fees from the mutual fund is disclosures to participants, allocation education materials can be indirect compensation in connection beneficiaries, and IRA owners may have prepared and delivered to participants with the rendering of investment advice limited effectiveness in alerting them to and IRA owners without including to the participant. the merit and wisdom of evaluating specific investment products and Some commenters additionally investment alternatives not used in the alternatives available under the plan. suggested that call center employees model. In practice, asset allocation The Department understands that not should not be treated as investment models concerning hypothetical incorporating the provisions of IB 96–1 advice fiduciaries where they are not individuals, and interactive materials at paragraph (d)(3)(iii) and (4)(iv) into specifically paid to provide investment which arrive at specific investment the proposal represents a significant advice and their compensation does not products and plan alternatives, can be change in the information and materials change based on their communications indistinguishable to the average that may constitute investment with participants and beneficiaries. The retirement investor from individualized education. Accordingly, the Department carve-out from the fiduciary investment invites comments on whether this advice definition for investment fiduciary would have no fiduciary responsibility or change is appropriate.24 education provides guidelines under liability with respect to the actions of a third party which call center staff and other selected by a participant or beneficiary to provide D. Fee or Other Compensation employees providing similar investor education or investment advice where the plan sponsor or fiduciary neither selects nor endorses A necessary element of fiduciary assistance services may avoid fiduciary the educator or advisor, nor otherwise makes status under section 3(21)(A)(ii) of status. However, commenters stated that arrangements with the educator or advisor to ERISA is that the investment advice be a specific carve-out for such call centers provide such services. for a ‘‘fee or other compensation, direct would provide a greater level of Unlike the remainder of the IB, this text does not belong in the investment advice regulation. Also, or indirect.’’ Consistent with the statute, certainty so as not to inhibit mutual the principles articulated in paragraph (e) are paragraph (f)(6) of the proposed funds, insurance companies, broker- generally understood and accepted such that regulation defines this phrase to mean dealers, recordkeepers and other retaining the paragraph as a stand-alone IB does not any fee or compensation for the advice financial service providers from appear necessary or appropriate. received by the advice provider (or by continuing to make such assistance 23 When the Department issued IB 96–1, it expressed concern that service providers could an affiliate) from any source and any fee available to participants and effectively steer participants to a specific or compensation incident to the beneficiaries in 401(k) and similar investment alternative by identifying only one transaction in which the investment participant-directed plans. In the particular fund available under the plan in advice has been rendered or will be Department’s view, such a carve-out connection with an asset allocation model. As a result, where it was possible to do so, the rendered. It further provides that the would be inappropriate. The fiduciary Department encouraged service providers to term ‘‘fee or compensation’’ includes, definition is intended to apply broadly identify other investment alternatives within an to all persons who engage in the asset class as part of a model. Ultimately, however, 24 As indicated earlier in this Notice, the activities set forth in the regulation, when asset allocation models and interactive Department believes that FINRA’s guidance in this regardless of job title or position, or investment materials identified any specific area may provide useful standards and guideposts investment alternative available under the plan, the for distinguishing investment education from whether the advice is rendered in Department required an accompanying statement investment advice under ERISA. The Department person, in writing or by phone. If, in the both indicating that other investment alternatives specifically solicits comments on the discussion in performance of their jobs, call center having similar risk and return characteristics may FINRA’s ‘‘Frequently Asked Questions, FINRA Rule employees make specific investment be available under the plan and identifying where 2111 (Suitability)’’ of the term ‘‘recommendation’’ information on those investment alternatives could in the context of asset allocation models and recommendations to plan participants be obtained. 61 FR 29586, 29587 (June 11, 1996). general investment strategies. or IRA owners under the circumstances © 2015 The Institute of Continuing Legal Education 12-47 Tax Conference, 28th Annual, May 21, 2015 21946 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules described in the proposal, it is 3(21)(A)(ii) of ERISA and the fiduciary, irrespective of labels. appropriate to treat them, and possibly definition’s counterpart in section Moreover, the statutory definition of their employers, as fiduciaries unless 4975(e)(3)(B) of the Code. As a result, it fiduciary advice is identical under both they meet the conditions of one of the applies to persons who give investment ERISA and the Code. There is no carve-outs set forth above. advice to IRAs. In this respect, the new indication that the definition should proposal is the same as the 2010 vary between plans and IRAs. E. Coverage of IRAs and Other Non- Proposal. In light of this statutory framework, ERISA Plans Many comments on the 2010 Proposal the Department does not believe it Certain provisions of Title I of ERISA, concerned its impact on IRAs and would be appropriate to carve out a 29 U.S.C. 1001–1108, such as those questioned whether the Department had special rule for IRAs, or for brokers or relating to participation, benefit accrual, adequately considered possible negative others who make specific investment and prohibited transactions also appear impacts. Some commenters were recommendations to IRA owners or to in the Code. This parallel structure especially concerned that application of other participants in non-ERISA plans ensures that the relevant provisions the new rule could disrupt existing for direct or indirect fees. When apply to all tax-qualified plans, brokerage arrangements that they Congress enacted ERISA and the including IRAs. With regard to believe are beneficial to customers. In corresponding Code provisions, it chose prohibited transactions, the Title I particular, brokers often receive revenue to impose fiduciary status on persons provisions generally authorize recovery sharing, 12b–1 fees, and other who provide investment advice to of losses from, and imposition of civil compensation from the parties whose plans, participants, beneficiaries and penalties on, the responsible plan investment products they recommend. If IRA owners, and to specifically prohibit fiduciaries, while the Code provisions the brokers were treated as fiduciaries, a wide variety of transactions in which impose excise taxes on persons engaging the receipt of such fees could violate the the fiduciary has financial interests that in the prohibited transactions. The Code’s prohibited transaction rules, potentially conflict with the fiduciary’s definition of fiduciary with respect to a unless eligible for a prohibited obligation to the plan or IRA. It did not plan is the same in section 4975(e)(3)(B) transaction exemption. According to provide a special carve-out for brokers of the IRC as the definition in section these commenters, the disruption of or IRAs, and the Department does not 3(21)(A)(ii) of ERISA, 29 U.S.C. such current fee arrangements could believe it would be appropriate to write 1002(21)(A)(ii), and the Department’s result in a reduced level of assistance to such a carve-out into the regulation 1975 regulation defining fiduciary investors, higher up-front fees, and less implementing the statutory definition. investment advice is virtually identical investment advice, particularly to Indeed, brokers who give investment to regulations that define the term investors with small accounts. In advice to IRA owners or plan ‘‘fiduciary’’ under the Code. 26 CFR addition, some commenters expressed participants, and who otherwise meet 54.4975–9(c) (1975). skepticism that the imposition of the terms of the current five-part test, To rationalize the administration and fiduciary standards would result in are already fiduciaries under the interpretation of dual provisions under improved advice and questioned the existing fiduciary regulation. If, for ERISA and the Code, Reorganization view that current compensation example, a broker regularly advises an Plan No. 4 of 1978 divided the arrangements could cause sub-optimal individual IRA owner on specific interpretive and rulemaking authority advice. Additionally, commenters investments, the IRA owner routinely for these provisions between the stressed the need for coordination follows the recommendations, and both Secretaries of Labor and of the Treasury, between the Department and other parties understand that the IRA owner so that, in general, the agency with regulatory agencies, such as the SEC, relies upon the broker’s advice, the responsibility for a given provision of CFTC, and Treasury. broker is almost certainly a fiduciary. In Title I of ERISA would also have As discussed above, to better align the such circumstances, the broker is responsibility for the corresponding regulatory definition of fiduciary with already subject to the excise tax on provision in the Code. Among the the statutory provisions and underlying prohibited transactions if he or she sections transferred to the Department Congressional goals, the Department is receives fees from a third party in were the prohibited transaction proposing a definition of a fiduciary connection with recommendations to provisions and the definition of a investment advice that would invest IRA assets in the third party’s fiduciary in both Title I of ERISA and encompass investment investment products, unless the broker in the Code. ERISA’s prohibited recommendations that are satisfies the conditions of a prohibited transaction rules, 29 U.S.C. 1106–1108, individualized or specifically directed transaction exemption that covers the apply to ERISA-covered plans, and the to plans, participants, beneficiaries or particular fees. Indeed, broker-dealers Code’s corresponding prohibited IRA owners, if the adviser receives a today can provide fiduciary investment transaction rules, 26 U.S.C. 4975(c), direct or indirect fee. Neither the advice by complying with prohibited apply both to ERISA-covered pension relevant statutory provisions, nor the transaction exemptions that permit the plans that are tax-qualified pension current regulation, draw a distinction receipt of commission-based plans, as well as other tax-advantaged between brokers and other advisers or compensation for the sale of mutual arrangements, such as IRAs, that are not carve brokers out of the scope of the funds and other securities. Moreover, subject to the fiduciary responsibility fiduciary provisions of ERISA and of the both ERISA and the Code were amended Code. The relevant statutory provisions, as part of the PPA to include a new and prohibited transaction rules in and accordingly the proposed prohibited transaction exemption that ERISA.25 Given this statutory structure, and the regulation, establish a functional test applies to investment advice in both the dual nature of the 1975 regulation, the based on the service provider’s actions, plan and IRA context. The PPA proposal would apply to both the rather than the provider’s title (e.g., exemption clearly reflects the definition of ‘‘fiduciary’’ in section broker or registered investment adviser). longstanding concern under ERISA and If one engages in specified activities, the Code about the dangers posed by 25 The Secretary of Labor also was transferred such as the provision of investment conflicts of interest, and the need for authority to grant administrative exemptions from advice for a direct or indirect fee, the appropriate safeguards in both the plan the prohibited transaction provisions of the Code. person engaging in those activities is a and IRA markets. Under the terms of the 12-48 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21947 exemption, the investment the benefit of an independent plan regarding other non-ERISA plans such recommendations must either result fiduciary to represent their interests in as Health Savings Accounts (HSAs), from the application of an unbiased and selecting a menu of investment options Archer Medical Savings Accounts and independently certified computer or structuring advice arrangements. Coverdell Education Savings Accounts program or the fiduciary’s fees must be They cannot sue fiduciary advisers were less prolific. The Department notes level (i.e., the fiduciary’s compensation under ERISA for losses arising from that these accounts are given tax cannot vary based on his or her fiduciary breaches, nor can the preferences as are IRAs. Further, some particular investment Department sue on their behalf. of the accounts, such as HSAs, can be recommendations). Compared to participants with ERISA used as long term savings accounts for Moreover, as discussed in the plan accounts, IRA owners often have retiree health care expenses. These regulatory impact analysis below, there larger account balances and are more types of accounts also are expressly is substantial evidence to support the likely to be elderly. Thus, limiting the defined by Code section 4975(e)(1) as statutory concern about conflicts of harms to IRA investors resulting from plans that are subject to the Code’s interest. As the analysis reflects, conflicts of interest of advisers is at least prohibited transaction rules. Thus, unmitigated conflicts can cause as important as protecting ERISA plans although they generally may hold fewer significant harm to investors. The and plan participants from such harms. assets and may exist for shorter available evidence supports a finding The Department believes that it is durations than IRAs, the owners of these that the negative impacts are present important to address the concerns of accounts or the persons for whom these and often times large. The proposal brokers and others providing investment accounts were established are entitled to would curtail the harms to investors advice to IRA owners about undue receive the same protections from from such conflicts and thus deliver disruptions to current fee arrangements, conflicted investment advice as IRA significant benefits to plan participants but also believes that such concerns are owners. Accordingly, these accounts are and IRA owners. Plans, plan best resolved within a fiduciary included in the scope of covered plans participants, beneficiaries and IRA framework, rather than by simply in paragraph (f)(2) of the new proposal. owners would all benefit from advice relieving advisers from fiduciary However, the Department solicits that is impartial and puts their interests responsibility. As previously discussed, specific comment as to whether it is first. Moreover, broker-dealer the proposed regulation permits appropriate to cover and treat these interactions with plan fiduciaries, investment professionals to provide plans under the proposed regulation in participants, and IRA owners present important financial information and a manner similar to IRAs as to both some of the most obvious conflict of education, without acting as fiduciaries coverage and applicable carve-outs. interest problems in this area. or being subject to the prohibited transaction rules. Moreover, ERISA and F. Administrative Prohibited Accordingly, in the Department’s view, Transaction Exemptions broker-dealers that provide investment the Code create a flexible process that advice should be subject to fiduciary enables the Department to grant class In addition to the new proposal in duties to mitigate conflicts of interest and individual exemptions from the this Notice, the Department is also and increase investor protections. prohibited transaction rules for fee proposing, elsewhere in this edition of Some commenters additionally practices that it determines are the Federal Register, certain suggested that the application of special beneficial to plan participants and IRA administrative class exemptions from fiduciary rules in the retail investment owners. For example, existing the prohibited transaction provisions of market to IRA accounts, but not savings prohibited transaction exemptions ERISA (29 U.S.C. 1106), and the Code outside of tax-preferred retirement already allow brokers who provide (26 U.S.C. 4975(c)(1)) as well as accounts, is inappropriate and could fiduciary advice to receive commissions proposed amendments to previously lead to confusion among investors and generating conflicts of interest for adopted exemptions. The proposed service providers. The distinction trading the types of securities and funds exemptions and amendments would allow, subject to appropriate safeguards, between IRAs and other retail accounts, that make up the large majority of IRA certain broker-dealers, insurance agents however, is a direct result of a statutory assets today. In addition, simultaneous and others that act as investment advice structure that draws a sensible with the publication of this proposed fiduciaries to nevertheless continue to distinction between tax-favored IRAs regulation, the Department is publishing receive a variety of forms of and other retail investment accounts. new exemption proposals that would compensation that would otherwise The Code itself treats IRAs differently, permit common fee practices, while at violate prohibited transaction rules and bestowing uniquely favorable tax the same time protecting plan trigger excise taxes. The proposed treatment on such accounts and participants, beneficiaries and IRA exemptions would supplement statutory prohibiting self-dealing by persons owners from abuse and conflicts of exemptions at 29 U.S.C. 1108 and 26 providing investment advice for a fee. In interest. As noted above, in contrast with many previously adopted PTE U.S.C. 4975(d), and previously adopted these respects, and in light of the special exemptions that are transaction-specific, class exemptions. public interest in retirement security, the Best Interest Contract PTE described Investment advice fiduciaries to plans IRAs are more like plans than like other below reflects a more flexible approach and plan participants must meet retail accounts. Indeed, as noted above, that accommodates a wide range of ERISA’s standards of prudence and the vast majority of IRA assets today are current business practices while loyalty to their plan customers. Such attributable to rollovers from plans.26 In minimizing the impact of conflicts of fiduciaries also face taxes, remedies and addition, IRA owners may be at even interest and ensuring that plans and other sanctions for engaging in certain greater risk from conflicted advice than IRAs receive investment transactions, such as self-dealing with plan participants. Unlike ERISA plan recommendations that are in their best plan assets or receiving payments from participants, IRA owners do not have interests. third parties in connection with plan As discussed, the Department transactions, unless the transactions are 26 Peter Brady, Sarah Holden, and Erin Shon, The U.S. Retirement Market, 2009, Investment Company received extensive comment on the permitted by an exemption from Institute, Research Fundamentals, Vol. 19, No. 3, application of the 2010 Proposal’s ERISA’s and the Code’s prohibited May 2010, at http://www.ici.org/pdf/fm-v19n3.pdf. provisions to IRAs, but comments transaction rules. IRA fiduciaries do not © 2015 The Institute of Continuing Legal Education 12-49 Tax Conference, 28th Annual, May 21, 2015 21948 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules have the same general fiduciary reasonably designed to mitigate any imposed on investors by such conflicts. obligations of prudence and loyalty harmful impact of conflicts of interest, The exemption is designed both to under the statute, but they too must and disclose basic information on their impose broad fiduciary standards of adhere to the prohibited transaction conflicts of interest and on the cost of conduct on advisers and financial rules or they must pay an excise tax. their advice. The standards of impartial institutions, and to give them sufficient The prohibited transaction rules help conduct to which the adviser and firm flexibility to accommodate a wide range ensure that investment advice provided must commit are basic obligations of fair of business practices and compensation to plan participants and IRA owners is dealing and fiduciary conduct to which structures that currently exist or that not driven by the adviser’s financial the Department believes advisers and may develop in the future. self-interest. firms often informally commit—to give The Department is also considering an advice that is in the customer’s best Proposed Best Interest Contract additional streamlined exemption that interest; avoid misleading statements; Exemption (Best Interest Contract PTE) would apply to compensation received and receive no more than reasonable in connection with investments by The proposed Best Interest Contract compensation. This standards-based plans, participants and beneficiaries, PTE would provide broad and flexible approach aligns the adviser’s interests and IRA owners, in certain high-quality, relief from the prohibited transaction with those of the plan or IRA customer, low-fee investments, subject to fewer restrictions on certain compensation while leaving the adviser and conditions than in the proposed Best received by investment advice employing firm the flexibility and Interest Contract PTE. If properly fiduciaries as a result of a plan’s or discretion necessary to determine how crafted, the streamlined exemption IRA’s purchase, sale or holding of best to satisfy these basic standards in could achieve important goals of specifically identified investments. The light of the unique attributes of their minimizing compliance burdens for conditions of the exemption are business. advisers and financial institutions when generally principles-based rather than As an additional protection for retail they offer investment products with prescriptive and require, in particular, investors, the exemption would not little potential for material conflicts of that advice be provided in the best apply if the contract contains interest. The Department is not interest of the plan or IRA. This exculpatory provisions disclaiming or proposing text for such a streamlined exemption was developed partly in otherwise limiting liability of the exemption due to the difficulty in response to comments received that adviser or financial institution for operationalizing this concept. However suggested such an approach. It is a violation of the contract’s terms. the Department is eager to receive Adopting the approach taken by FINRA, significant departure from existing comments on whether such an the contract could require the parties to exemptions, examples of which are exemption would be worthwhile and, as arbitrate individual claims, but it could discussed below, which are limited to part of the notice proposing the Best not limit the rights of the plan, much narrower categories of Interest Contract PTE, is soliciting participant, beneficiary, or IRA owner to investments under more prescriptive comments on a number of issues bring or participate in a class action and less flexible and adaptable relating to the design of a streamlined against the adviser or financial conditions. exemption. The proposed Best Interest Contract institution. PTE was developed to promote the Additional conditions would apply to Proposed Principal Transaction provision of investment advice that is in firms that limit the products that their Exemption (Principal Transaction PTE) advisers can recommend based on the the best interest of retail investors, such Broker-dealers and other advisers as plan participants and beneficiaries, receipt of third party payments or the proprietary nature of the products (i.e., commonly sell debt securities out of IRA owners, and small plans. The their own inventory to plans, proposed exemption would apply to products offered or managed by the firm or its affiliates) or for other reasons. The participants and beneficiaries and IRA compensation received by individual owners in a type of transaction known investment advice fiduciaries (including conditions require, among other things, 27 that such firms provide notice of the as a ‘‘principal transaction.’’ Fiduciaries individual advisers and firms that trigger taxes, remedies and other legal employ or otherwise contract with such limitations to plans, participants and beneficiaries and IRA owners, as well as sanctions when they engage in such individuals) as well as their affiliates activities, unless they qualify for an and related entities, that is provided in make a written finding that the limitations do not prevent advisers from exemption from the prohibited connection with the purchase, sale or transaction rules. These principal holding of certain assets by the plans, providing advice in those investors’ best interest. transactions raise issues similar to those participants and beneficiaries, and IRAs. addressed in the Best Interest Contract In order to protect the interests of these Finally, certain notice and data collection requirements would apply to PTE, but also raise unique concerns investors, the exemption requires the because the conflicts of interest are firm and the adviser to contractually all firms relying on the exemption. Specifically, firms would be required to particularly acute. In these transactions, acknowledge fiduciary status, commit to the adviser sells the security directly adhere to basic standards of impartial notify the Department in advance of doing so, and they would have to from its own inventory, and may be able conduct, warrant that they will comply to dictate the price that the plan, with applicable federal and state laws maintain certain data, and make it available to the Department upon participant or beneficiary, or IRA owner governing advice and that they have pays. adopted policies and procedures request, to help evaluate the effectiveness of the exemption in Because of the prevalence of the practice in the market for fixed income 27 By using the term ‘‘adviser,’’ the Department safeguarding the interests of plan and does not intend to limit the exemption to IRA investors. securities, the Department has proposed investment advisers registered under the The Department’s intent in crafting a separate Principal Transactions PTE Investment Advisers Act of 1940; under the the Best Interest Contract PTE is to that would permit principal transactions exemption an adviser is individual who can be a in certain debt securities between a plan representative of a registered investment adviser, a permit common compensation bank or similar financial institution, an insurance structures that create conflicts of or IRA owner and an investment advice company, or a broker-dealer. interest, while minimizing the costs fiduciary, under certain circumstances. 12-50 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21949 The Principal Transaction PTE would standards required in the Best Interest provide relief for these types of include all of the contract requirements Contract PTE. At the same time, the transactions in PTE 86–128, and so is of the Best Interest Contract PTE. In proposed amendment would eliminate proposing to revoke PTE 75–1, Part II(2), addition, however, it would include relief for investment advice fiduciaries in its entirety. As discussed in more specific conditions related to the price to IRA owners; instead they would be detail in the notice of proposed of the debt security involved in the required to rely on the Best Interest amendment/revocation, the Department transaction. The adviser would have to Contract PTE for an exemption for such believes the conditions of PTE 86–128 obtain two price quotes from compensation. In the Department’s are more appropriate for these unaffiliated counterparties for the same view, the provisions in the Best Interest transactions. or a similar security, and the transaction Contract Exemption better address the PTE 75–1, Part V, currently permits would have to occur at a price at least interests of IRAs with respect to broker-dealers to extend credit to a plan as favorable to the plan or IRA as the transactions otherwise covered by PTE or IRA in connection with the purchase two price quotes. Additionally, the 86–128 and, unlike plan participants or sale of securities. The exemption adviser would have to disclose the and beneficiaries, there is no separate does not permit broker-dealers that are amount of compensation and profit plan fiduciary in the IRA market to fiduciaries to receive compensation (sometimes referred to as a ‘‘mark up’’ review and authorize the transaction. when doing so. The Department is or ‘‘mark down’’) that it expects to Investment advice fiduciaries to plans proposing to amend PTE 75–1, Part V, receive on the transaction. would remain eligible for relief under to permit investment advice fiduciaries the exemption, as would investment Amendments to Existing PTEs to receive compensation for lending managers with full investment money or otherwise extending credit, In addition to the Best Interest discretion over the investments of plans but only for the limited purpose of Contract PTE and the Principal and IRA owners, but they would be avoiding a failed securities transaction. Transaction PTE, the Department is also required to comply with all the proposing elsewhere in the Federal protective conditions, described above. Prohibited Transaction Exemption Register amendments to certain existing Finally, the Department is proposing 84–24 PTEs. that PTE 86–128 extend to a new PTE 84–24 30 covers transactions Prohibited Transaction Exemption covered transaction, for fiduciaries who involving mutual fund shares, or 86–128 sell mutual fund shares out of their own insurance or annuity contracts, sold to inventory (i.e., acting as principals, plans or IRA investors by pension Prohibited Transaction Exemption rather than agents) to plans and IRAs (PTE) 86–128 28 currently allows an consultants, insurance agents, brokers, and to receive commissions for doing and mutual fund principal underwriters investment advice fiduciary to cause the so. This transaction is currently the recipient plan or IRA to pay the who are fiduciaries as a result of advice subject of another exemption, PTE 75– they give in connection with these investment advice fiduciary or its 1, Part II(2) (discussed below) that the affiliate a fee for effecting or executing transactions. The exemption allows Department is proposing to revoke. these investment advice fiduciaries to securities transactions as agent. To Several changes are proposed with receive a sales commission with respect prevent churning, the exemption does respect to PTE 75–1, a multi-part to products purchased by plans or IRA not apply if such transactions are exemption for securities transactions investors. The exemption is limited to excessive in either amount or frequency. involving broker dealers and banks, and The exemption also allows the plans and IRAs.29 Part I(b) and (c) sales commissions that are reasonable investment advice fiduciary to act as an currently provide relief for certain non- under the circumstances. The agent for both the plan and the other fiduciary services to plans and IRAs. investment advice fiduciary must party to the transaction (i.e., the buyer The Department is proposing to revoke provide disclosure of the amount of the and the seller of securities) and receive these provisions, and require persons commission and other terms of the a reasonable fee. To use the exemption, seeking to engage in such transactions to transaction to an independent fiduciary the fiduciary cannot be a plan rely instead on the existing statutory of the plan or IRA, and obtain approval administrator or employer, unless all exemptions provided in ERISA section for the transaction. To use this profits earned by these parties are 408(b)(2) and Code section 4975(d)(2), exemption, the investment advice returned to the plan. The conditions of and the Department’s implementing fiduciary may not have certain roles the exemption require that a plan regulations at 29 CFR 2550.408b–2. The with respect to the plan or IRA such as fiduciary independent of the investment Department believes the conditions of trustee, plan administrator, fiduciary advice fiduciary receive certain the statutory exemptions are more with written authorization to manage disclosures and authorize the appropriate for the provision of these the plan’s assets and employers. transaction. In addition, the services. However it is available to investment independent fiduciary must receive PTE 75–1, Part II(2), currently advice fiduciaries regardless of whether confirmations and an annual ‘‘portfolio provides relief for fiduciaries selling they expressly acknowledge their turnover ratio’’ demonstrating the mutual fund shares to plans and IRAs in fiduciary status or are simply functional amount of turnover in the account a principal transaction to receive or ‘‘inadvertent’’ fiduciaries that have during that year. These conditions are commissions. PTE 75–1, Part II(2) not expressly agreed to act as fiduciary not presently applicable to transactions currently provides relief for fiduciaries advisers, provided there is no written involving IRAs. to receive commissions for selling authorization granting them discretion The Department is proposing to mutual fund shares to plans and IRAs in to acquire or dispose of the assets of the amend PTE 86–128 to require all a principal transaction. As described plan or IRA. fiduciaries relying on the exemption to above, the Department is proposing to adhere to the same impartial conduct 30 Class Exemption for Certain Transactions 29 Exemptions from Prohibitions Respecting Involving Insurance Agents and Brokers, Pension 28 Class Exemption for Securities Transactions Certain Classes of Transactions Involving Employee Consultants, Insurance Companies, Investment Involving Employee Benefit Plans and Broker- Benefit Plans and Certain Broker-Dealers, Reporting Companies and Investment Company Principal Dealers, 51 FR 41686 (Nov. 18, 1986), amended at Dealers and Banks, 40 FR 50845 (Oct. 31, 1975), as Underwriters, 49 FR 13208 (Apr. 3, 1984), amended 67 FR 64137 (Oct. 17, 2002). amended at 71 FR 5883 (Feb. 3, 2006). at 71 FR 5887 (Feb. 3, 2006). © 2015 The Institute of Continuing Legal Education 12-51 Tax Conference, 28th Annual, May 21, 2015 21950 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules The Department is proposing to under the scope of the 2010 Proposal of the new rule to allow service amend PTE 84–24 to require all would include the provision of providers sufficient time to make fiduciaries relying on the exemption to information and plan services that necessary changes in business practices, adhere to the same impartial conduct traditionally have been performed in a recordkeeping, communication standards required in the Best Interest non-fiduciary capacity. For example, materials, sales processes, compensation Contract Exemption. At the same time, they requested that the proposal be arrangements, and related agreements, the proposed amendment would revoke revised to make clear that actuaries, as well as the time necessary to obtain PTE 84–24 in part so that investment accountants, and attorneys, who have and adjust to any additional individual advice fiduciaries to IRA owners would historically not been treated as ERISA or class exemptions. Several said that not be able to rely on PTE 84–24 with fiduciaries for plan clients, would not applicability of any changes in the 1975 respect to (1) transactions involving become fiduciary investment advisers regulation should be no earlier than two variable annuity contracts and other by reason of providing actuarial, years after the promulgation of a final annuity contracts that constitute accounting and legal services. They said regulation. Other commenters thought securities under federal securities laws, that if individuals providing these that the effective dates in the 2010 and (2) transactions involving the services were classified as fiduciaries, proposal were reasonable and asked that purchase of mutual fund shares. the associated costs would almost the final rules should go into effect Investment advice fiduciaries to IRA certainly increase because of the need to promptly in order to reduce ongoing owners would instead be required to account for their new potential fiduciary harms to savers. rely on the Best Interest Contract liability. This was not the intent of the In response to these concerns, the Exemption for most common forms of 2010 proposal. Department has revised the date by compensation received in connection The new proposal clarifies that which the final rule would apply. with these transactions. The Department attorneys, accountants, and actuaries Specifically, the final rule would be believes that investment advice would not be treated as fiduciaries effective 60 days after publication in the transactions involving annuity contracts merely because they provide such Federal Register and the requirements that are treated as securities and professional assistance in connection of the final rule would generally become transactions involving the purchase of with a particular investment applicable eight months after mutual fund shares should occur under transaction. Only when these publication of a final rule, with the the conditions of the Best Interest professionals act outside their normal potential exceptions noted below. This Contract Exemption due to the roles and recommend specific modification is intended to balance the similarity of these investments, investments or render valuation concerns raised by commenters about including their distribution channels opinions in connection with particular the need for prompt action with and disclosure obligations, to other investment transactions, would they be concerns raised about the cost and investments covered in the Best Interest subject to the proposed fiduciary burden associated with transitioning Contract Exemption. Investment advice definition. current and future contracts or fiduciaries to ERISA plans would Similarly, the new proposal does not arrangements to satisfy the requirements remain eligible for relief under the alter the principle articulated in ERISA of the final rule and any accompanying exemption with respect to transactions Interpretive Bulletin 75–8, D–2 at 29 prohibited transaction exemptions. involving all insurance and annuity CFR 2509.75–8 (1975). Under the Administrative Prohibited Transaction contracts and mutual fund shares and bulletin, the plan sponsor’s human Exemptions the receipt of commissions allowable resources personnel or plan service under that exemption. Investment providers who have no power to make The Department proposes to make the advice fiduciaries to IRAs could still decisions as to plan policy, Best Interest Contract Exemption, if receive commissions for transactions interpretations, practices or procedures, granted, available on the final rule’s involving non-securities insurance and but who perform purely administrative applicability date, i.e., eight months annuity contracts, but they would be functions for an employee benefit plan, after publication of a final rule. Further, required to comply with all the within a framework of policies, the department proposes that the other protective conditions, described above. interpretations, rules, practices and new and revised PTEs that it is Finally, the Department is proposing procedures made by other persons, are proposing go into effect as of the final amendments to certain other existing not fiduciaries with respect to the plan. rule’s applicability date.31 class exemptions to require adherence For those fiduciary investment to the impartial conduct standards H. Effective Date; Applicability Date advisers who choose to avail themselves required in the Best Interest Contract Final Rule of the Best Interest Contract Exemption, PTE. Specifically, PTEs 75–1, Part III, the Department recognizes that Commenters on the 2010 Proposal 75–1, Part IV, 77–4, 80–83, and 83–1, compliance with certain requirements of asked the Department to provide would be amended. These existing class the new exemption may be difficult sufficient time for orderly and efficient exemptions will otherwise remain in within the eight-month timeframe. The compliance, and to make it clear that place, affording flexibility to fiduciaries Department therefore is soliciting the final rule would not apply in who currently use the exemptions or comments on whether to delay the connection with advice provided before who wish to use the exemptions in the application of certain requirements of the effective date of the final rule. Many future. the Best Interest Contract Exemption for commenters also expressed concern The proposed dates on which the new several months (for example, certain with the provision in the Department’s exemptions and amendments to existing data collection requirements), thereby 2010 Proposal that the final regulation exemptions would be effective are enabling firms and advisers to benefit and class exemptions would be effective summarized below. from the Best Interest Contract 90 days after their publication in the Exemption without meeting all the G. The Provision of Professional Federal Register. Some commenters Services Other Than Investment Advice suggested that these effective dates 31 See the notices with respect to these proposals, Several commenters asserted that it should be extended to as much as 12 published elsewhere in this issue of the Federal was unclear whether investment advice months or longer following publication Register. 12-52 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21951 requirements for a limited period of at www.dol.gov/ebsa/pdf/ financial advisor.33 Timely regulatory time. Although the Department does not conflictsofinterestria.pdf. It is action to redress advisers’ conflicts is believe that a general delay in the summarized below. warranted to avert such losses. application of the exemption’s Tax-preferred retirement savings, in In the retail IRA marketplace, growing requirements is warranted, it recognizes the form of private-sector, employer- consumer demand for personalized that a short-term delay of some sponsored retirement plans, such as advice, together with competition from requirements may be appropriate and 401(k) plans (‘‘plans’’), and Individual online discount brokerage firms, has may not compromise the overall Retirement Accounts (‘‘IRAs’’), are pushed brokers to offer more protections created by the proposed rule critical to the retirement security of comprehensive guidance services rather and exemptions. As discussed in more most U.S. workers. Investment than just transaction support. detail in the Notice proposing the Best professionals play a major role in Unfortunately, their traditional Interest Contract Exemption published guiding their investment decisions. compensation sources—such as elsewhere in this issue of the Federal However, these professional advisers brokerage commissions, revenue shared Register, the Department requests often are compensated in ways that by mutual funds and funds’ asset comments on this approach. create conflicts of interest, which can managers, and mark-ups on bonds sold bias the investment advice they render I. Public Hearing from their own inventory—can and erode plan and IRA investment introduce acute conflicts of interest. The Department plans to hold an results. In order to limit or mitigate Brokers and others advising IRA administrative hearing within 30 days of conflicts of interest and thereby improve investors are often able to calibrate their the close of the comment period. As retirement security, the Department of business practices to steer around the with the 2010 Proposal, the Department Labor (‘‘the Department’’) is proposing narrow 1975 rule and thereby avoid will ensure ample opportunity for to attach fiduciary status to more of the fiduciary status and prohibited public comment by reopening the advice rendered to plan officials, transactions for accepting conflict-laden record following the hearing and participants, and beneficiaries (plan compensation. Many brokers market publication of the hearing transcript. investors) and IRA investors. retirement investment services in ways Specific information regarding the date, Since the Department issued its 1975 that clearly suggest the provision of location and submission of requests to rule, the retirement savings market has tailored or individualized advice, while testify will be published in a notice in changed profoundly. Financial products at the same time relying on the 1975 the Federal Register. are increasingly varied and complex. rule to disclaim any fiduciary Individuals, rather than large J. Regulatory Impact Analysis responsibility in the fine print of employers, are increasingly responsible contracts and marketing materials. Under Executive Order 12866, for their investment decisions as IRAs Thus, at the same time that marketing ‘‘significant’’ regulatory actions are and 401(k)-type defined contribution materials may characterize the financial subject to the requirements of the plans have supplanted defined benefit adviser’s relationship with the customer Executive Order and review by the pensions as the primary means of as one-on-one, personalized, and based Office of Management and Budget providing retirement security. Plan and on the client’s best interest, footnotes (OMB). Section 3(f) of the executive IRA investors often lack investment and legal boilerplate disclaim the order defines a ‘‘significant regulatory expertise and must rely on experts—but requisite mutual agreement, action’’ as an action that is likely to are unable to assess the quality of the arrangement, or understanding that the result in a rule (1) having an annual expert’s advice or police its conflicts of advice is individualized or should serve effect on the economy of $100 million interest. Most have no idea how as a primary basis for investment or more, or adversely and materially ‘‘advisers’’ are compensated for selling decisions. What is presented to an IRA affecting a sector of the economy, them products. Many are bewildered by investor as trusted advice is often paid productivity, competition, jobs, the complex choices that require substantial for by a financial product vendor in the environment, public health or safety, or financial literacy and welcome ‘‘free’’ form of a sales commission or shelf- State, local or tribal governments or advice. The risks are growing as baby space fee, without adequate counter- communities (also referred to as boomers retire and move money from balancing consumer protections that are ‘‘economically significant’’); (2) creating plans, where their employer has both designed to ensure that the advice is in serious inconsistency or otherwise the incentive and the fiduciary duty to the investor’s best interest. In another interfering with an action taken or facilitate sound investment choices, to variant of the same problem, brokers planned by another agency; (3) IRAs, where both good and bad and others provide apparently tailored materially altering the budgetary investment choices are myriad and most advice to customers under the guise of impacts of entitlement grants, user fees, advice is conflicted. These ‘‘rollovers’’ general education to avoid triggering or loan programs or the rights and are expected to approach $2.5 trillion fiduciary status and responsibility. obligations of recipients thereof; or (4) over the next 5 years.32 These rollovers, raising novel legal or policy issues which will be one-time and not ‘‘on a 33 arising out of legal mandates, the regular basis’’ and thus not covered by For example, an ERISA plan investor who rolls President’s priorities, or the principles $200,000 into an IRA, earns a 6% nominal rate of the 1975 standard, will be the most return with 3% inflation, and aims to spend down set forth in the Executive Order. OMB important financial decisions that many her savings in 30 years, would be able to consume has determined that this proposed rule consumers make in their lifetime. An $10,204 per year for the 30 year period. A similar is economically significant within the ERISA plan investor who rolls her investor whose assets underperform by 1 or 2 meaning of section 3(f)(1) of the percentage points per year would only be able to retirement savings into an IRA could consume $8,930 or $7,750 per year, respectively, in Executive Order, because it would be lose 12 to 24 percent of the value of her each of the 30 years. The 1 to 2 percentage point likely to have an effect on the economy savings over 30 years of retirement by underperformance comes from a careful review of of $100 million in at least one year. accepting advice from a conflicted a large and growing body of literature which Accordingly, OMB has reviewed the consistently points to a substantial failure of the market for retirement advice. The literature is rule pursuant to the Executive Order. 32 Cerulli Associates, ‘‘Retirement Markets 2014: discussed in the Department’s complete Regulatory The Department’s complete Sizing Opportunities in Private and Public Impact Analysis (available at www.dol.gov/ebsa/ Regulatory Impact Analysis is available Retirement Plans,’’ 2014. pdf/conflictsofinterestria.pdf). © 2015 The Institute of Continuing Legal Education 12-53 Tax Conference, 28th Annual, May 21, 2015 21952 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules Likewise in the plan market, pension The current proposal adopts what the www.dol.gov/ebsa/pdf/ consultants and advisers that plan Department intends to be a balanced conflictsofinterestria.pdf), supports a sponsors rely on to guide their decisions approach to prohibited transaction finding that the impact of these conflicts often avoid fiduciary status under the exemptions. The proposal narrows and of interest on investment outcomes is five-part test and are conflicted. For attaches new protective conditions to large and negative. The supporting example, if a plan hires an investment some existing PTEs. At the same time it evidence includes, among other things, professional or appraiser on a one-time includes some new PTEs with broad but statistical analyses of conflicted basis for an investment recommendation targeted combined scope and strong investment channels, experimental on a large, complex investment, the protective conditions. These elements of studies, government reports adviser has no fiduciary obligation to the proposal reflect the Department’s documenting abuse, and economic the plan under ERISA. Even if the plan effort to ensure that advice is impartial theory on the dangers posed by conflicts official, who lacks the specialized while avoiding larger and costlier than of interest and by the asymmetries of expertise necessary to evaluate the necessary disruptions to existing information and expertise that complex transaction on his or her own, business arrangements or constraints on characterize interactions between invests all or substantially all of the future innovation. ordinary retirement investors and plan’s assets in reliance on the In developing the current proposal, conflicted advisers. A review of this consultant’s professional judgment, the the Department conducted an in-depth data, which consistently points to a consultant is not a fiduciary because he economic assessment of the market for substantial failure of the market for or she does not advise the plan on a retirement investment advice. As further retirement advice, suggests that IRA ‘‘regular basis’’ and therefore may stand discussed below, the Department found holders receiving conflicted investment to profit from the plan’s investment due that conflicted advice is widespread, advice can expect their investments to to a conflict of interest that could affect causing serious harm to plan and IRA underperform by an average of 100 basis the consultant’s best judgment. Too investors, and that disclosing conflicts points per year over the next 20 years. much has changed since 1975, and too alone would fail to adequately mitigate The underperformance associated with many investment decisions are made as the conflicts or remedy the harm. By conflicts of interest—in the mutual one-time decisions and not advice on a extending fiduciary status to more funds segment alone—could cost IRA regular basis for the five-part test to be providers of advice and providing broad investors more than $210 billion over a meaningful safeguard any longer. but targeted and protective PTEs, the the next 10 years and nearly $500 over Department believes the current The proposed definition of fiduciary the next 20 years. Some studies suggest proposal would mitigate conflicts, investment advice included in this that the underperformance of broker- support consumer choice, and deliver sold mutual funds may be even higher NPRM generally covers specific substantial gains for retirement than 100 basis points. If the true recommendations on investments, investors and economic benefits that underperformance of broker-sold funds investment management, the selection more than justify its costs. is 200 basis points, IRA mutual fund of persons to provide investment advice Advisers’ conflicts take a variety of holders could suffer from or management, and appraisals in forms and can bias their advice in a underperformance amounting to $430 connection with investment decisions. variety of ways. For example, advisers billion over 10 years and nearly $1 Persons who provide such advice would often are paid more for selling some trillion across the next 20 years. While fall within the proposed regulation’s mutual funds than others, and to the estimates based on the mutual fund ambit if they either (a) represent that execute larger and more frequent trades market are large, the total market impact they are acting as an ERISA fiduciary or of mutual fund shares or other could be much larger. Insurance (b) make investment recommendations securities. Broker-dealers reap price products, Exchange Traded Funds pursuant to an agreement, arrangement, spreads from principal transactions, so (ETFs), individual stocks and bonds, or understanding that the advice is advisers may be encouraged to and other products are all sold by individualized or specifically directed recommend larger and more frequent brokers with conflicts of interest. to the recipient for consideration in trades. These and other adviser Disclosure alone has proven making investment or investment compensation arrangements introduce ineffective to mitigate conflicts in management decisions regarding plan or direct and serious conflicts of interest advice. Extensive research has IRA assets. between advisers and retirement demonstrated that most investors have The current proposal specifically investors. Advisers often are paid a great little understanding of their advisers’ includes as fiduciary investment advice deal more if they recommend conflicts, and little awareness of what recommendations concerning the investments and transactions that are they are paying via indirect channels for investment of assets that are rolled over highly profitable to the financial the conflicted advice. Even if they or otherwise distributed from a plan. industry, even if they are not in understand the scope of the advisers’ This would supersede guidance the investors’ best interests. These financial conflicts, most consumers generally Department provided in a 2005 advisory incentives can and do bias the advisers’ cannot distinguish good advice, or even opinion,34 which concluded that such recommendations. good investment results, from bad. The recommendations did not constitute Following such biased advice can same gap in expertise that makes fiduciary advice. However, the current inflict losses on investors in several investment advice necessary frequently proposal provides that an adviser does ways. They may choose more expensive also prevents investors from recognizing not act as a fiduciary merely by and/or poorer performing investments. bad advice or understanding advisers’ providing plan investors with They may trade too much and thereby disclosures. Recent research suggests information about plan distribution incur excessive transaction costs, and that even if disclosure about conflicts options, including the tax consequences they may incur more costly timing could be made simple and clear, it associated with the available types of errors, which are a common would be ineffective—or even benefit distributions. consequence of chasing returns. harmful.35 A wide body of economic evidence, 34 DOL Advisory Opinion 2005–23A (Dec. 7, reviewed in the Department’s full 35 See Loewenstein et al., (2011) for a summary 2005). Regulatory Impact Analysis (available at of some relevant literature. 12-54 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21953 Excessive fees and substandard higher than these quantified gains alone. models, including technology-driven investment performance in DC plans or The Department expects the proposal to models, may be accelerated, and nudged IRAs, which can result when advisers’ yield large, additional gains for IRA away from conflicts and toward conflicts bias their advice, erode benefit investors, including improvements in transparency, thereby promoting security. This proposal aims to ensure the performance of IRA investments healthy competition in the fiduciary that advice is impartial, thereby rooting other than front-load mutual funds and advice market. out excessive fees and substandard potential reductions in excessive trading A major expected positive effect of the performance otherwise attributable to and associated transaction costs and current proposal in the plan advice advisers’ conflicts, producing gains for timing errors (such as might be market is improved compliance and retirement investors. Delivering these associated with return chasing). As associated improved security of plan gains would entail compliance costs— noted above, under current rules, assets and benefits. Clarity about namely, the cost incurred by new adviser conflicts could cost IRA advisers’ fiduciary status would fiduciary advisers to avoid the investors as much as $410 billion over strengthen EBSA’s enforcement prohibited transaction rules and/or 10 years and $1 trillion over 20 years, activities resulting in fuller and faster satisfy relevant PTE conditions. The so the potential additional gains to IRA correction, and stronger deterrence, of Department expects investor gains investors from this proposal could be ERISA violations. would be very large relative to very large. In conclusion, the Department compliance costs, and therefore believes Just as with IRAs, there is evidence believes that the current proposal would this proposal is economically justified that conflicts of interest in the mitigate adviser conflicts and thereby and sound. investment advice market also erode improve plan and IRA investment Because of limitations of the literature plan assets. For example, the U.S. results, while avoiding greater than and other evidence, only some of these Government Accountability Office necessary disruption of existing gains can be quantified with confidence. (GAO) found that defined benefit business practices and would deliver Focusing only on how load shares paid pension plans using consultants with large gains to retirement investors and a to brokers affect the size of loads IRA undisclosed conflicts of interest earned variety of other economic benefits, investors holding front-end load funds 1.3 percentage points per year less than which would more than justify its costs. pay and the returns they achieve, we other plans.36 Other GAO reports point K. Initial Regulatory Flexibility Analysis estimate the proposal would deliver to out how adviser conflicts may cause The Regulatory Flexibility Act (5 IRA investors gains of between $40 plan participants to roll plan assets into billion and $44 billion over 10 years and U.S.C. 601 et seq.) (RFA) imposes IRAs that charge high fees or 401(k) plan certain requirements with respect to between $88 and $100 billion over 20 officials to include expensive or years. These estimates assume that the Federal rules that are subject to the underperforming funds in investment notice and comment requirements of rule will eliminate (rather than just menus.37 A number of academic studies reduce) underperformance associated section 553(b) of the Administrative find that 401(k) plan investment options Procedure Act (5 U.S.C. 551 et seq.) and with the practice of incentivizing broker underperform the market,38 and at least recommendations through variable which are likely to have a significant one study attributes such economic impact on a substantial front-end-load sharing; if the rule’s underperformance to excessive reliance effectiveness in this area is substantially number of small entities. Unless an on funds that are proprietary to plan agency determines that a proposal is not below 100 percent, these estimates may service providers who may be providing overstate these particular gains to likely to have a significant economic investment advice to plan officials that investors in the front-load mutual fund impact on a substantial number of small choose the investment options.39 segment of the IRA market. The entities, section 603 of the RFA requires The Department expects the current Department nonetheless believes that the agency to present an initial proposal’s positive effects to extend these gains alone would far exceed the regulatory flexibility analysis (IRFA) of well beyond improved investment proposal’s compliance cost which are the proposed rule. The Department’s results for retirement investors. The IRA estimated to be between $2.4 billion and IRFA of the proposed rule is provided and plan markets for fiduciary advice $5.7 billion over 10 years, mostly below. and other services may become more reflecting the cost incurred by new The Department believes that efficient as a result of more transparent fiduciary advisers to satisfy relevant amending the current regulation by PTE conditions (these costs are also pricing and greater certainty about the broadening the scope of service front-loaded and will be less in fiduciary status of advisers and about providers, regardless of size, that would subsequent years). For example, if only the impartiality of their advice. There be considered fiduciaries would 75 percent of the potential gains were may be benefits from the increased enhance the Department’s ability to realized in the subset of the market that flexibility that the current proposal’s redress service provider abuses that was analyzed (the front-load mutual PTEs would provide with respect to currently exist in the plan service fund segment of the IRA market), the fiduciary investment advice currently provider market, such as undisclosed gains would amount to between $30 falling within the ambit of the 1975 rule. fees, misrepresentation of compensation billion and $33 billion over 10 years. If The current proposal’s defined arrangements, and biased appraisals of only 50 percent were realized, the boundaries between fiduciary advice, the value of plan investments. expected gains in this subset of the education, and sales activity directed at The Department’s complete Initial market would total between $20 billion large plans, may bring greater clarity to Regulatory Flexibility Analysis is and $22 billion over 10 years, still the IRA and plan services markets. available at www.dol.gov/ebsa/pdf/ several times the proposal’s estimated Innovation in new advice business conflictsofinterestria.pdf. It is compliance cost summarized below. These estimates account for only a 36 GAO Report, Publication No. GAO–09–503T, The Department believes that the 2009. fraction of potential conflicts, associated 37 GAO Report, Publication No. GAO–11–119, proposal would provide benefits to losses, and affected retirement assets. 2011. small plans and their related small The total gains to IRA investors 38 See e.g. Elton et al. (2013). employers and IRA holders, and impose attributable to the rule may be much 39 See Pool et al. (2014). costs on small service providers © 2015 The Institute of Continuing Legal Education 12-55 Tax Conference, 28th Annual, May 21, 2015 21954 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules providing investment advice to ERISA disclosure costs are not expected to Carveout Disclosure Requirements to plans, ERISA plan participants and IRA disproportionately affect small entities. the Office of Management and Budget holders. Small service providers Although the PTEs allow firms to (OMB) in accordance with 44 U.S.C. affected by this rule are defined to maintain their existing business models, 3507(d) for review of its information include broker-dealers, registered some small affected entities may collections. The Department and OMB investment advisers, consultants, determine that it is more cost effective are particularly interested in comments appraisers, and others providing to shift business models. In this that: investment advice to small ERISA plans scenario, some BDs might incur the • Evaluate whether the collection of and IRA that have less than $38.5 costs of switching to becoming RIAs, information is necessary for the proper million in revenue. including training, testing, and licensing performance of the functions of the The Department anticipates that costs, at a cost of approximately $5,600 agency, including whether the broker-dealers would experience the per representative. information would have practical largest impact from the proposed rule Some small service providers may utility; and associated proposed exemptions. find that the increased costs associated • Evaluate the accuracy of the Registered investment advisers and with ERISA fiduciary status outweigh agency’s estimate of the burden of the other ERISA plan service providers the benefit of continuing to service the collection of information, including the would experience less of a burden from ERISA plan market or the IRA market. validity of the methodology and the rule. The Department assumes that The Department does not believe that assumptions used; firms would utilize whichever PTEs this outcome would be widespread or • Enhance the quality, utility, and would be most cost effective for their that it would result in a diminution of clarity of the information to be business models. Regardless of which the amount or quality of advice collected; and PTEs they use, small affected entities available to small or other retirement • Minimize the burden of the would incur costs associated with savers. It is also possible that the collection of information on those who developing and implementing new economic impact of the rule on small are to respond, including through the compliance policies and procedures to entities would not be as significant as it use of appropriate automated, minimize conflicts of interest; creating would be for large entities, because electronic, mechanical, or other and distributing new disclosures; anecdotal evidence indicates that some technological collection techniques or maintaining additional compliance small entities do not have as many other forms of information technology, records; familiarizing and training staff business arrangements that give rise to e.g., permitting electronic submission of on new requirements; and obtaining conflicts of interest. Therefore, they responses. additional liability insurance. would not be confronted with the same Comments should be sent to the As discussed previously, the costs to restructure transactions that Office of Information and Regulatory Department estimated the costs of would be faced by large entities. Affairs, Office of Management and implementing new compliance policies Budget, Room 10235, New Executive L. Paperwork Reduction Act and procedures, training staff, and Office Building, Washington, DC 20503; creating disclosures for small broker- As part of its continuing effort to Attention: Desk Officer for the dealers. The Department estimates that reduce paperwork and respondent Employee Benefits Security small broker-dealers could expend on burden, the Department of Labor Administration. OMB requests that average approximately $53,000 in the conducts a preclearance consultation comments be received within 30 days of first year and $21,000 in subsequent program to provide the general public publication of the Proposed Investment years; small registered investment and Federal agencies with an Advice Initiative to ensure their advisers would spend approximately opportunity to comment on proposed consideration. $5,300 in the first year and $500 in and continuing collections of PRA Addressee: Address requests for subsequent years; and small service information in accordance with the copies of the ICR to G. Christopher providers would spend approximately Paperwork Reduction Act of 1995 (PRA) Cosby, Office of Policy and Research, $5,300 in the first year and $500 in (44 U.S.C. 3506(c)(2)(A)). This helps to U.S. Department of Labor, Employee subsequent years. The estimated cost for ensure that the public understands the Benefits Security Administration, 200 small broker-dealers is believed to be an Department’s collection instructions; Constitution Avenue NW., Room N– overestimate, especially for the smallest respondents can provide the requested 5718, Washington, DC 20210. firms as they are believed to have on data in the desired format; reporting Telephone (202) 693–8410; Fax: (202) average simpler arrangements and they burden (time and financial resources) is 219–5333. These are not toll-free may have relationships with larger firms minimized; collection instruments are numbers. ICRs submitted to OMB also that help with compliance, thus clearly understood; and the Department are available at http://www.RegInfo.gov. lowering their costs. Additionally, can properly assess the impact of As discussed in detail above, broker-dealers and service providers collection requirements on respondents. Paragraph (b)(1)(i) of the proposed would incur an expense of about $300 Currently, the Department is soliciting regulation provides a carve-out to the in additional liability insurance comments concerning the proposed general definition for advice provided in premiums for each representative or information collection requests (ICRs) connection with an arm’s length sale, other individual who would now be included in the ‘‘carve-outs’’ section of purchase, loan, or bilateral contract considered a fiduciary. Of this expense, its proposal to amend its 1975 rule that between a sophisticated plan investor, $150 is estimated to be paid to the defines when a person who provides which has 100 or more plan insuring firms and the other $150 is investment advice to an employee participants, and the adviser (‘‘seller’s estimated to be paid out as benefit plan becomes an ERISA carve-out’’). It also applies in compensation to those harmed, which is fiduciary. A copy of the ICRs may be connection with an offer to enter into counted as a transfer. Any disclosures obtained by contacting the PRA such a transaction or when the person produced by affected entities would addressee shown below or at http:// providing the advice is acting as an cost, on average, about $1.53 in the first www.RegInfo.gov. agent or appraiser for the plan’s year and about $1.15 in subsequent The Department has submitted a copy counterparty. In order to rely on this years. These per-representative and per- of the Conflict of Interest Proposed Rule carve-out, the person must provide 12-56 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21955 advice to a plan fiduciary who is out disclosure, and the education carve- result in approximately 43,000 hours of independent of such person and who out disclosures for asset allocation legal time at an equivalent cost of exercises authority or control respecting models and interactive investment approximately $5.6 million. It would the management or disposition of the materials are information collection also result in approximately 21,000 plan’s assets, with respect to an arm’s requests (ICRs) subject to the Paperwork hours of clerical time at an equivalent length sale, purchase, loan or bilateral Reduction Act. The Department has cost of approximately $653,000. In total, contract between the plan and the made the following assumptions in the burden associated with the seller’s counterparty, or with respect to a order to establish a reasonable estimate carve-out representation is proposal to enter into such a sale, of the paperwork burden associated approximately 64,000 hours at an purchase, loan or bilateral contract. with these ICRs: equivalent cost of $6.2 million. The seller’s carve-out applies if • Approximately 43,000 plans would The Department estimates that each certain conditions are met. Among these utilize the seller’s carve-out; service provider using the platform conditions are the following: The • Approximately 1,800 service provider carve-out would require ten adviser must obtain a written providers would utilize the platform minutes of legal professional time to representation from the plan fiduciary provider carve-out; draft the needed disclosure. Therefore, that (1) the plan fiduciary is a fiduciary • Approximately 2,800 financial the platform provider carve-out who exercises authority or control institutions would utilize the education disclosure would result in respecting the management or carve-out; approximately 300 hours of legal time at disposition of the employee benefit • Plans and advisers using the seller’s an equivalent cost of approximately plan’s assets (as described in section carve-out are entities with financial $39,000. 3(21)(A)(i) of the Act), (2) that the expertise and would distribute The Department estimates that each employee benefit plan has 100 or more substantially all of the disclosures financial institution using the education participants covered under the plan, electronically via means already used in carve-out would require twenty minutes and that (3) the fiduciary will not rely their normal course of business and the of legal professional time to draft the on the person to act in the best interests costs arising from electronic distribution disclosure. Therefore, this carve-out of the plan, to provide impartial would be negligible; disclosure would result in investment advice, or to give advice in • Service providers using the approximately 900 hours of legal time at a fiduciary capacity. platform provider carve-out already an equivalent cost of approximately Paragraph (b)(3) of the proposed maintain contracts with their customers $121,000. regulation provides a carve-out making as a regular and customary business In total, the hour burden for the clear that persons who merely market practice and the materials costs arising representation and disclosures required and make available, securities or other from inserting the platform provider by the carve-outs is approximately property through a platform or similar carve-out into the existing contracts 66,000 hours at an equivalent cost of mechanism to an employee benefit plan would be negligible; $6.4 million. without regard to the individualized • Materials costs arising from Because the Department assumes that needs of the plan, its participants, or inserting the required education carve- all disclosures would be distributed beneficiaries do not act as investment out disclosure into existing models and electronically or require small amounts advice fiduciaries. This carve-out interactive materials would be of space to include in existing materials, applies if the person discloses in writing negligible; the Department has not associated any to the plan fiduciary that the person is • Advisers would use existing in- cost burden with these ICRs. not undertaking to provide impartial house resources to prepare the These paperwork burden estimates investment advice or to give advice in disclosures; and are summarized as follows: a fiduciary capacity. • The tasks associated with the ICRs Type of Review: New collection Paragraph (b)(6) of the proposal makes would be performed by clerical (Request for new OMB Control clear that furnishing and providing personnel at an hourly rate of $30.42 Number). certain specified investment educational and legal professionals at an hourly rate Agency: Employee Benefits Security information and materials (including of $129.94.40 Administration, Department of Labor. certain investment allocation models The Department estimates that each Title: Conflict of Interest Proposed and interactive plan materials) to a plan, plan would require one hour of legal Rule Carveout Disclosure Requirements. plan fiduciary, participant, beneficiary professional time and 30 minutes of OMB Control Number: 1210—NEW. or IRA owner would not constitute the clerical time to produce the seller’s Affected Public: Business or other for- rendering of investment advice if certain carve-out representation. Therefore, the profit. conditions are met. One of the seller’s carve-out representation would Estimated Number of Respondents: conditions is that the asset allocation 47,532. models or interactive materials must 40 The Department’s estimated 2015 hourly labor Estimated Number of Annual explain all material facts and rates include wages, other benefits, and overhead Responses: 47,532. assumptions on which the models and are calculated as follows: Mean wage from the 2013 Frequency of Response: When materials are based and include a National Occupational Employment Survey (April 2014, Bureau of Labor Statistics http://www.bls.gov/ engaging in excepted transaction. statement indicating that, in applying news.release/pdf/ocwage.pdf); wages as a percent of Estimated Total Annual Burden particular asset allocation models to total compensation from the Employer Cost for Hours: 65,631 hours. their individual situations, participants, Employee Compensation (June 2014, Bureau of Estimated Total Annual Burden Cost: beneficiaries, or IRA owners should Labor Statistics http://www.bls.gov/news.release/ $0. consider their other assets, income, and ecec.t02.htm); overhead as a multiple of compensation is assumed to be 25 percent of total M. Congressional Review Act investments in addition to their compensation for paraprofessionals, 20 percent of interests in the plan or IRA to the extent compensation for clerical, and 35 percent of The proposed rule is subject to the they are not taken into account in the compensation for professional; annual inflation Congressional Review Act provisions of assumed to be 2.3 percent annual growth of total model or estimate. labor cost since 2013 (Employment Costs Index data the Small Business Regulatory The seller’s carve-out written for private industry, September 2014 http:// Enforcement Fairness Act of 1996 (5 representation, platform provider carve- www.bls.gov/news.release/eci.nr0.htm). U.S.C. 801 et seq.) and, if finalized, © 2015 The Institute of Continuing Legal Education 12-57 Tax Conference, 28th Annual, May 21, 2015 21956 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules would be transmitted to Congress and investment capital, and gains to Register on October 20, 2010 (75 FR the Comptroller General for review. The investors. 65263) is hereby withdrawn. proposed rule is a ‘‘major rule’’ as that The current proposal is not expected List of Subjects in 29 CFR Parts 2509 term is defined in 5 U.S.C. 804, because to have any material economic impacts and 2510 it is likely to result in an annual effect on State, local or tribal governments, or on the economy of $100 million or on health, safety, or the natural Employee benefit plans, Employee more. environment. The North American Retirement Income Security Act, Pensions, Plan assets. N. Unfunded Mandates Reform Act Securities Administrators Association commented in support of the For the reasons set forth in the Title II of the Unfunded Mandates Department’s 2010 proposal.43 preamble, the Department is proposing Reform Act of 1995 (Pub. L. 104–4) to amend parts 2509 and 2510 of requires each Federal agency to prepare O. Federalism Statement subchapters A and B of Chapter XXV of a written statement assessing the effects Executive Order 13132 (August 4, Title 29 of the Code of Federal of any Federal mandate in a proposed or 1999) outlines fundamental principles Regulations as follows: final agency rule that may result in an of federalism, and requires the expenditure of $100 million or more SUBCHAPTER A—GENERAL adherence to specific criteria by Federal (adjusted annually for inflation with the agencies in the process of their PART 2509—INTERPRETIVE base year 1995) in any one year by State, formulation and implementation of BULLETINS RELATING TO THE local, and tribal governments, in the EMPLOYEE RETIREMENT INCOME aggregate, or by the private sector. Such policies that have substantial direct SECURITY ACT OF 1974 a mandate is deemed to be a ‘‘significant effects on the States, the relationship regulatory action.’’ The current proposal between the national government and States, or on the distribution of power ■ 1. The authority citation for part 2509 is expected to have such an impact on continues to read as follows: the private sector, and the Department and responsibilities among the various therefore hereby provides such an levels of government. This proposed Authority: 29 U.S.C. 1135. Secretary of assessment. rule does not have federalism Labor’s Order 1–2011, 77 FR 1088 (Jan. 9, The Department is issuing the current implications because it has no 2012). Sections 2509.75–10 and 2509.75–2 substantial direct effect on the States, on issued under 29 U.S.C. 1052, 1053, 1054. Sec. proposal under ERISA section 2509.75–5 also issued under 29 U.S.C. 1002. 3(21)(A)(ii) (29 U.S.C. 1002(21)(a)(ii)).41 the relationship between the national government and the States, or on the Sec. 2509.95–1 also issued under sec. 625, The Department is charged with Pub. L. 109–280, 120 Stat. 780. interpreting the ERISA and Code distribution of power and provisions that attach fiduciary status to responsibilities among the various § 2509.96–1 [Removed] anyone who is paid to provide levels of government. Section 514 of ■ 2. Remove § 2509.96–1. investment advice to plan or IRA ERISA provides, with certain exceptions specifically enumerated, that the SUBCHAPTER B—DEFINITIONS AND investors. The current proposal would COVERAGE UNDER THE EMPLOYEE update and supersede the 1975 rule 42 provisions of Titles I and IV of ERISA RETIREMENT INCOME SECURITY ACT OF that currently interprets these statutory supersede any and all laws of the States 1974 provisions. as they relate to any employee benefit The Department assessed the plan covered under ERISA. The PART 2510—DEFINITIONS OF TERMS anticipated benefits and costs of the requirements implemented in the USED IN SUBCHAPTERS C, D, E, F, current proposal pursuant to Executive proposed rule do not alter the AND G OF THIS CHAPTER fundamental reporting and disclosure Order 12866 in the Regulatory Impact ■ Analysis for the current proposal and requirements of the statute with respect 3. The authority citation for part 2510 concluded that its benefits would justify to employee benefit plans, and as such is revised to read as follows: its costs. The Department’s complete have no implications for the States or Authority: 29 U.S.C. 1002(2), 1002(21), Regulatory Impact Analysis is available the relationship or distribution of power 1002(37), 1002(38), 1002(40), 1031, and 1135; at www.dol.gov/ebsa/pdf/ between the national government and Secretary of Labor’s Order 1–2011, 77 FR conflictsofinterestria.pdf. To the States. 1088; Secs. 2510.3–21, 2510.3–101 and summarize, the current proposals’ 2510.3–102 also issued under Sec. 102 of Statutory Authority Reorganization Plan No. 4 of 1978, 5 U.S.C. material benefits and costs generally App. 237. Section 2510.3–38 also issued would be confined to the private sector, This regulation is proposed pursuant under Pub. L. 105–72, Sec. 1(b), 111 Stat. where plans and IRA investors would, to the authority in section 505 of ERISA 1457 (1997). in the Department’s estimation, benefit (Pub. L. 93–406, 88 Stat. 894; 29 U.S.C. ■ 4. Revise § 2510.3–21 to read as on net, partly at the expense of their 1135) and section 102 of Plan No. 4 of follows: fiduciary advisers and upstream 1978 (43 FR 47713, October 17, 1978), financial service and product producers. effective December 31, 1978 (44 FR § 2510.3–21 Definition of ‘‘Fiduciary.’’ The Department itself would benefit 1065, January 3, 1979), 3 CFR 1978 (a) Investment advice. For purposes of from increased efficiency in its Comp. 332, and under Secretary of section 3(21)(A)(ii) of the Employee enforcement activity. The public and Labor’s Order No. 1–2011, 77 FR 1088 Retirement Income Security Act of 1974 overall US economy would benefit from (Jan. 9, 2012). (Act) and section 4975(e)(3)(B) of the increased compliance with ERISA and Internal Revenue Code (Code), except as Withdrawal of Proposed Regulation the Code and confidence in advisers, as provided in paragraph (b) of this well as from more efficient allocation of Paragraph (c) of the proposed section, a person renders investment regulation relating to the definition of advice with respect to moneys or other 41 Under section 102 of the Reorganization Plan fiduciary (proposed 29 CFR 2510.3(21)) property of a plan or IRA described in No. 4 of 1978, the authority of the Secretary of the paragraph (f)(2) of this section if— Treasury to interpret section 4975 of the Code has that was published in the Federal been transferred, with exceptions not relevant here, (1) Such person provides, directly to to the Secretary of Labor. 43 Available at http://www.dol.gov/ebsa/pdf/1210- a plan, plan fiduciary, plan participant 42 29 CFR 2510.3–21(c). AB32-PH007.pdf. or beneficiary, IRA, or IRA owner the 12-58 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21957 following types of advice in exchange respect to the management or investment advice, or to give advice in for a fee or other compensation, whether disposition of the plan’s assets, with a fiduciary capacity; and direct or indirect: respect to an arm’s length sale, (3) Does not receive a fee or other (i) A recommendation as to the purchase, loan or bilateral contract compensation directly from the plan, or advisability of acquiring, holding, between the plan and the counterparty, plan fiduciary, for the provision of disposing or exchanging securities or or with respect to a proposal to enter investment advice (as opposed to other other property, including a into such a sale, purchase, loan or services) in connection with the recommendation to take a distribution bilateral contract, if, prior to providing transaction. of benefits or a recommendation as to any recommendation with respect to the (ii) Swap and security-based swap the investment of securities or other transaction, such person satisfies the transactions. The person is a property to be rolled over or otherwise requirements of either paragraph counterparty to an employee benefit distributed from the plan or IRA; (b)(1)(i)(B) or (C) of this section. plan (as described in section 3(3) of the (ii) A recommendation as to the (B) Such person— Act) in connection with a swap or management of securities or other (1) Obtains a written representation security-based swap, as defined in property, including recommendations as from the independent plan fiduciary section 1(a) of the Commodity Exchange to the management of securities or other that the independent fiduciary exercises Act (7 U.S.C. 1(a) and section 3(a) of the property to be rolled over or otherwise authority or control with respect to the Securities Exchange Act (15 U.S.C. distributed from the plan or IRA; management or disposition of the 78c(a)), if— (iii) An appraisal, fairness opinion, or employee benefit plan’s assets (as (A) The plan is represented by a similar statement whether verbal or described in section 3(21)(A)(i) of the fiduciary independent of the person; written concerning the value of Act), that the employee benefit plan has (B) The person is a swap dealer, securities or other property if provided 100 or more participants covered under security-based swap dealer, major swap in connection with a specific the plan, and that the independent participant, or major security-based transaction or transactions involving the fiduciary will not rely on the person to swap participant; acquisition, disposition, or exchange, of act in the best interests of the plan, to (C) The person (if a swap dealer or such securities or other property by the provide impartial investment advice, or security-based swap dealer), is not plan or IRA; to give advice in a fiduciary capacity; acting as an advisor to the plan (within (iv) A recommendation of a person (2) Fairly informs the independent the meaning of section 4s(h) of the who is also going to receive a fee or plan fiduciary of the existence and Commodity Exchange Act or section other compensation for providing any of nature of the person’s financial interests 15F(h) of the Securities Exchange Act of the types of advice described in in the transaction; 1934) in connection with the paragraphs (i) through (iii); and (3) Does not receive a fee or other transaction; and (2) Such person, either directly or compensation directly from the plan, or (D) In advance of providing any indirectly (e.g., through or together with plan fiduciary, for the provision of recommendations with respect to the any affiliate),— investment advice (as opposed to other transaction, the person obtains a written (i) Represents or acknowledges that it services) in connection with the representation from the independent is acting as a fiduciary within the transaction; and plan fiduciary, that the fiduciary will meaning of the Act with respect to the (4) Knows or reasonably believes that not rely on recommendations provided advice described in paragraph (a)(1) of the independent plan fiduciary has by the person. this section; or sufficient expertise to evaluate the (2) Employees. In his or her capacity (ii) Renders the advice pursuant to a transaction and to determine whether as an employee of any employer or written or verbal agreement, the transaction is prudent and in the employee organization sponsoring the arrangement or understanding that the best interest of the plan participants (the employee benefit plan (as described in advice is individualized to, or that such person may rely on written section 3(3) of the Act), the person advice is specifically directed to, the representations from the plan or the provides the advice to a plan fiduciary, advice recipient for consideration in plan fiduciary to satisfy this subsection and he or she receives no fee or other making investment or management (b)(1)(i)(B)(4)). compensation, direct or indirect, in decisions with respect to securities or (C) Such person— connection with the advice beyond the other property of the plan or IRA. (1) Knows or reasonably believes that employee’s normal compensation for (b) Carve-outs—investment advice. the independent plan fiduciary has work performed for the employer or Except for persons described in responsibility for managing at least $100 employee organization. paragraph (a)(2)(i) of this section, the million in employee benefit plan assets (3) Platform providers. The person rendering of advice or other (for purposes of this paragraph merely markets and makes available to communications in conformance with a (b)(1)(i)(C), when dealing with an an employee benefit plan (as described carve-out set forth in paragraph (b)(1) individual employee benefit plan, a in section 3(3) of the Act), without through (6) of this section shall not person may rely on the information on regard to the individualized needs of the cause the person who renders the advice the most recent Form 5500 Annual plan, its participants, or beneficiaries, to be treated as a fiduciary under Return/Report filed for the plan to securities or other property through a paragraph (a) of this section. determine the value and, in the case of platform or similar mechanism from (1) Counterparties to the plan—(i) an independent fiduciary acting as an which a plan fiduciary may select or Counterparty transaction with plan asset manager for multiple employee monitor investment alternatives, fiduciary with financial expertise. (A) In benefit plans, a person may rely on including qualified default investment such person’s capacity as a counterparty representations from the independent alternatives, into which plan (or representative of a counterparty) to plan fiduciary regarding the value of participants or beneficiaries may direct an employee benefit plan (as described employee benefit plan assets under the investment of assets held in, or in section 3(3) of the Act), the person management); contributed to, their individual provides advice to a plan fiduciary who (2) Fairly informs the independent accounts, if the person discloses in is independent of such person and who plan fiduciary that the person is not writing to the plan fiduciary that the exercises authority or control with undertaking to provide impartial person is not undertaking to provide © 2015 The Institute of Continuing Legal Education 12-59 Tax Conference, 28th Annual, May 21, 2015 21958 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules impartial investment advice or to give or in combination with other materials) (H) General methods and strategies for advice in a fiduciary capacity. recommendations with respect to managing assets in retirement (e.g., (4) Selection and monitoring specific investment products or specific systematic withdrawal payments, assistance. In connection with the plan or IRA alternatives, or annuitization, guaranteed minimum activities described in paragraph (b)(3) recommendations on investment, withdrawal benefits), including those of this section with respect to an management, or value of a particular offered outside the plan or IRA. employee benefit plan (as described in security or securities, or other property. (iii) Asset allocation models. section 3(3) of the Act), the person— (i) Plan information. Information and Information and materials (e.g., pie (i) Merely identifies investment materials that, without reference to the charts, graphs, or case studies) that alternatives that meet objective criteria appropriateness of any individual provide a plan fiduciary, participant or specified by the plan fiduciary (e.g., investment alternative or any individual beneficiary, or IRA owner with models stated parameters concerning expense benefit distribution option for the plan of asset allocation portfolios of ratios, size of fund, type of asset, credit or IRA, or a particular participant or hypothetical individuals with different quality); or beneficiary or IRA owner, describe the time horizons (which may extend (ii) Merely provides objective terms or operation of the plan or IRA, beyond an individual’s retirement date) financial data and comparisons with inform a plan fiduciary, participant, and risk profiles, where— independent benchmarks to the plan beneficiary, or IRA owner about the (A) Such models are based on fiduciary. benefits of plan or IRA participation, the generally accepted investments theories (5) Financial reports and valuations. benefits of increasing plan or IRA that take into account the historic The person provides an appraisal, contributions, the impact of returns of different asset classes (e.g., fairness opinion, or statement of value preretirement withdrawals on equities, bonds, or cash) over defined to— (i) An employee stock ownership plan retirement income, retirement income periods of time; (as defined in section 407(d)(6) of the needs, varying forms of distributions, (B) All material facts and assumptions Act) regarding employer securities (as including rollovers, annuitization and on which such models are based (e.g., defined section 407(d)(5) of the Act); other forms of lifetime income payment retirement ages, life expectancies, (ii) An investment fund, such as a options (e.g., immediate annuity, income levels, financial resources, collective investment fund or pooled deferred annuity, or incremental replacement income ratios, inflation separate account, in which more than purchase of deferred annuity), rates, and rates of return) accompany one unaffiliated plan has an investment, advantages, disadvantages and risks of the models; or which holds plan assets of more than different forms of distributions, or (C) Such models do not include or one unaffiliated plan under 29 CFR describe investment objectives and identify any specific investment product 2510.3–101; or philosophies, risk and return or specific alternative available under (iii) A plan, a plan fiduciary, a plan characteristics, historical return the plan or IRA; and participant or beneficiary, an IRA or IRA information or related prospectuses of (D) The asset allocation models are owner solely for purposes of compliance investment alternatives under the plan accompanied by a statement indicating with the reporting and disclosure or IRA. that, in applying particular asset provisions under the Act, the Code, and (ii) General financial, investment and allocation models to their individual the regulations, forms and schedules retirement information. Information and situations, participants, beneficiaries, or issued thereunder, or any applicable materials on financial, investment and IRA owners should consider their other reporting or disclosure requirement retirement matters that do not address assets, income, and investments (e.g., under a Federal or state law, rule or specific investment products, specific equity in a home, Social Security regulation or self-regulatory plan or IRA alternatives or distribution benefits, individual retirement plan organization rule or regulation. options available to the plan or IRA or investments, savings accounts and (6) Investment education. The person to participants, beneficiaries and IRA interests in other qualified and non- furnishes or makes available any of the owners, or specific alternatives or qualified plans) in addition to their following categories of investment- services offered outside the plan or IRA, interests in the plan or IRA, to the related information and materials and inform the plan fiduciary, extent those items are not taken into described in paragraphs (b)(6)(i) through participant or beneficiary, or IRA owner account in the model or estimate. (iv) of this section to a plan, plan about— (iv) Interactive investment materials. fiduciary, participant or beneficiary, (A) General financial and investment Questionnaires, worksheets, software, IRA or IRA owner irrespective of who concepts, such as risk and return, and similar materials which provide a provides or makes available the diversification, dollar cost averaging, plan fiduciary, participant or information and materials (e.g., plan compounded return, and tax deferred beneficiary, or IRA owners the means to sponsor, fiduciary or service provider), investment; estimate future retirement income needs the frequency with which the (B) Historic differences in rates of and assess the impact of different asset information and materials are provided, return between different asset classes allocations on retirement income; the form in which the information and (e.g., equities, bonds, or cash) based on questionnaires, worksheets, software materials are provided (e.g., on an standard market indices; and similar materials which allow a individual or group basis, in writing or (C) Effects of inflation; plan fiduciary, participant or orally, or via call center, video or (D) Estimating future retirement beneficiary, or IRA owners to evaluate computer software), or whether an income needs; distribution options, products or identified category of information and (E) Determining investment time vehicles by providing information under materials is furnished or made available horizons; paragraphs (b)(6)(i) and (ii) of this alone or in combination with other (F) Assessing risk tolerance; section; questionnaires, worksheets, categories of information and materials (G) Retirement-related risks (e.g., software, and similar materials that identified in paragraphs (b)(6)(i) through longevity risks, market/interest rates, provide a plan fiduciary, participant or (iv), provided that the information and inflation, health care and other beneficiary, or IRA owner the means to materials do not include (standing alone expenses); and estimate a retirement income stream 12-60 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21959 that could be generated by an actual or reference to the criteria set forth in (B) A price range within which such hypothetical account balance, where— paragraph (a) of this section. security is to be purchased or sold, or, (A) Such materials are based on (c) Scope of fiduciary duty— if such security is issued by an open- generally accepted investment theories investment advice. A person who is a end investment company registered that take into account the historic fiduciary with respect to an employee under the Investment Company Act of returns of different asset classes (e.g., benefit plan or IRA by reason of 1940 (15 U.S.C. 80a–1, et seq.), a price equities, bonds, or cash) over defined rendering investment advice (as defined which is determined in accordance with periods of time; in paragraph (a) of this section) for a fee Rule 22c1 under the Investment (B) There is an objective correlation or other compensation, direct or Company Act of 1940 (17 CFR270.22c1); between the asset allocations generated indirect, with respect to any securities (C) A time span during which such by the materials and the information or other property of such plan, or having security may be purchased or sold (not and data supplied by the participant, any authority or responsibility to do so, to exceed five business days); and beneficiary or IRA owner; shall not be deemed to be a fiduciary (D) The minimum or maximum (C) There is an objective correlation regarding any assets of the plan or IRA quantity of such security which may be between the income stream generated by with respect to which such person does purchased or sold within such price the materials and the information and not have any discretionary authority, range, or, in the case of a security issued data supplied by the participant, discretionary control or discretionary by an open-end investment company beneficiary or IRA owner; responsibility, does not exercise any registered under the Investment (D) All material facts and assumptions authority or control, does not render Company Act of 1940, the minimum or (e.g., retirement ages, life expectancies, investment advice (as defined in maximum quantity of such security income levels, financial resources, paragraph (a)(1) of this section) for a fee which may be purchased or sold, or the replacement income ratios, inflation or other compensation, and does not value of such security in dollar amount rates, rates of return and other features have any authority or responsibility to which may be purchased or sold, at the and rates specific to income annuities or render such investment advice, price referred to in paragraph systematic withdrawal plan) that may provided that nothing in this paragraph (d)(1)(ii)(B) of this section. affect a participant’s, beneficiary’s or shall be deemed to: (2) A person who is a broker-dealer, IRA owner’s assessment of the different (1) Exempt such person from the reporting dealer, or bank which is a asset allocations or different income provisions of section 405(a) of the Act fiduciary with respect to an employee streams accompany the materials or are concerning liability for fiduciary benefit plan or IRA solely by reason of specified by the participant, beneficiary breaches by other fiduciaries with the possession or exercise of or IRA owner; respect to any assets of the plan; or discretionary authority or discretionary (E) The materials do not include or (2) Exclude such person from the control in the management of the plan identify any specific investment definition of the term ‘‘party in interest’’ or IRA, or the management or alternative available or distribution (as set forth in section 3(14)(B) of the disposition of plan or IRA assets in option available under the plan or IRA, Act or ‘‘disqualified person’’ as set forth connection with the execution of a unless such alternative or option is in section 4975(e)(2) of the Code) with transaction or transactions for the specified by the participant, beneficiary respect to a plan. purchase or sale of securities on behalf or IRA owner; and (d) Execution of securities of such plan or IRA which fails to (F) The materials either take into transactions. (1) A person who is a comply with the provisions of account other assets, income and broker or dealer registered under the paragraph (d)(1) of this section, shall not investments (e.g., equity in a home, Securities Exchange Act of 1934, a be deemed to be a fiduciary regarding Social Security benefits, individual reporting dealer who makes primary any assets of the plan or IRA with retirement account/annuity markets in securities of the United respect to which such broker-dealer, investments, savings accounts, and States Government or of an agency of reporting dealer or bank does not have interests in other qualified and non- the United States Government and any discretionary authority, qualified plans) or are accompanied by reports daily to the Federal Reserve discretionary control or discretionary a statement indicating that, in applying Bank of New York its positions with responsibility, does not exercise any particular asset allocations to their respect to such securities and authority or control, does not render individual situations, or in assessing the borrowings thereon, or a bank investment advice (as defined in adequacy of an estimated income supervised by the United States or a paragraph (a) of this section) for a fee or stream, participants, beneficiaries or State, shall not be deemed to be a other compensation, and does not have IRA owners should consider their other fiduciary, within the meaning of section any authority or responsibility to render assets, income, and investments in 3(21)(A) of the Act or section such investment advice, provided that addition to their interests in the plan or 4975(e)(3)(B) of the Code, with respect nothing in this paragraph shall be IRA. to an employee benefit plan or IRA deemed to: (v) The information and materials solely because such person executes (i) Exempt such broker-dealer, described in paragraphs (b)(6)(i) through transactions for the purchase or sale of reporting dealer, or bank from the (iv) of this section represent examples of securities on behalf of such plan in the provisions of section 405(a) of the Act the type of information and materials ordinary course of its business as a concerning liability for fiduciary that may be furnished to participants, broker, dealer, or bank, pursuant to breaches by other fiduciaries with beneficiaries and IRA owners without instructions of a fiduciary with respect respect to any assets of the plan; or such information and materials to such plan or IRA, if: (ii) Exclude such broker-dealer, constituting investment advice. (i) Neither the fiduciary nor any reporting dealer, or bank from the Determinations as to whether the affiliate of such fiduciary is such broker, definition of the term party in interest provision of any information, materials dealer, or bank; and (as set forth in section 3(14)(B) of the or educational services not described (ii) The instructions specify: Act) or disqualified person 4975(e)(2) of herein constitutes the rendering of (A) The security to be purchased or the Code with respect to any assets of investment advice must be made by sold; the plan or IRA. © 2015 The Institute of Continuing Legal Education 12-61 Tax Conference, 28th Annual, May 21, 2015 21960 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules (e) Internal Revenue Code. Section controlled by, or under common control and beneficiaries, and IRA owners. The 4975(e)(3) of the Code contains with such person; any officer, director, proposed exemption would affect provisions parallel to section 3(21)(A) of partner, employee or relative (as defined participants and beneficiaries of plans, the Act which define the term in section 3(15) of the Act) of such IRA owners and fiduciaries with respect ‘‘fiduciary’’ for purposes of the person; and any corporation or to such plans and IRAs. prohibited transaction provisions in partnership of which such person is an DATES: Comments: Written comments Code section 4975. Effective December officer, director or partner. concerning the proposed class 31, 1978, section 102 of the (8) ‘‘Control’’ for purposes of exemption must be received by the Reorganization Plan No. 4 of 1978, 5 paragraph (f)(7) of this section means Department on or before July 6, 2015. U.S.C. App. 237 transferred the the power to exercise a controlling Applicability: The Department authority of the Secretary of the influence over the management or proposes to make this exemption Treasury to promulgate regulations of policies of a person other than an available eight months after publication the type published herein to the individual. of the final exemption in the Federal Secretary of Labor. All references herein Signed at Washington, DC, this 14th day of Register. We request comment below on to section 3(21)(A) of the Act should be April, 2015. whether the applicability date of certain read to include reference to the parallel Phyllis C. Borzi, conditions should be delayed. provisions of section 4975(e)(3) of the Assistant Secretary, Employee Benefits ADDRESSES: All written comments Code. Furthermore, the provisions of Security Administration, Department of concerning the proposed class this section shall apply for purposes of Labor. exemption should be sent to the Office the application of Code section 4975 [FR Doc. 2015–08831 Filed 4–15–15; 11:15 am] of Exemption Determinations by any of with respect to any plan described in BILLING CODE 4510–29–P the following methods, identified by Code section 4975(e)(1). ZRIN: 1210–ZA25: (f) Definitions. For purposes of this Federal eRulemaking Portal: http:// section— DEPARTMENT OF LABOR www.regulations.gov at Docket ID (1) ‘‘Recommendation’’ means a number: EBSA–2014–0016. Follow the communication that, based on its Employee Benefits Security instructions for submitting comments. content, context, and presentation, Administration Email to: [email protected]. would reasonably be viewed as a Fax to: (202) 693–8474. suggestion that the advice recipient 29 CFR Part 2550 Mail: Office of Exemption engage in or refrain from taking a Determinations, Employee Benefits particular course of action. [Application No. D–11712] Security Administration, (Attention: D– (2)(i) ‘‘Plan’’ means any employee ZRIN 1210–ZA25 11712), U.S. Department of Labor, 200 benefit plan described in section 3(3) of Constitution Avenue NW., Suite 400, the Act and any plan described in Proposed Best Interest Contract Washington DC 20210. section 4975(e)(1)(A) of the Code, and Exemption Hand Delivery/Courier: Office of (ii) ‘‘IRA’’ means any trust, account or Exemption Determinations, Employee annuity described in Code section AGENCY: Employee Benefits Security Benefits Security Administration, 4975(e)(1)(B) through (F), including, for Administration (EBSA), U.S. (Attention: D–11712), U.S. Department example, an individual retirement Department of Labor. of Labor, 122 C St. NW., Suite 400, account described in section 408(a) of ACTION: Notice of Proposed Class Washington DC 20001. the Code and a health savings account Exemption. Instructions. All comments must be described in section 223(d) of the Code. received by the end of the comment (3) ‘‘Plan participant’’ means for a SUMMARY: This document contains a period. The comments received will be plan described in section 3(3) of the Act, notice of pendency before the U.S. available for public inspection in the a person described in section 3(7) of the Department of Labor of a proposed Public Disclosure Room of the Act. exemption from certain prohibited Employee Benefits Security (4) ‘‘IRA owner’’ means with respect transactions provisions of the Employee Administration, U.S. Department of to an IRA either the person who is the Retirement Income Security Act of 1974 Labor, Room N–1513, 200 Constitution owner of the IRA or the person for (ERISA) and the Internal Revenue Code Avenue NW., Washington, DC 20210. whose benefit the IRA was established. (the Code). The provisions at issue Comments will also be available online (5) ‘‘Plan fiduciary’’ means a person generally prohibit fiduciaries with at www.regulations.gov, at Docket ID described in section (3)(21) of the Act respect to employee benefit plans and number: EBSA–2014–0016 and and 4975(e)(3) of the Code. individual retirement accounts (IRAs) www.dol.gov/ebsa, at no charge. (6) ‘‘Fee or other compensation, direct from engaging in self-dealing and Warning: All comments will be made or indirect’’ for purposes of this section receiving compensation from third available to the public. Do not include and section 3(21)(A)(ii) of the Act, parties in connection with transactions any personally identifiable information means any fee or compensation for the involving the plans and IRAs. The (such as Social Security number, name, advice received by the person (or by an exemption proposed in this notice address, or other contact information) or affiliate) from any source and any fee or would allow entities such as broker- confidential business information that compensation incident to the dealers and insurance agents that are you do not want publicly disclosed. All transaction in which the investment fiduciaries by reason of the provision of comments may be posted on the Internet advice has been rendered or will be investment advice to receive such and can be retrieved by most Internet rendered. The term fee or other compensation when plan participants search engines. compensation includes, for example, and beneficiaries, IRA owners, and FOR FURTHER INFORMATION CONTACT: brokerage fees, mutual fund and certain small plans purchase, hold or Karen E. Lloyd or Brian L. Shiker, Office insurance sales commissions. sell certain investment products in of Exemption Determinations, Employee (7) ‘‘Affiliate’’ includes: Any person accordance with the fiduciaries’ advice, Benefits Security Administration, U.S. directly or indirectly, through one or under protective conditions to safeguard Department of Labor (202) 693–8824 more intermediaries, controlling, the interests of the plans, participants (this is not a toll-free number). 12-62 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21961 SUPPLEMENTARY INFORMATION: The with transactions involving a plan or within 30 days of the close of the Department is proposing this class IRA. Certain types of fees and comment period. exemption on its own motion, pursuant compensation common in the retail Summary of the Major Provisions to ERISA section 408(a) and Code market, such as brokerage or insurance section 4975(c)(2), and in accordance commissions, 12b-1 fees and revenue The proposed exemption would apply with the procedures set forth in 29 CFR sharing payments, fall within these to compensation received by investment part 2570 (76 FR 66637 (October 27, prohibitions when received by advice fiduciaries—both individual 2011)). fiduciaries as a result of transactions ‘‘advisers’’ 2 and the ‘‘financial Public Hearing: The Department plans involving advice to the plan participants institutions’’ that employ or otherwise to hold an administrative hearing within and beneficiaries, IRA owners and small contract with them—and their affiliates 30 days of the close of the comment plan sponsors. To facilitate continued and related entities that is provided in period. The Department will ensure provision of advice to such retail connection with the purchase, sale or ample opportunity for public comment investors and under conditions holding of certain assets by plans and by reopening the record following the designed to safeguard the interests of IRAs. In particular, the exemption hearing and publication of the hearing these investors, the exemption would would apply when prohibited transcript. Specific information allow certain investment advice compensation is received as a result of regarding the date, location and fiduciaries, including broker-dealers advice to retail ‘‘retirement investors’’ submission of requests to testify will be and insurance agents, to receive these including plan participants and published in a notice in the Federal various forms of compensation that, in beneficiaries, IRA owners, and plan Register. the absence of an exemption, would not sponsors (or their employees, officers or directors) of plans with fewer than 100 Executive Summary be permitted under ERISA and the Code. participants making investment Purpose of Regulatory Action Rather than create a set of highly decisions on behalf of the plans and The Department is proposing this prescriptive transaction-specific IRAs. exemption in connection with its exemptions, which has generally been In order to protect the interests of the proposed regulation under ERISA the regulatory approach to date, the plan participants and beneficiaries, IRA section 3(21)(A)(ii) and Code section proposed exemption would flexibly owners, and small plan sponsors, the 4975(e)(3)(B) (Proposed Regulation), accommodate a wide range of current exemption would require the adviser published elsewhere in this issue of the business practices, while minimizing and financial institution to contractually Federal Register. The Proposed the harmful impact of conflicts of acknowledge fiduciary status, commit to Regulation would amend the definition interest on the quality of advice. The adhere to basic standards of impartial of a ‘‘fiduciary’’ under ERISA and the Department has sought to preserve conduct, warrant that they have adopted Code to specify when a person is a beneficial business models by taking a policies and procedures reasonably fiduciary by reason of the provision of standards-based approach that will designed to mitigate any harmful impact investment advice for a fee or other broadly permit firms to continue to rely of conflicts of interest, and disclose compensation regarding assets of a plan on common fee practices, as long as basic information on their conflicts of or IRA. If adopted, the Proposed they are willing to adhere to basic interest and on the cost of their advice. Regulation would replace an existing standards aimed at ensuring that their The adviser and firm must commit to regulation dating to 1975. The Proposed advice is in the best interest of their fundamental obligations of fair dealing Regulation is intended to take into customers. and fiduciary conduct—to give advice account the advent of 401(k) plans and ERISA section 408(a) specifically that is in the customer’s best interest; IRAs, the dramatic increase in rollovers, authorizes the Secretary of Labor to avoid misleading statements; receive no and other developments that have grant administrative exemptions from more than reasonable compensation; transformed the retirement plan ERISA’s prohibited transaction and comply with applicable federal and landscape and the associated provisions.1 Regulations at 29 CFR state laws governing advice. This investment market over the four decades 2570.30 to 2570.52 describe the standards-based approach aligns the since the existing regulation was issued. procedures for applying for an adviser’s interests with those of the plan In light of the extensive changes in administrative exemption. Before or IRA customer, while leaving the retirement investment practices and granting an exemption, the Department adviser and employing firm the relationships, the Proposed Regulation must find that the exemption is flexibility and discretion necessary to would update existing rules to administratively feasible, in the determine how best to satisfy these distinguish more appropriately between interests of plans and their participants basic standards in light of the unique the sorts of advice relationships that and beneficiaries and IRA owners, and attributes of their business. All financial should be treated as fiduciary in nature protective of the rights of participants institutions relying on the exemption and those that should not. and beneficiaries of plans and IRA would be required to notify the The exemption proposed in this owners. Interested parties are permitted Department in advance of doing so. notice (‘‘the Best Interest Contract to submit comments to the Department Finally, all financial institutions making Exemption’’) was developed to promote through July 6, 2015. The Department use of the exemption would have to the provision of investment advice that plans to hold an administrative hearing maintain certain data, and make it is in the best interest of retail investors available to the Department, to help such as plan participants and 1 Code section 4975(c)(2) authorizes the Secretary of the Treasury to grant exemptions from the 2 By using the term ‘‘adviser,’’ the Department beneficiaries, IRA owners, and small parallel prohibited transaction provisions of the does not intend to limit the exemption to plans. ERISA and the Code generally Code. Reorganization Plan No. 4 of 1978 (5 U.S.C. investment advisers registered under the prohibit fiduciaries from receiving app. at 214 (2000)) generally transferred the Investment Advisers Act of 1940 or under state law. payments from third parties and from authority of the Secretary of the Treasury to grant As explained herein, an adviser is an individual administrative exemptions under Code section 4975 who can be a representative of a registered acting on conflicts of interest, including to the Secretary of Labor. This proposed exemption investment adviser, a bank or similar financial using their authority to affect or increase would provide relief from the indicated prohibited institution, an insurance company, or a broker- their own compensation, in connection transaction provisions of both ERISA and the Code. dealer. © 2015 The Institute of Continuing Legal Education 12-63 Tax Conference, 28th Annual, May 21, 2015 21962 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules evaluate the effectiveness of the Department has undertaken an IRA owners for the losses caused by exemption in safeguarding the interests assessment of the costs and benefits of their misconduct. Nor can the Secretary of the plan participants and the proposed exemption, and OMB has of Labor bring suit to enforce the beneficiaries, IRA owners, and small reviewed this regulatory action. prohibited transactions rules on behalf plans. of IRA owners. The exemption proposed Background herein, as well as the Proposed Class Executive Order 12866 and 13563 Proposed Regulation Defining a Exemption for Principal Transactions in Statement Fiduciary Certain Debt Securities between Under Executive Orders 12866 and As explained more fully in the Investment Advice Fiduciaries and 13563, the Department must determine preamble to the Department’s Proposed Employee Benefit Plans and IRAs, whether a regulatory action is Regulation under ERISA section published elsewhere in this issue of the ‘‘significant’’ and therefore subject to 3(21)(A)(ii) and Code section Federal Register, would create the requirements of the Executive Order 4975(e)(3)(B), also published in this contractual obligations for fiduciaries to and subject to review by the Office of issue of the Federal Register, ERISA is adhere to certain standards (the Management and Budget (OMB). a comprehensive statute designed to Impartial Conduct Standards) if they Executive Orders 13563 and 12866 protect the interests of plan participants want to take advantage of the direct agencies to assess all costs and and beneficiaries, the integrity of exemption. IRA owners would have a benefits of available regulatory employee benefit plans, and the security right to enforce these new contractual alternatives and, if regulation is of retirement, health, and other critical rights. necessary, to select regulatory benefits. The broad public interest in Under the statutory framework, the approaches that maximize net benefits ERISA-covered plans is reflected in its determination of who is a ‘‘fiduciary’’ is (including potential economic, imposition of fiduciary responsibilities of central importance. Many of ERISA’s environmental, public health and safety on parties engaging in important plan and the Code’s protections, duties, and effects, distributive impacts, and activities, as well as in the tax-favored liabilities hinge on fiduciary status. In equity). Executive Order 13563 status of plan assets and investments. relevant part, ERISA section 3(21)(A) emphasizes the importance of One of the chief ways in which ERISA and Code section 4975(e)(3) provide that quantifying both costs and benefits, of protects employee benefit plans is by a person is a fiduciary with respect to reducing costs, of harmonizing and requiring that plan fiduciaries comply a plan or IRA to the extent he or she (i) streamlining rules, and of promoting with fundamental obligations rooted in exercises any discretionary authority or flexibility. It also requires federal the law of trusts. In particular, plan discretionary control with respect to agencies to develop a plan under which fiduciaries must manage plan assets management of such plan or IRA, or they will periodically review their prudently and with undivided loyalty to exercises any authority or control with existing significant regulations to make the plans and their participants and respect to management or disposition of regulatory programs more effective or beneficiaries.3 In addition, they must its assets; (ii) renders investment advice less burdensome in achieving their refrain from engaging in ‘‘prohibited for a fee or other compensation, direct regulatory objectives. transactions,’’ which ERISA does not or indirect, with respect to any moneys Under Executive Order 12866, or other property of such plan or IRA, ‘‘significant’’ regulatory actions are permit because of the dangers posed by the fiduciaries’ conflicts of interest with or has any authority or responsibility to subject to the requirements of the 4 do so; or, (iii) has any discretionary Executive Order and review by the respect to the transactions. When fiduciaries violate ERISA’s fiduciary authority or discretionary responsibility Office of Management and Budget in the administration of such plan or (OMB). Section 3(f) of Executive Order duties or the prohibited transaction rules, they may be held personally liable IRA. 12866, defines a ‘‘significant regulatory The statutory definition deliberately for the breach.5 In addition, violations action’’ as an action that is likely to casts a wide net in assigning fiduciary of the prohibited transaction rules are result in a rule (1) having an annual responsibility with respect to plan and effect on the economy of $100 million subject to excise taxes under the Code. The Code also has rules regarding IRA assets. Thus, ‘‘any authority or or more, or adversely and materially control’’ over plan or IRA assets is fiduciary conduct with respect to tax- affecting a sector of the economy, sufficient to confer fiduciary status, and favored accounts that are not generally productivity, competition, jobs, the any persons who render ‘‘investment covered by ERISA, such as IRAs. environment, public health or safety, or advice for a fee or other compensation, Although ERISA’s general fiduciary State, local or tribal governments or direct or indirect’’ are fiduciaries, obligations of prudence and loyalty do communities (also referred to as an regardless of whether they have direct not govern the fiduciaries of IRAs, these ‘‘economically significant’’ regulatory control over the plan’s or IRA’s assets fiduciaries are subject to the prohibited action); (2) creating serious and regardless of their status as an transaction rules. In this context, inconsistency or otherwise interfering investment adviser or broker under the fiduciaries engaging in the prohibited with an action taken or planned by federal securities laws. The statutory another agency; (3) materially altering transactions are subject to an excise tax definition and associated the budgetary impacts of entitlement enforced by the Internal Revenue responsibilities were enacted to ensure grants, user fees, or loan programs or the Service. Unlike participants in plans that plans, plan participants, and IRA rights and obligations of recipients covered by Title I of ERISA, IRA owners owners can depend on persons who thereof; or (4) raising novel legal or do not have a statutory right to bring provide investment advice for a fee to policy issues arising out of legal suit against fiduciaries for violation of provide recommendations that are mandates, the President’s priorities, or the prohibited transaction rules and untainted by conflicts of interest. In the the principles set forth in the Executive fiduciaries are not personally liable to absence of fiduciary status, the Order. Pursuant to the terms of the providers of investment advice are 3 Executive Order, OMB has determined ERISA section 404(a). neither subject to ERISA’s fundamental 4 ERISA section 406. ERISA also prohibits certain that this action is ‘‘significant’’ within transactions between a plan and a ‘‘party in fiduciary standards, nor accountable for the meaning of Section 3(f)(4) of the interest.’’ imprudent, disloyal, or tainted advice Executive Order. Accordingly, the 5 ERISA section 409; see also ERISA section 405. under ERISA or the Code, no matter 12-64 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21963 how egregious the misconduct or how allows advisers, brokers, consultants (2) A recommendation as to the substantial the losses. Retirement and valuation firms to play a central management of securities or other investors typically are not financial role in shaping plan investments, property, including recommendations as experts and consequently must rely on without ensuring the accountability that to the management of securities or other professional advice to make critical Congress intended for persons having property to be rolled over or otherwise investment decisions. In the years since such influence and responsibility. Even distributed from the plan or IRA; then, the significance of financial advice when plan sponsors, participants, (3) An appraisal, fairness opinion or has become still greater with increased beneficiaries and IRA owners clearly similar statement, whether verbal or reliance on participant directed plans rely on paid consultants for impartial written, concerning the value of and IRAs for the provision of retirement guidance, the regulation allows many securities or other property, if provided benefits. advisers to avoid fiduciary status and in connection with a specific In 1975, the Department issued a the accompanying fiduciary obligations transaction or transactions involving the regulation, at 29 CFR 2510.3– of care and prohibitions on disloyal and acquisition, disposition or exchange of 21(c)(1975), defining the circumstances conflicted transactions. As a such securities or other property by the under which a person is treated as consequence, under ERISA and the plan or IRA; and providing ‘‘investment advice’’ to an Code, these advisers can steer customers (4) a recommendation of a person who employee benefit plan within the to investments based on their own self- is also going to receive a fee or other meaning of ERISA section 3(21)(A)(ii) interest, give imprudent advice, and compensation in providing any of the (the ‘‘1975 regulation’’).6 The 1975 engage in transactions that would types of advice described in paragraphs regulation narrowed the scope of the otherwise be prohibited by ERISA and (1) through (3), above. statutory definition of fiduciary the Code. In addition, to be a fiduciary, such investment advice by creating a five-part In the Department’s Proposed person must either (i) represent or test that must be satisfied before a Regulation defining a fiduciary under acknowledge that it is acting as a person can be treated as rendering ERISA section 3(21)(A)(ii) and Code fiduciary within the meaning of ERISA investment advice for a fee. Under the section 4975(e)(3)(B), the Department (or the Code) with respect to the advice, 1975 regulation, for advice to constitute seeks to replace the existing regulation or (ii) render the advice pursuant to a ‘‘investment advice,’’ an adviser who with one that more appropriately written or verbal agreement, does not have discretionary authority or distinguishes between the sorts of arrangement or understanding that the control with respect to the purchase or advice relationships that should be advice is individualized to, or that such sale of securities or other property of the treated as fiduciary in nature and those advice is specifically directed to, the plan must (1) render advice as to the that should not, in light of the legal advice recipient for consideration in value of securities or other property, or framework and financial marketplace in making investment or management make recommendations as to the which IRAs and plans currently decisions with respect to securities or advisability of investing in, purchasing operate.8 Under the Proposed other property of the plan or IRA. or selling securities or other property (2) Regulation, plans include IRAs. In the Proposed Regulation, the on a regular basis (3) pursuant to a The Proposed Regulation describes Department refers to FINRA guidance mutual agreement, arrangement or the types of advice that constitute on whether particular communications understanding, with the plan or a plan ‘‘investment advice’’ with respect to should be viewed as fiduciary that (4) the advice will serve plan or IRA assets for purposes of the ‘‘recommendations’’9 within the as a primary basis for investment definition of a fiduciary at ERISA meaning of the fiduciary definition, and decisions with respect to plan assets, section 3(21)(A)(ii) and Code section requests comment on whether the and that (5) the advice will be 4975(e)(3)(B). The proposal provides, Proposed Regulation should adhere to individualized based on the particular subject to certain carve-outs, that a or adopt some or all of the standards needs of the plan. The regulation person renders investment advice with developed by FINRA in defining provides that an adviser is a fiduciary respect to assets of a plan or IRA if, communications which rise to the level with respect to any particular instance among other things, the person of a recommendation. For more detailed of advice only if he or she meets each provides, directly to a plan, a plan information regarding the Proposed and every element of the five-part test fiduciary, a plan participant or Regulation, see the Notice of the with respect to the particular advice beneficiary, IRA or IRA owner, one of Proposed Regulation published in this recipient or plan at issue. A 1976 the following types of advice: issue of the Federal Register. Department of Labor Advisory Opinion (1) A recommendation as to the For advisers who do not represent further limited the application of the advisability of acquiring, holding, that they are acting as ERISA or Code statutory definition of ‘‘investment disposing or exchanging securities or fiduciaries, the Proposed Regulation advice’’ by stating that valuations of other property, including a provides that advice rendered in employer securities in connection with recommendation to take a distribution conformance with certain carve-outs employee stock ownership plan (ESOP) of benefits or a recommendation as to will not cause the adviser to be treated purchases would not be considered the investment of securities or other as a fiduciary under ERISA or the Code. fiduciary advice.7 property to be rolled over or otherwise For example, under the seller’s carve- As the marketplace for financial distributed from a plan or IRA; out, counterparties in arm’s length services has developed in the years transactions with plans may make since 1975, the five-part test may now 8 The Department initially proposed an investment recommendations without undermine, rather than promote, the amendment to its regulation defining a fiduciary acting as fiduciaries if certain statutes’ text and purposes. The under ERISA section 3(21)(A)(ii) and Code section conditions are met.10 The proposal also narrowness of the 1975 regulation 4975(e)(3)(B) on October 22, 2010, at 75 FR 65263. It subsequently announced its intention to withdraw the proposal and propose a new rule, 9 See NASD Notice to Members 01–23 and FINRA 6 The Department of Treasury issued a virtually consistent with the President’s Executive Orders Regulatory Notices 11–02, 12–25 and 12–55. identical regulation, at 26 CFR 54.4975–9(c), which 12866 and 13563, in order to give the public a full 10 Although the preamble adopts the phrase interprets Code section 4975(e)(3). opportunity to evaluate and comment on the new ‘‘seller’s carve-out’’ as a shorthand way of referring 7 Advisory Opinion 76–65A (June 7, 1976). proposal and updated economic analysis. Continued © 2015 The Institute of Continuing Legal Education 12-65 Tax Conference, 28th Annual, May 21, 2015 21964 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules contains a carve-out from fiduciary additional fee to such fiduciary, or to a (3) protective of the rights of the status for providers of appraisals, person in which such fiduciary has an participants and beneficiaries of such fairness opinions, or statements of value interest that may affect the exercise of plans and IRA owners. in specified contexts (e.g., with respect the fiduciary’s best judgment as a Over the years, the Department has to ESOP transactions). The proposal fiduciary. Likewise, a fiduciary is granted several conditional additionally includes a carve-out from prohibited from receiving compensation administrative class exemptions from fiduciary status for the marketing of from third parties in connection with a the prohibited transactions provisions of investment alternative platforms to transaction involving the plan or IRA, or plans, certain assistance in selecting from causing a person in which the ERISA and the Code. The exemptions investment alternatives and other fiduciary has an interest which may focus on specific types of compensation activities. Finally, the Proposed affect its best judgment as a fiduciary to arrangements. Fiduciaries relying on Regulation carves out the provision of receive such compensation.12 Given these exemptions must comply with investment education from the these prohibitions, conferring fiduciary certain conditions designed to protect definition of an investment advice status on particular investment advice the interests of plans and IRAs. In fiduciary. activities can have important connection with the development of the implications for many investment Proposed Regulation, the Department Prohibited Transactions professionals. has considered comments suggesting the The Department anticipates that the In particular, investment need for additional prohibited Proposed Regulation will cover many professionals typically receive transaction exemptions for the wide investment professionals who do not compensation for services to retirement variety of compensation structures that currently consider themselves to be investors in the retail market through a exist today in the marketplace for fiduciaries under ERISA or the Code. If variety of arrangements. These include investments. Some commentators have the Proposed Regulation is adopted, commissions paid by the plan, suggested that the lack of such relief these entities will become subject to the participant or beneficiary, or IRA, or may cause financial professionals to cut prohibited transaction restrictions in commissions, sales loads, 12b–1 fees, back on the provision of investment ERISA and the Code that apply revenue sharing and other payments advice and the availability of products specifically to fiduciaries. ERISA from third parties that provide to plan participants and beneficiaries, section 406(b)(1) and Code section investment products. The investment IRAs, and smaller plans. 4975(c)(1)(E) prohibit a fiduciary from professional or its affiliate may receive dealing with the income or assets of a such fees upon the purchase or sale by After consideration of the issue, the plan or IRA in his own interest or his a plan, participant or beneficiary Department has determined to propose own account. ERISA section 406(b)(2) account, or IRA of the product, or while the new class exemption described provides that a fiduciary shall not ‘‘in the plan, participant or beneficiary below, which applies to investment his individual or in any other capacity account, or IRA, holds the product. In advice fiduciaries providing advice to act in any transaction involving the plan the Department’s view, receipt by a plan participants and beneficiaries, on behalf of a party (or represent a fiduciary of such payments would IRAs, and certain employee benefit party) whose interests are adverse to the violate the prohibited transaction plans with fewer than 100 participants interests of the plan or the interests of provisions of ERISA section 406(b) and (referred to as ‘‘retirement investors’’). its participants or beneficiaries.’’ As this Code section 4975(c)(1)(E) and (F) The exemption would apply broadly to provision is not in the Code, it does not because the amount of the fiduciary’s many common types of otherwise apply to transactions involving IRAs. compensation is affected by the use of prohibited compensation that such ERISA section 406(b)(3) and Code its authority in providing investment investment advice fiduciaries may section 4975(c)(1)(F) prohibit a fiduciary advice, unless such payments meet the receive, provided the protective from receiving any consideration for his requirements of an exemption. conditions of the exemption are own personal account from any party Prohibited Transaction Exemptions satisfied. The Department is also dealing with the plan or IRA in seeking public comment on whether it connection with a transaction involving ERISA and the Code counterbalance should issue a separate streamlined the broad proscriptive effect of the assets of the plan or IRA. exemption that would allow advisers to prohibited transaction provisions with Parallel regulations issued by the receive otherwise prohibited numerous statutory exemptions. For Departments of Labor and the Treasury compensation in connection with explain that these provisions impose on example, ERISA section 408(b)(14) and advice to invest in certain high-quality fiduciaries of plans and IRAs a duty not Code section 4975(d)(17) specifically low-fee investments, subject to fewer to act on conflicts of interest that may exempt transactions in connection with conditions. affect the fiduciary’s best judgment on the provision of fiduciary investment behalf of the plan or IRA.11 The advice to a participant or beneficiary of Elsewhere in this issue of the Federal prohibitions extend to a fiduciary an individual account plan or IRA Register, the Department is also causing a plan or IRA to pay an owner where the advice, resulting proposing a new class exemption for transaction, and the adviser’s fees meet ‘‘principal transactions’’ for investment to the carve-out and its terms, the regulatory carve- certain conditions. The Secretary of advice fiduciaries selling certain debt out is not limited to sellers but rather applies more Labor may grant administrative securities out of their own inventories to broadly to counterparties in arm’s length exemptions under ERISA and the Code transactions with plan investors with financial plans and IRAs. expertise. on an individual or class basis if the Lastly, the Department is also 11 Subsequent to the issuance of these regulations, Secretary finds that the exemption is (1) proposing, elsewhere in this issue of the Reorganization Plan No. 4 of 1978, 5 U.S.C. App. administratively feasible, (2) in the Federal Register, amendments to the (2010), divided rulemaking and interpretive interests of plans and their participants following existing class prohibited authority between the Secretaries of Labor and the and beneficiaries and IRA owners, and Treasury. The Secretary of Labor was provided exemptions, which are particularly interpretive and rulemaking authority regarding the relevant to broker-dealers and other definition of fiduciary in both Title I of ERISA and 12 29 CFR 2550.408b–2(e); 26 CFR 54.4975– the Internal Revenue Code. 6(a)(5). investment advice fiduciaries. 12-66 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21965 Prohibited Transaction Exemption inventory (i.e. acting as principals, fiduciaries as a result of advice they give (PTE) 86–128 13 currently allows an rather than agents) to plans and IRAs in connection with these transactions. investment advice fiduciary to cause a and to receive commissions for doing The exemption allows these investment plan or IRA to pay the investment so. This transaction is currently the advice fiduciaries to receive a sales advice fiduciary or its affiliate a fee for subject of another exemption, PTE 75– commission with respect to products effecting or executing securities 1, Part II(2) (discussed below) that the purchased by plans or IRAs. The transactions as agent. To prevent Department is proposing to revoke. exemption is limited to sales churning, the exemption does not apply Several changes are proposed with commissions that are reasonable under if such transactions are excessive in respect to PTE 75–1, a multi-part the circumstances. The investment either amount or frequency. The exemption for securities transactions advice fiduciary must provide exemption also allows the investment involving broker-dealers and banks, and disclosure of the amount of the advice fiduciary to act as the agent for plans and IRAs.14 Part I(b) and (c) commission and other terms of the both the plan and the other party to the currently provide relief for certain non- transaction to an independent fiduciary transaction (i.e., the buyer and the seller fiduciary services to plans and IRAs. of the plan or IRA, and obtain approval of securities), and receive a reasonable The Department is proposing to revoke for the transaction. To use this fee. To use the exemption, the fiduciary these provisions, and require persons exemption, the investment advice cannot be a plan administrator or seeking to engage in such transactions to fiduciary may not have certain roles employer, unless all profits earned by rely instead on the existing statutory with respect to the plan or IRA such as these parties are returned to the plan. exemptions provided in ERISA section trustee, plan administrator, or fiduciary The conditions of the exemption require 408(b)(2) and Code section 4975(d)(2), with written authorization to manage that a plan fiduciary independent of the and the Department’s implementing the plan’s assets and employers. investment advice fiduciary receive regulations at 29 CFR 2550.408b–2. In However it is available to investment certain disclosures and authorize the the Department’s view, the conditions of advice fiduciaries regardless of whether transaction. In addition, the the statutory exemption are more they expressly acknowledge their independent fiduciary must receive appropriate for the provision of services. fiduciary status or are simply functional confirmations and an annual ‘‘portfolio PTE 75–1, Part II(2), currently or ‘‘inadvertent’’ fiduciaries that have turnover ratio’’ demonstrating the provides relief for fiduciaries to receive not expressly agreed to act as fiduciary amount of turnover in the account commissions for selling mutual fund advisers, provided there is no written during that year. These conditions are shares to plans and IRAs in a principal authorization granting them discretion not presently applicable to transactions transaction. As described above, the to acquire or dispose of the assets of the involving IRAs. Department is proposing to provide plan or IRA. The Department is proposing to relief for these types of transactions in PTE 86–128, and so is proposing to The Department is proposing to amend PTE 86–128 to require all amend PTE 84–24 to require all fiduciaries relying on the exemption to revoke PTE 75–1, Part II(2), in its entirety. As discussed in more detail in fiduciaries relying on the exemption to adhere to the same impartial conduct adhere to the same impartial conduct standards required in the Best Interest the notice of proposed amendment/ revocation, the Department believes the standards required in the Best Interest Contract Exemption. At the same time, Contract Exemption. At the same time, the proposed amendment would conditions of PTE 86–128 are more appropriate for these transactions. the proposed amendment would revoke eliminate relief for investment advice PTE 84–24 in part so that investment fiduciaries to IRA owners; instead they PTE 75–1, Part V, currently permits broker-dealers to extend credit to a plan advice fiduciaries to IRA owners would would be required to rely on the Best or IRA in connection with the purchase not be able to rely on PTE 84–24 with Interest Contract Exemption for an or sale of securities. The exemption respect to (1) transactions involving exemption for such compensation. In does not permit broker-dealers that are variable annuity contracts and other the Department’s view, the provisions in fiduciaries to receive compensation annuity contracts that constitute the Best Interest Contract Exemption when doing so. The Department is securities under federal securities laws, better address the interests of IRAs with proposing to amend PTE 75–1, Part V, and (2) transactions involving the respect to transactions otherwise to permit investment advice fiduciaries purchase of mutual fund shares. covered by PTE 86–128 and, unlike plan to receive compensation for lending Investment advice fiduciaries would participants and beneficiaries, there is money or otherwise extending credit to instead be required to rely on the Best no separate plan fiduciary in the IRA plans and IRAs, but only for the limited Interest Contract Exemption for market to review and authorize the purpose of avoiding a failed securities compensation received in connection transaction. Investment advice transaction. with these transactions. The Department fiduciaries to plans would remain PTE 84–24 15 covers transactions believes that investment advice eligible for relief under the exemption, involving mutual fund shares, or transactions involving annuity contracts as would investment managers with full insurance or annuity contracts, sold to that are treated as securities and investment discretion over the plans or IRAs by pension consultants, transactions involving the purchase of investments of plans and IRA owners, insurance agents, brokers, and mutual mutual fund shares should occur under but they would be required to comply fund principal underwriters who are the conditions of the Best Interest with all the protective conditions, Contract Exemption due to the described above. Finally, the 14 Exemptions from Prohibitions Respecting similarity of these investments, Department is proposing that PTE 86– Certain Classes of Transactions Involving Employee including their distribution channels Benefit Plans and Certain Broker-Dealers, Reporting 128 extend to a new covered and disclosure obligations, to other transaction, for fiduciaries to sell Dealers and Banks, 40 FR 50845 (Oct. 31, 1975), as amended at 71 FR 5883 (Feb. 3, 2006). investments covered in the Best Interest mutual fund shares out of their own 15 Class Exemption for Certain Transactions Contract Exemption. Investment advice Involving Insurance Agents and Brokers, Pension fiduciaries to ERISA plans would 13 Class Exemption for Securities Transactions Consultants, Insurance Companies, Investment Involving Employee Benefit Plans and Broker- Companies and Investment Company Principal remain eligible for relief under the Dealers, 51 FR 41686 (Nov. 18, 1986), amended at Underwriters, 49 FR 13208 (Apr. 3, 1984), amended exemption with respect to transactions 67 FR 64137 (Oct. 17, 2002). at 71 FR 5887 (Feb. 3, 2006). involving all insurance and annuity © 2015 The Institute of Continuing Legal Education 12-67 Tax Conference, 28th Annual, May 21, 2015 21966 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules contracts and mutual fund shares and promoting the provision of investment with respect to the Adviser or Financial the receipt of commissions allowable advice that is in the best interest of Institution.21 Affiliates are (i) any under that exemption. Investment retirement investors. person directly or indirectly through advice fiduciaries to IRAs could still Section I of the proposed exemption one or more intermediaries, controlling, receive commissions for transactions would provide relief for the receipt of controlled by, or under common control involving non-securities insurance and prohibited compensation by ‘‘Advisers,’’ with the Adviser or Financial annuity contracts, but they would be ‘‘Financial Institutions,’’ ‘‘Affiliates’’ Institution; (ii) any officer, director, required to comply with all the and ‘‘Related Entities’’ for services employee, agent, registered protective conditions, described above. provided in connection with a purchase, representative, relative, member of Finally, the Department is proposing sale or holding of an ‘‘Asset’’ 17 by a family, or partner in, the Adviser or amendments to certain other existing plan or IRA as a result of the Adviser’s Financial Institution; and (iii) any class exemptions to require adherence advice. The exemption also uses the corporation or partnership of which the to the impartial conduct standards term ‘‘Retirement Investor’’ to describe Adviser or Financial Institution is an required in the Best Interest Contract the types of persons who can be advice officer, director or employee or in which Exemption. Specifically, PTEs 75–1, recipients under the exemption.18 These the Adviser or Financial Institution is a Part III, 75–1, Part IV, 77–4, 80–83, and terms are defined in Section VIII of this partner. For this purpose, ‘‘control’’ 83–1, would be amended. Other than proposed exemption. The following means the power to exercise a the amendments described above, sections discuss these key definitional controlling influence over the however, the existing class exemptions terms of the exemption as well as the management or policies of a person will remain in place, affording scope and conditions of the proposed other than an individual. Related additional flexibility to fiduciaries who exemption. Entities are entities other than Affiliates currently use the exemptions or who Entities Defined in which an Adviser or Financial wish to use the exemptions in the Institution has an interest that may future. The Department seeks comment 1. Adviser affect their exercise of their best on whether additional exemptions are The proposed exemption judgment as fiduciaries. needed in light of the Proposed contemplates that an individual person, 4. Retirement Investor Regulation. an Adviser, will provide advice to the Retirement Investor. An Adviser must The proposed exemption uses the Proposed Best Interest Contract term ‘‘Retirement Investor’’ to describe Exemption be an investment advice fiduciary of a plan or IRA who is an employee, the types of persons who can be As noted above, the exemption independent contractor, agent, or investment advice recipients under the proposed in this notice provides relief registered representative of a ‘‘Financial exemption. The Retirement Investor for some of the same compensation Institution’’ (discussed in the next may be a plan participant or beneficiary payments as the existing exemptions section), and the Adviser must satisfy with authority to direct the investment described above. It is intended, the applicable federal and state of assets in his or her plan account or however, to flexibly accommodate a regulatory and licensing requirements of to take a distribution; in the case of an wide range of current business insurance, banking, and securities laws IRA, the beneficial owner of the IRA practices, while minimizing the harmful with respect to the receipt of the (i.e., the IRA owner); or a plan sponsor impact of conflicts of interest on the compensation.19 Advisers may be, for (or an employee, officer or director quality of advice. The exemption example, registered representatives of thereof) of a non-participant-directed permits fiduciaries to continue to ERISA plan that has fewer than 100 broker-dealers registered under the 22 receive a wide variety of types of Securities Exchange Act of 1934, or participants. compensation that would otherwise be insurance agents or brokers. Scope of Relief in the Best Interest prohibited. It seeks to preserve Contract Exemption beneficial business models by taking a 2. Financial Institutions standards-based approach that will For purposes of the proposed The Best Interest Contract Exemption broadly permit firms to continue to rely exemption, a Financial Institution is the set forth in Section I would provide on common fee practices, as long as entity that employs an Adviser or prohibited transaction relief for the they are willing to adhere to basic otherwise retains the Adviser as an receipt by Advisers, Financial standards aimed at ensuring that their independent contractor, agent or Institutions, Affiliates and Related advice is in the best interest of their registered representative.20 Financial Entities of a wide variety of customers. This standards-based Institutions must be registered compensation forms as a result of approach stands in marked contrast to investment advisers, banks, insurance investment advice provided to the existing class exemptions that generally companies, or registered broker-dealers. Retirement Investors, if the conditions focus on very specific types of of the exemption are satisfied. 3. Affiliates and Related Entities investments or compensation and take a Specifically, Section I(b) of the highly prescriptive approach to Relief is also proposed for the receipt proposed exemption provides that the specifying conditions. The proposed of otherwise prohibited compensation exemption would permit an Adviser, exemption would provide relief for by ‘‘Affiliates’’ and ‘‘Related Entities’’ Financial Institution and their Affiliates common investments 16 of retirement and Related Entities to receive investors under the umbrella of one 17 See Section VIII(c) of the proposed exemption. compensation for services provided in exemption. It is intended that this 18 While the Department uses the term connection with the purchase, sale or ‘‘Retirement Investor’’ throughout this document, updated approach will ease compliance holding of an Asset by a plan, the proposed exemption is not limited only to participant or beneficiary account, or costs and reduce complexity while investment advice fiduciaries of employee pension benefit plans and IRAs. Relief would be available IRA, as a result of an Adviser’s or 16 See Section VIII(c) of the proposed exemption, for investment advice fiduciaries of employee defining the term ‘‘Asset,’’ and the preamble welfare benefit plans as well. 21 See Section VIII(b) and (k) of the proposed discussion in the ‘‘Scope of Relief in the Best 19 See Section VIII(a) of the proposed exemption. exemption. Interest Contract Exemption’’ section below. 20 See Section VIII(e) of the proposed exemption. 22 See Section VIII(l) of the proposed exemption. 12-68 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21967 Financial Institution’s investment definition does not encompass any otherwise prohibited compensation advice to a Retirement Investor. equity security that is a security future commonly received in the retail market, The proposed exemption would apply or a put, call, straddle, or any other such as commissions, 12b–1 fees, and to the restrictions of ERISA section option or privilege of buying an equity revenue sharing payments, subject to 406(b) and the sanctions imposed by security from or selling an equity conditions designed specifically to Code section 4975(a) and (b), by reason security to another without being bound protect the interests of the investors. For of Code section 4975(c)(1)(E) and (F). to do so.24 consistency with these objectives, the These provisions prohibit conflict of Prohibited compensation received for exemption would apply to the receipt of interest transactions and receipt of investments that fall outside the such compensation by Advisers, third-party payments by investment definition of Asset would not be Financial Institutions and their advice fiduciaries.23 For relief to be covered by the exemption. Limiting the Affiliates and Related Entities only available under the exemption, the exemption in this manner ensures that when advice is provided to retail Adviser and Financial Institution must the investments needed to build a basic Retirement Investors, including plan comply with the applicable conditions, diversified portfolio are available to participants and beneficiaries, IRA including entering into a contract that plans, participant and beneficiary owners, and plan sponsors (including acknowledges fiduciary status and accounts, and IRAs, while limiting the the sponsor’s employees, officers, and requires adherence to certain Impartial exemption to those investments that are directors) acting on behalf of non- Conduct Standards. relatively transparent and liquid, many participant-directed plans that have The types of compensation payments of which have a ready market price. The fewer than 100 participants. As contemplated by this proposed Department also notes that many discussed in the preamble to the exemption include commissions paid investment types and strategies that Proposed Regulation and in the directly by the plan or IRA, as well as would not be covered by the exemption associated Regulatory Impact Analysis, commissions, trailing commissions, can be obtained through pooled these investors are particularly sales loads, 12b–1 fees, and revenue investment funds, such as mutual funds, vulnerable to abuse. The proposed sharing payments paid by the that are covered by the exemption. exemption is designed to protect these investment providers or other third Request for Comment. The investors from the harmful impact of parties to Advisers and Financial Department requests comment on the conflicts of interest, while minimizing Institutions. The exemption also would proposed definition of Assets, in the potential disruption to a retail cover other compensation received by particular: market that relies upon many forms of the Adviser, Financial Institution or • Do commenters agree we have compensation that ERISA would their Affiliates and Related Entities as a identified all common investments of otherwise prohibit. result of an investment by a plan, retail investors? The Department believes that participant or beneficiary account, or • Have we defined individual investment advice in the institutional IRA, such as investment management investment products with enough market is best addressed through other fees or administrative services fees from precision that parties will know if they approaches. Accordingly, the proposed an investment vehicle in which the are complying with this aspect of the exemption does not extend to plan, participant or beneficiary account, exemption? transactions involving certain larger or IRA invests. • Should additional investments be ERISA plans—those with more than 100 As proposed, the exemption is limited included in the scope of the exemption? participants. Advice providers to these to otherwise prohibited compensation Commenters urging addition of other plans are already accustomed to generated by investments that are investment products should fully operating in a fiduciary environment commonly purchased by plans, describe the characteristics and fee and within the framework of existing participant and beneficiary accounts, structures associated with the products, prohibited transaction exemptions, and IRAs. Accordingly, the exemption as well as data supporting their position which tightly constrain the operation of defines the ‘‘Assets’’ that can be sold that the product is a common conflicts of interest. As a result, under the exemption as bank deposits, investment for retail investors. including large plans within the CDs, shares or interests in registered The Department encourages parties to definition of Retirement Investor could investment companies, bank collective apply to the Department for individual have the undesirable consequence of funds, insurance company separate or class exemptions for types of reducing protections provided under accounts, exchange-traded REITs, investments not covered by the existing law to these investors, without exchange-traded funds, corporate bonds exemption to the extent that they offsetting benefits. In particular, it could offered pursuant to a registration believe the proposed package of have the undesirable effect of increasing statement under the Securities Act of exemptions does not adequately cover the number and impact of conflicts of 1933, agency debt securities as defined beneficial investment practices for interest, rather than reducing or in FINRA Rule 6710(l) or its successor, which appropriate protections could be mitigating them. U.S. Treasury securities as defined in crafted in an exemption. While the Department believes that FINRA Rule 6710(p) or its successor, the Best Interest Contract Exemption is insurance and annuity contracts (both Limitation to Prohibited Compensation not the appropriate way to address any securities and non-securities), Received As a Result of Advice to potential concerns about the impact of guaranteed investment contracts, and Retirement Investors the expanded fiduciary definition on equity securities within the meaning of The Department proposed this large plans, the Department agrees that 17 CFR 230.405 that are exchange- exemption to promote the provision of an adjustment is necessary to traded securities within the meaning of investment advice to retail investors accommodate arm’s length transactions 17 CFR 242.600. However, the that is in their best interest and with plan investors with financial untainted by conflicts of interest. The expertise. Accordingly, as part of this 23 Relief is also proposed from ERISA section exemption would permit receipt by regulatory project, the Department has 406(a)(1)(D) and Code section 4975(c)(1)(D), which separately proposed a seller’s carve-out prohibit transfer of plan assets to, or use of plan Advisers and Financial Institutions of assets for the benefit of, a party in interest in the Proposed Conflict of Interest (including a fiduciary). 24 See Section VIII(c) of the proposed exemption. Regulation. Under the terms of that © 2015 The Institute of Continuing Legal Education 12-69 Tax Conference, 28th Annual, May 21, 2015 21968 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules carve-out, persons who provide alerting typically unsophisticated the Adviser, Financial Institution or recommendations to certain ERISA plan investors to the dangers posed by Affiliate is the employer of employees investors with financial expertise (but conflicts of interest, and may even covered by the ERISA plan. The not to plan participants or beneficiaries, exacerbate the dangers. Most retail Department believes that due to the or IRA owners) can avoid fiduciary investors lack financial expertise, are special nature of the employer/ status altogether. The seller’s carve-out unaware of the magnitude and impact of employee relationship, an exemption was developed to avoid the application conflicts of interest, and are unable permitting an Adviser and Financial of fiduciary status to a plan’s effectively to assess the quality of the Institution to profit from investments by counterparty in an arm’s length advice they receive. employees in their employer-sponsored commercial transaction in which the The 100 or more threshold is also plan would not be in the interest of, or plan’s representative has no reasonable consistent with that applicable for protective of, the plans and their expectation of impartial advice. When similar purposes under existing rules participants and beneficiaries. This the carve-out’s terms are satisfied, it is and practices. The Regulatory restriction does not apply, however, in available for transactions with plans Flexibility Act (5 U.S.C. 601 et seq.) the case of an IRA or other similar plan that have more than 100 participants. (RFA) imposes certain requirements that is not covered by Title I of ERISA. The Department recognizes, however, with respect to Federal rules that are Accordingly, an Adviser or Financial that there are smaller non-participant- subject to the notice and comment Institution may provide advice to the directed plans for which the plan requirements of section 553(b) of the beneficial owner of an IRA who is sponsor (or an employee, officer or Administrative Procedure Act (5 U.S.C. employed by the Adviser, its Financial director thereof) is responsible for 551 et seq.) and which are likely to have Institution or an Affiliate, and receive choosing the specific investments and a significant economic impact on a prohibited compensation as a result, allocations for their participating substantial number of small entities. For provided the IRA is not covered by Title employees. The Department believes purposes of the RFA, the Department I of ERISA. that these small plan fiduciaries are considers a small entity to be an Section I(c)(1) further provides that appropriately categorized with plan employee benefit plan with fewer than the exemption does not apply if the participants and beneficiaries and IRA 100 participants. The basis of this Adviser or Financial Institution is a owners, as retail investors. For this definition is found in section 104(a)(2) named fiduciary or plan administrator, reason, the proposed exemption’s of ERISA that permits the Secretary of as defined in ERISA section 3(16)(A)) definition of Retirement Investor Labor to prescribe simplified annual with respect to an ERISA plan, or an includes plan sponsors (or employees, reports for pension plans that cover affiliate thereof, that was selected to officers and directors thereof) of plans fewer than 100 participants. Under provide advice to the plan by a fiduciary with fewer than 100 participants.25 As current Department rules, such small who is not independent of them.26 This a result, the exemption would extend to plans generally are eligible for provision is intended to disallow advice providers to such smaller plans. streamlined reporting and relieved of selection of Advisers and Financial The proposed threshold of fewer than related audit requirements. Institutions by named fiduciaries or 100 participants is intended to The Department invites comment on plan administrators that have an interest reasonably identify plans that will most the proposed exemption’s limitation to in them. benefit from both the flexibility prohibited compensation received as a Section I(c)(2) provides that the provided by this exemption and the result of advice to Retirement Investors. exemption does not extend to protections embodied in its conditions. In particular, we ask whether prohibited compensation received when The threshold also mirrors the Proposed commenters support the limitation as the Adviser engages in a principal Regulations’ 100-or-more participant currently formulated, whether the transaction with the plan, participant or threshold for the seller’s carve-out. That definitions should be revised, or beneficiary account, or IRA.27 A threshold recognizes the generally whether there should not be an principal transaction is a transaction in greater sophistication possessed by exclusion with respect to such larger which the Adviser engages in a larger plans’ discretionary fiduciaries, as plans at all. Commenters on this subject transaction with the plan, participant or well as the greater vulnerability of retail are also encouraged to address the beneficiary account, or IRA, on behalf of investors, such as small plans. As interaction of the exemption’s limitation the account of the Financial Institution explained in more detail in the with the scope of the seller’s carve-out or another person directly or indirectly, preamble to the Proposed Regulation, in the Proposed Regulation. Finally, we through one or more intermediaries, investment recommendations to small request comment on whether the controlling, controlled by, or under plans, IRA owners and plan participants exemption should be expanded to cover common control with the Financial and beneficiaries do not fit the ‘‘arms advice to plan sponsors (including the Institution. Principal transactions length’’ characteristics that the seller’s sponsor’s employees, officers, and involve conflicts of interest not carve-out is designed to preserve. directors) of participant-directed plans addressed by the safeguards of this Recommendations to retail investors are with fewer than 100 participants on the proposed exemption. Elsewhere in routinely presented as advice, composition of the menu of investment today’s Federal Register, the consulting, or financial planning options available under such plans, and Department is proposing an exemption services. In the securities markets, if so, whether additional or different for investment advice fiduciaries to brokers’ suitability obligations generally conditions should apply. engage in principal transactions require a significant degree of involving certain debt securities. The individualization, and research has Exclusions in Section I(c) of the proposed exemption for principal shown that disclaimers are ineffective in Proposed Exemption transactions contains conditions Section I(c) of the proposal sets forth 25 The Department notes that plan participants additional exclusions from the 26 See Section VIII(f), defining the term and beneficiaries in ERISA plans can be Retirement exemption. Section I(c)(1) provides that ‘‘Independent.’’ Investors regardless of the number of participants the exemption would not apply to the 27 For purposes of this proposed exemption, in such plan. Therefore, the 100-participant however, the Department does not view a riskless limitation does not apply when advice is provided receipt of prohibited compensation from principal transaction involving mutual fund shares directly to the participants and beneficiaries. a transaction involving an ERISA plan if as an excluded principal transaction. 12-70 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21969 specific to those transactions but is participants and beneficiaries, and IRA It should be noted, however, that designed to align with this proposed owners and protective of the rights of compliance with the exemption’s exemption so as to ease parties’ ability the participants and beneficiaries of conditions is necessary only with to comply with both exemptions with such plans and IRA owners. Under respect to transactions that otherwise respect to the same investor. ERISA section 408(a)(2), and Code would constitute prohibited Section I(c)(3) provides that the section 4975(c)(2), the Secretary may transactions under ERISA and the Code. exemption would not cover prohibited not grant an exemption without making The exemption does not purport to compensation that is received by an such findings. The proposed conditions impose conditions on the management Adviser or Financial Institution as a of the exemption are described below. of investments held outside of ERISA- result of investment advice that is covered plans and IRAs. Accordingly, Contractual Obligations Applicable to generated solely by an interactive Web the contract and its conditions are the Best Interest Contract Exemption site in which computer software-based mandatory only with respect to (Section II) models or applications provide investments held by plans and IRAs. investment advice to Retirement Section II(a) of the proposal requires Investors based on personal information that an Adviser and Financial 1. Fiduciary Status each investor supplies through the Web Institution enter into a written contract The proposal sets forth multiple site without any personal interaction or with the Retirement Investor prior to contractual requirements. The first and advice from an individual Adviser. recommending that the plan, participant most fundamental contractual Such computer derived advice is often or beneficiary account, or IRA, requirement, which is set out in Section referred to as ‘‘robo-advice.’’ While the purchase, sell or hold an Asset. The II(b) of proposal, is that that both the Department believes that computer contract must be executed by both the Adviser and Financial Institution must generated advice that is delivered in this Adviser and the Financial Institution as acknowledge fiduciary status under manner may be very useful to well as the Retirement Investor. In the ERISA or the Code, or both, with respect Retirement Investors, relief will not be case of advice provided to a plan to any recommendations to the included in the proposal. As the participant or beneficiary in a Retirement Investor to purchase, sell or marketplace for such advice is still participant-directed individual account hold an Asset. If this acknowledgment evolving in ways that both appear to plan, the participant or beneficiary of fiduciary status does not appear in a avoid conflicts of interest that would should be the Retirement Investor that contract with a Retirement Investor, the violate the prohibited transaction rules, is the party to the contract, on behalf of exemption is not satisfied with respect and minimize cost, the Department his or her individual account. to transactions involving that believes that inclusion of such advice in The contract may be part of a master Retirement Investor. This fiduciary this exemption could adversely modify agreement with the Retirement Investor acknowledgment is critical to ensuring the incentives currently shaping the and does not require execution prior to that there is no uncertainty—before or market for robo-advice. Furthermore, a each additional recommendation to after investment advice is given with statutory prohibited transaction purchase, sell or hold an Asset. The regard to the Asset—that both the exemption at ERISA section 408(g) exemption, in particular the Adviser and Financial Institution are covers computer-generated investment requirement to adhere to a best interest acting as fiduciaries under ERISA and advice and is available for robo-advice standard, does not mandate an ongoing the Code with respect to that advice. involving prohibited transactions if its or long-term advisory relationship, but The acknowledgment of fiduciary conditions are satisfied. See 29 CFR rather leaves that to the parties. The status in the contract is nonetheless 2550.408g–1. terms of the contract, along with other limited to the advice to the Retirement Finally, Section I(c)(4) provides that representations, agreements, or Investor to purchase, sell or hold the the exemption is limited to Advisers understandings between the Adviser, Asset. The Adviser and Financial who are fiduciaries by reason of Financial Institution and Retirement Institution do not become fiduciaries providing investment advice.28 Advisers Investor, will govern whether the nature with respect to any other conduct by who have full investment discretion of the relationship between the parties virtue of this contractual requirement. is ongoing or not. with respect to plan or IRA assets or 2. Standards of Impartial Conduct who have discretionary authority over The contract is the cornerstone of the the administration of the plan or IRA, proposed exemption, and the Building upon the required Department believes that by requiring a for example, are not affected by the acknowledgment of fiduciary status, the contract as a condition of the proposed Proposed Regulation and are therefore proposal additionally requires that both exemption, it creates a mechanism by not the subject of this exemption. the Adviser and the Financial which a Retirement Investor can be Institution contractually commit to Conditions of the Proposed Exemption alerted to the Adviser’s and Financial adhering to certain specifically Sections II–V of the proposal list the Institution’s obligations and be provided delineated Impartial Conduct Standards conditions applicable to the Best with a basis upon which its rights can when providing investment advice to Interest Contract Exemption described be enforced. In order to comply with the the Retirement Investor regarding in Section I. All applicable conditions exemption, the contract must contain Assets, and that they in fact do adhere must be satisfied in order to avoid every required element set forth in to such standards. Therefore, if an application of the specified prohibited Section II(b)–(e) and also must not Adviser and/or Financial Institution fail transaction provisions of ERISA and the include any of the prohibited provisions to comply with the Impartial Conduct Code. The Department believes that described in Section II(f). It is intended Standards, relief under the exemption is these conditions are necessary for the that the contract creates actionable no longer available and the contract is Secretary to find that the exemption is obligations with respect to both the violated. administratively feasible, in the Impartial Conduct Standards and the Specifically, Section II(c)(1) of the interests of plans and of their warranties, described below. In proposal requires that under the addition, failure to satisfy the Impartial contract the Adviser and Financial 28 See also Section VIII(a), defining the term Conduct Standards will result in loss of Institution provide advice regarding ‘‘Adviser.’’ the exemption. Assets that is in the ‘‘best interest’’ of © 2015 The Institute of Continuing Legal Education 12-71 Tax Conference, 28th Annual, May 21, 2015 21970 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules the Retirement Investor. Best interest is relief under the proposed exemption, this warranty must be included in the defined to mean that the Adviser and both IRA and plan fiduciaries would contract, the exemption is not Financial Institution act with the care, have to agree to, and uphold, the best conditioned on compliance with the skill, prudence, and diligence under the interest and Impartial Conduct warranty. Accordingly, the failure to circumstances then prevailing that a Standards, as set forth in Section II(c). comply with applicable federal or state prudent person would exercise based on The best interest standard is defined to law could result in contractual liability the investment objectives, risk effectively mirror the ERISA section 404 for breach of warranty, but it would not tolerance, financial circumstances, and duties of prudence and loyalty, as result in loss of the exemption, as long the needs of the Retirement Investor, applied in the context of fiduciary as the breach did not involve a violation when providing investment advice to investment advice. of one of the exemption’s other them. Further, under the best interest In addition to the best interest conditions (e.g., the best interest standard, the Adviser and Financial standard, the exemption imposes other standard). De minimis violations of state Institution must act without regard to important standards of impartial or federal law would be unlikely to the financial or other interests of the conduct in Section II(c) of the proposal. violate the exemption’s other Adviser, Financial Institution or their Section II(c)(2) requires that the Adviser conditions, such as the best interest Affiliates or any other party. Under this and Financial Institution agree that they standard, and would not typically result standard, the Adviser and Financial will not recommend an Asset if the total in the loss of the exemption. Institution must put the interests of the amount of compensation anticipated to 4. Warranty—Policies and Procedures Retirement Investor ahead of the be received by the Adviser, Financial financial interests of the Adviser, Institution, and their Affiliates and The Financial Institution must also Financial Institution or their Affiliates, Related Entities in connection with the contractually warrant that it has Related Entities or any other party. purchase, sale or holding of the Asset by adopted written policies and procedures The best interest standard set forth in the plan, participant or beneficiary that are reasonably designed to mitigate this exemption is based on longstanding account, or IRA, will exceed reasonable the impact of material conflicts of concepts derived from ERISA and the compensation in relation to the total interest that exist with respect to the law of trusts. For example, ERISA services they provide to the applicable provision of investment advice to section 404 requires a fiduciary to act Retirement Investor. The obligation to Retirement Investors and ensure that ‘‘solely in the interest of the participants pay no more than reasonable individual Advisers adhere to the . . . with the care, skill, prudence, and compensation to service providers is Impartial Conduct Standards described diligence under the circumstances then long recognized under ERISA. See above. For purposes of the exemption, a prevailing that a prudent man acting in ERISA section 408(b)(2), 29 CFR material conflict of interest is deemed to a like capacity and familiar with such 2550.408b–2(a)(3), and 29 CFR exist when an Adviser or Financial matters would use in the conduct of an 2550.408c–2. The reasonableness of the Institution has a financial interest that enterprise of a like character and with fees depends on the particular facts and could affect the exercise of its best like aims.’’ Similarly, both ERISA circumstances. Finally, Section II(c)(3) judgment as a fiduciary in rendering section 404(a)(1)(A) and the trust-law requires that the Adviser’s and advice to a Retirement Investor duty of loyalty require fiduciaries to put Financial Institution’s statements about regarding an Asset.29 Like the warranty the interests of trust beneficiaries first, Assets, fees, material conflicts of on compliance with applicable law, without regard to the fiduciaries’ own interest, and any other matters relevant discussed above, this warranty must be self-interest. Accordingly, the to a Retirement Investor’s investment in the contract but the exemption is not Department would expect the standard decisions, not be misleading. conditioned on compliance with the to be interpreted in light of forty years Under ERISA section 408(a) and Code warranty. Failure to comply with the of judicial experience with ERISA’s section 4975(c), the Department cannot warranty could result in contractual fiduciary standards and hundreds more grant an exemption unless it first finds liability for breach of warranty. with the duties imposed on trustees that the exemption is administratively As part of the contractual warranty on under the common law of trusts. In feasible, in the interests of plans and policies and procedures, the Financial general, courts focus on the process the their participants and beneficiaries and Institution must state that in fiduciary used to reach its IRA owners, and protective of the rights formulating its policies and procedures, determination or recommendation— of participants and beneficiaries of it specifically identified material whether the fiduciaries, ‘‘at the time plans and IRA owners. An exemption conflicts of interest and adopted they engaged in the challenged permitting transactions that violate the measures to prevent those material transactions, employed the proper requirements of Section II(c) would be conflicts of interest from causing procedures to investigate the merits of unlikely to meet these standards. violations of the Impartial Conduct the investment and to structure the Standards. Further, the Financial 3. Warranty—Compliance With investment.’’ Donovan v. Mazzola, 716 Institution must state that neither it nor Applicable Law F.2d 1226, 1232 (9th Cir. 1983). (to the best of its knowledge) its Moreover, a fiduciary’s investment Section II(d) of the proposal requires Affiliates or Related Entities will use recommendation is measured based on that the contract include certain quotas, appraisals, performance or the circumstances prevailing at the time warranties intended to be protective of personnel actions, bonuses, contests, of the transaction, not on how the the rights of Retirement Investors. In special awards, differentiated investment turned out with the benefit particular, to satisfy the exemption, the compensation or other actions or of hindsight. Adviser, and Financial Institution must incentives to the extent they would tend In this regard, the Department notes warrant that they and their Affiliates to encourage individual Advisers to that while fiduciaries of plans covered will comply with all applicable federal make recommendations that are not in by ERISA are subject to the ERISA and state laws regarding the rendering the best interest of Retirement Investors. section 404 standards of prudence and of the investment advice, the purchase, While these warranties must be part loyalty, the Code contains no provisions sale or holding of the Asset and the of the contract between the Adviser and that hold IRA fiduciaries to these payment of compensation related to the standards. However, as a condition of purchase, sale and holding. Although 29 See Section VIII(h) of the proposed exemption. 12-72 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21971 Financial Institution and the Retirement investment advice that is in accordance with must be reasonably designed to avoid Investor, the proposal does not mandate an unbiased computer model created by an incentives to Advisers to recommend the specific content of the policies and independent third party. Under this example, investment transactions that are not in procedures. This flexibility is intended the Adviser can receive any form or amount Retirement Investors’ best interest. of compensation so long as the advice is Example 5: Alignment of Interests. The to allow Financial Institutions to rendered in strict accordance with the Financial Institution’s policies and develop policies and procedures that are model.31 procedures establish a compensation effective for their particular business Example 2: Asset-based compensation. The structure that is reasonably designed to align models, within the constraints of their Financial Institution pays the Adviser a the interests of the Adviser with the interests fiduciary obligations and the Impartial percentage, which does not vary based on the of the Retirement Investor. For example, this Conduct Standards. types of investments, of the dollar amount of might include compensation that is primarily Under the proposal, a Financial assets invested by the plans, participant and asset-based, as discussed in Example 2, with Institution’s policies and procedures beneficiary accounts, and IRAs with the the addition of bonuses and other incentives must not authorize compensation or Adviser. Under this example, assume the paid to promote advice that is in the Best Interest of the Retirement Investor. While the incentive systems that would tend to Financial Institution established the percentage as 0.1% on a quarterly basis. If a compensation would be variable, it would encourage individual Advisers to make plan, participant or beneficiary account, or align with the customer’s best interest. recommendations that are not in the IRA, invested a total of $10,000 with the These examples are not exhaustive, best interest of Retirement Investors. Adviser, divided 25% in equity securities, and many other compensation and Consistent with the general approach in 50% in proprietary mutual funds, and 25% employment arrangements may satisfy the proposal to the Financial in bonds underwritten by non-Related the contractual warranties. The Institution’s policies and procedures, Entities, and did not withdraw any of the exemption imposes a broad standard for however, there are no particular money within the quarter, the Adviser would receive 0.1% of the $10,000. the warranty and policies and required compensation or employment Example 3: Fee offset. The Financial procedures requirement, not an structures. Certainly, one way for a Institution establishes a fee schedule for its inflexible and highly-prescriptive set of Financial Institution to comply is to services. It accepts transaction-based rules. The Financial Institution retains adopt a ‘‘level-fee’’ structure, in which payments directly from the plan, participant the latitude necessary to design its compensation for Advisers does not or beneficiary account, or IRA, and/or from compensation and employment vary based on the particular investment third party investment providers. To the arrangements, provided that those product recommended. But the extent the payments from third party arrangements promote, rather than exemption does not mandate such a investment providers exceed the established undermine, the best interest and structure. The Department believes that fee for a particular service, such amounts are rebated to the plan, participant or beneficiary Impartial Conduct Standards. the specific implementation of this account, or IRA. To the extent third party Whether a Financial Institution requirement is best determined by the payments do not satisfy the established fee, adopts one of the specific approaches Financial Institution in light of its the plan, participant or beneficiary account, taken in the examples above or a particular circumstances and business or IRA is charged directly for the remaining different approach, the Department models. 32 amount due. expects that it will engage in a good For further clarification, the Example 4: Differential Payments Based faith process to prudently establish and Department sets forth the following on Neutral Factors. The Financial Institution oversee policies and procedures that examples of broad approaches to establishes payment structures under which will effectively mitigate conflicts of compensation structures that could help transactions involving different investment interest and ensure adherence to the satisfy the contractual warranty products result in differential compensation to the Adviser based on a reasonable Impartial Conduct Standards. To this regarding the policies and procedures. assessment of the time and expertise end, Financial Institutions may also In connection with all these examples, necessary to provide prudent advice on the want to consider designating an it is important that the Financial product or other reasonable and objective individual or group responsible for Institution carefully monitor whether neutral factors. For example, a Financial addressing material conflicts of interest the policies and procedures are, in fact, Institution could compensate an Adviser issues. An internal compliance officer or working to prevent the provision of differently for advisory work relating to a committee could monitor adherence to biased advice. The Financial Institution annuities, as opposed to shares in a mutual the Impartial Conduct Standards and must correct isolated or systemic fund, if it reasonably determined that the consider ways to ensure compliance. violations of the Impartial Conduct time to research and explain the products differed. However, the payment structure The individual or group could also Standards and reasonably revise develop procedures for reporting policies and procedures when failures used as part of an advice arrangement that satisfies material conflicts of interest and for are identified. the conditions under the prohibited transaction handling external and internal Example 1: Independently certified exemption in ERISA section 408(b)(14) and (g), computer models.30 The Adviser provides described above. complaints within the Financial 31 As previously noted, this exemption is not Institution, and disciplinary measures 30 These examples should not be read as available for advice generated solely by a computer for non-compliance with the Impartial retracting views the Department expressed in prior model and provided to the Retirement Investor Conduct Standards. Additionally, Advisory Opinions regarding how an investment electronically without live advice. Nevertheless, Financial Institutions should consider advice fiduciary could avoid prohibited this exemption remains available in the transactions that might result from differential hypothetical because the advice is delivered by a how best to inform and train individual compensation arrangements. Specifically, in live Adviser. Advisers on the Impartial Conduct Advisory Opinion 2001–09A, the Department 32 See footnote 31 supra. Certain types of fee- Standards and other requirements of the concluded that the provision of fiduciary offset arrangements may result in avoidance of exemption. investment advice would not result in prohibited prohibited transactions altogether. In Advisory transactions under circumstances where the advice Opinion Nos. 97–15A and 2005–10A, the Additionally, Financial Institutions provided by the fiduciary with respect to Department explained that a fiduciary investment could consider the following investment funds that pay additional fees to the adviser could provide investment advice to a plan components of effective policies and fiduciary is the result of the application of with respect to investment funds that pay it or an procedures relating to an Adviser’s methodologies developed, maintained and overseen affiliate additional fees without engaging in a by a party independent of the fiduciary in prohibited transaction if those fees are offset against compensation: (i) Avoiding creating accordance with the conditions set forth in the fees that the plan otherwise is obligated to pay to compensation thresholds that enable an Advisory Opinion. A computer model also can be the fiduciary. Adviser to increase his or her © 2015 The Institute of Continuing Legal Education 12-73 Tax Conference, 28th Annual, May 21, 2015 21972 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules compensation disproportionately that is kept current is available on the plans, participants and beneficiaries, through an incremental increase in Financial Institution’s Web site (web IRA owners and the Department. sales; (ii) monitoring activity of address provided) and by mail, upon 1. IRA Owners Advisers approaching compensation request of the Retirement Investor. thresholds such as higher payout Second, Section II(e)(2) requires that The contract between the IRA owner percentages, back-end bonuses, or the written contract must inform the and the Adviser and Financial participation in a recognition club, such Retirement Investor of the right to Institution forms the basis of the IRA as a President’s Club; (iii) maintaining obtain complete information about all of owner’s enforcement rights. As outlined neutral compensation grids that pay the the fees currently associated with the above, the contract embodies obligations Adviser a flat payout percentage Assets in which it is invested, including on the part of the Adviser and Financial regardless of product type sold (so long all of the fees payable to the Adviser, Institution. The Department intends that as they do not merely transmit the Financial Institution, and any Affiliates all the contractual obligations (the Financial Institution’s conflicts to the and Related Entities in connection with Impartial Conduct Standards and the Adviser); (iv) refraining from providing such investments. The fee information warranties) will be actionable by IRA higher compensation or other rewards must be complete, and it must include owners. The most important of these for the sale of proprietary products or both the direct and the indirect fees contractual obligations for enforcement products for which the firm has entered paid by the plan or IRA.34 Section purposes is the obligation imposed on into revenue sharing arrangements; (v) II(e)(3) provides that the written both the Adviser and the Financial stringently monitoring contract also must disclose to the Institution to comply with the Impartial recommendations around key liquidity Retirement Investor whether the Conduct Standards. Because these events in the investor’s lifecycle where Financial Institution offers proprietary standards are contractually imposed, the the recommendation is particularly products or receives third party IRA owner has a contract claim if, for significant (e.g. when an investor rolls payments with respect to the purchase, example, the Adviser recommends an over his pension or 401(k) account); and sale or holding of any Asset. Third party investment product that is not in the (vi) developing metrics for good and bad payments, for purposes of this best interest of the IRA owner. behavior (red flag processes) and using exemption, are defined as sales charges 2. Plans, Plan Participants and clawbacks of deferred compensation to (when not paid directly by the plan, Beneficiaries adjust compensation for employees who participant or beneficiary account, or The protections of the exemption and do not properly manage conflicts of IRA), 12b–1 fees, and other payments contractual terms will also be interest.33 paid to the Adviser, Financial enforceable by plans, plan participants The Department seeks comments on Institution or any Affiliate or Related and beneficiaries. Specifically, if an all aspects of its discussion of the sorts Entity by a third party as a result of the Adviser or Financial Institution of policies and procedures that will purchase, sale or holding of an Asset by received compensation in a prohibited satisfy the required contractual a plan, participant or beneficiary transaction but failed to satisfy any of warranties of Section II(d)(2)–(4). In account, or IRA. A proprietary product the Impartial Conduct Standards or any particular, the Department requests is defined for purposes of this other condition of the exemption, the comments on whether the exemption exemption as a product that is managed Adviser and Financial Institution would should be more prescriptive about the by the Financial Institution or any of its be unable to qualify for relief under the terms of policies and procedures, or Affiliates. In conjunction with this exemption, and, as a result, could be provide more detailed examples of disclosure, the contract must provide liable under ERISA section 502(a)(2) acceptable policies and procedures. In the address of a Web page that discloses and (3). An Adviser’s failure to comply addition, the Department requests the compensation arrangements entered with the exemption or the Impartial comments on whether commenters into by the Adviser and the Financial Conduct Standards would result in a believe the examples describe policies Institution, as required by Section III(c) non-exempt prohibited transaction and and procedures that would achieve the of the proposal and discussed below. investor-protective objectives of the would likely constitute a fiduciary exemption. Enforcement of the Contractual breach. As a result, a plan, plan Obligations participant or beneficiary would be able 5. Contractual Disclosures The contractual requirements set forth to sue under ERISA section 502(a)(2) or Finally, Section II(e) of the proposal in Section II of the proposal are (3) to recover any loss in value to the requires certain disclosures in the enforceable. Plans, plan participants plan (including the loss in value to an written contract. If the disclosures do and beneficiaries, IRA owners, and the individual account), or to obtain not appear in a contract with a Department may use the contract as a disgorgement of any wrongful profits or Retirement Investor, the exemption is tool to ensure compliance with the unjust enrichment. Additionally, plans, not satisfied with respect to transactions exemption. The Department notes, participants and beneficiaries could involving that Retirement Investor. however, that this contractual tool enforce their obligations in an action First, Section II(e)(1) provides that the creates different rights with respect to based on breach of the agreement. Financial Institution and the Adviser 3. The Department must identify in the written contract any 34 To the extent compliance with this information material conflicts of interest. This request requires Advisers and Financial Institutions In addition, the Department would be disclosure may be a general description to obtain such information from entities that are not able to enforce ERISA’s prohibited closely affiliated with them, the Adviser or transaction and fiduciary duty of the types of material conflicts of Financial Institution may supply such information interest applicable to the Financial to the Retirement Investor in compliance with the provisions with respect to employee Institution and Adviser, provided the exemption provided the Adviser and Financial benefit plans, but not IRAs, in the event disclosure also informs the Retirement Institution act in good faith and do not know that that the Adviser or Financial Institution the materials are incomplete or inaccurate. For received compensation in a prohibited Investor that a more specific description purposes of the proposed exemption, Affiliates within the meaning of Section VIII(b)(1) and (2) are transaction but failed to comply with 33 See FINRA Report on Conflicts of Interest, considered closely affiliated such that the good the exemption or the Impartial Conduct October 2013. faith reliance would not apply. Standards. If, for example, any of the 12-74 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21973 specific conditions of the exemption are Disclosure Requirements for Best 2. Individual Transactional Disclosure not met, the Adviser and Financial Interest Contract Exemption (Section III) In Section III(a), the exemption Institution will have engaged in a non- In order to facilitate access to requires point of sale disclosure to the exempt prohibited transaction, and the Retirement Investor, prior to the information on Financial Institution and Department will be entitled to seek execution of the investment transaction, Adviser compensation, the proposal relief under ERISA section 502(a)(2) and regarding the all-in cost and anticipated requires both public disclosure and (5). future costs of recommended Assets. disclosure to Retirement Investors. 4. Excise Taxes Under the Code The disclosure is designed to make as 1. Web Page clear and salient as possible the total In addition to the claims described cost that the plan, participant or above that may be brought by IRA Section III(c) of the proposal requires beneficiary account, or IRA will incur owners, plans, plan participants and that the Financial Institution maintain a when following the Adviser’s beneficiaries, and the Department, to public Web page that provides several recommendation, and to provide cost enforce the contract and ERISA, different types of information. The Web information that can be compared across Advisers and Financial Institutions that page must show the direct and indirect different Assets that are recommended engage in prohibited transactions under material compensation payable to the for investment. In addition, the the Code are subject to an excise tax. Adviser, Financial Institution and any projection of the costs over various The excise tax is generally equal to 15% Affiliate for services provided in holding periods would inform the of the amount involved. Parties who connection with each Asset (or, if Retirement Investor of the cumulative have participated in a prohibited uniform across a class of Assets, the impact of the costs over time and of transaction for which an exemption is class of Assets) that a plan, participant potential costs when the investment is not available must pay the excise tax or beneficiary account, or an IRA, is able sold. and file Form 5330 with the Internal to purchase, hold, or sell through the As proposed, the disclosure Revenue Service. Adviser or Financial Institution, and requirement of Section III(a) would be provided in a summary chart designed Prohibited Provisions that a plan, participant or beneficiary account, or an IRA has purchased, held, to direct the Retirement Investor’s Finally, in order to preserve these or sold within the last 365 days, the attention to a few important data points various enforcement rights, Section II(f) source of the compensation, and how regarding fees, in a time frame that of the proposal provides that certain the compensation varies within and would enable the Retirement Investor to provisions may not be part of the among Asset classes. The Web page discuss other (possibly less costly) contract. If these provisions appear in a must be updated at reasonable intervals, alternatives with the Adviser prior to contract with a Retirement Investor, the not less than quarterly. The executing the transaction. The exemption is not satisfied with respect compensation may be expressed as a disclosure chart does not have to be to transactions involving that monetary amount, formula or provided again with respect to a Retirement Investor. First, the proposal percentage of the assets involved in the subsequent recommendation to requires that the contract may not purchase, sale or holding. purchase the same investment product, contain exculpatory provisions that so long as the chart was previously The information provided by the Web provided to the Retirement Investor disclaim or otherwise limit liability for page will provide a broad base of an Adviser’s or Financial Institution’s within the past 12 months and the total information about the various pricing violations of the contract’s terms. cost has not materially changed. and compensation structures adopted by Second, the contract may not require the To the extent compliance with the Financial Institutions and Advisers. The Retirement Investor to agree to waive or point of sale disclosure requires Department believes that the data qualify its right to bring or participate in Advisers and Financial Institutions to provided on the Web page will provide obtain cost information from entities a class action or other representative information that can be used by that are not closely affiliated with them, action in court in a contract dispute financial information companies to they may rely in good faith on with the Adviser or Financial analyze and provide information information and assurances from the Institution. The right of a Retirement comparing the practices of different other entities, as long as they do not Investor to bring a class-action claim in Advisers and Financial Institutions. know that the materials are incomplete court (and the corresponding limitation Such information will allow a or inaccurate. This good faith reliance on fiduciaries’ ability to mandate class- applies unless the entity providing the action arbitration) is consistent with Retirement Investor to evaluate costs information to the Adviser and FINRA’s position that its arbitral forum and Advisers’ and Financial Institutions’ compensation practices. Financial Institution is (1) a person is not the correct venue for class-action directly or indirectly through one or The Web page information must be claims. As proposed, this section would more intermediaries, controlling, provided in a manner that is easily not affect the ability of a Financial controlled by, or under common control accessible to a Retirement Investor and Institution or Adviser, and a Retirement with the Adviser or Financial the general public. Appendix I to this Investor, to enter into a pre-dispute Institution; or (2) any officer, director, notice is an exemplar of a possible web binding arbitration agreement with employee, agent, registered respect to individual contract claims. disclosure. In addition, the Web page representative, relative (as defined in The Department expects that most must also contain a version of the same ERISA section 3(15)), member of family individual arbitration claims under this information that is formatted in a (as defined in Code section 4975(e)(6)) exemption will be subject to FINRA’s machine-readable manner. The of, or partner in, the Adviser or arbitration procedures and consumer Department recognizes that machine Financial Institution.35 protections. The Department seeks readable data can be formatted in many The required chart would disclose comments on whether there are certain ways. Therefore, the Department with respect to each Asset procedures and/or consumer protections requests comment on the format and that it should adopt or mandate for data fields that should be required 35 See proposed definition of Affiliate, Section those disputes not covered by FINRA. under such a condition. VIII(b)(1) and (b)(2). © 2015 The Institute of Continuing Legal Education 12-75 Tax Conference, 28th Annual, May 21, 2015 21974 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules recommended, the ‘‘total cost’’ to the 10 years. The all-in cost would be Retirement Investors or share of plan, participant or beneficiary account, calculated with the following transactions executed by Advisers and or IRA, of the investment for 1-, 5- and components: ‘‘acquisition costs,’’ Financial Institutions fall within the 10-year periods expressed as a dollar ‘‘ongoing costs,’’ ‘‘disposition costs,’’ asset classes for which the point of sale amount, assuming an investment of the and ‘‘other.’’ The Department seeks disclosure is more feasible and less dollar amount recommended by the comment on all aspects of this feasible? Adviser, and reasonable assumptions approach. In particular, we ask: • Are there particular asset classes for about investment performance, which • Are the all-in costs of the which all the information that would be must be disclosed. investments permitted under the required to be disclosed in the chart is As defined in the proposal, the ‘‘total proposal capable of being reflected currently required in a similar format cost’’ of investing in an asset means the accurately in the chart? under existing law? sum of the following, as applicable: • Are all-in costs already reflected in • Would the required disclosure be Acquisition costs, ongoing costs, the summary prospectuses for certain more feasible or less costly if a narrative disposition costs, and any other costs investments? statement were required instead of a that reduce the asset’s rate of return, are • Have we correctly identified the summary chart? paid by direct charge to the plan, possible various costs associated with Impact. The point of sale disclosure participant or beneficiary account, or the permitted investments? would be intended to inform the • IRA, or reduce the amounts received by Should the point of sale disclosure Retirement Investor of the costs the plan, participant or beneficiary requirement be limited to certain events, associated with the investment. Would account, or IRA (e.g., contingent fees, such as opening a new account or such a disclosure in this simple format such as back-end loads, including those rolling over existing investments? If so, provide information that is meaningful that phase out over time, with such what changes would be needed to the and likely to improve a Retirement terms explained beneath the table). The model chart? Investor’s decision making? We ask for • terms ‘‘acquisition costs,’’ ‘‘ongoing Are our proposed definitions of the input on the following: costs,’’ and ‘‘disposition costs,’’ are various costs clear enough to result in • Would the simplified format result defined in the proposal. Appendix II to information that is reasonably in the communication of information this proposal contains a model chart comparable across different Financial that is accurate, and contribute to that may be used to provide the Institutions? • informed investment decisions? information required under this section. Is it possible to attribute all the • Do commenters recommend an Use of the model chart is not costs to the account of a particular plan, alternative format or alternative mandatory. However, use of an participant or beneficiary, or IRA? • disclosures? appropriately completed model chart How should long-term costs be • Would the relative fees associated will be deemed to satisfy the measured? with different types of investment Feasibility. The point of sale requirement of Section III(a). products, without a required disclosure Request for comment. The disclosure is proposed to be an of the relative risks of the product (i.e., Department requests comment on the individualized disclosure provided mutual fund ongoing fees versus a one- design of this proposed point of sale prior to the execution of the transaction. time brokerage commission for a stock disclosure, as well as issues related to The Department seeks comment on transaction) contribute to informed the ability of the Adviser to provide the whether there are practical impediments investment decisions? disclosure and whether it will provide to the creation and disclosure of the • In the absence of a required information that is meaningful to chart in the time frame proposed. benchmark, is the disclosure of the all- Retirement Investors. In general, Therefore, we ask: in fees of a particular investment commenters are asked to address the • Will Advisers and Financial helpful to the Retirement Investor? If anticipated cost of compliance with the Institutions have access to the not, how could a benchmark be crafted point of sale disclosure and whether the information required to be disclosed in for the various Assets permitted to be disclosure as we have described it will the chart? provide information that is more useful • Are there existing systems at sold under the proposal? to Retirement Investors than other Financial Institutions that could Alternative. Instead of the point of similar disclosures that are required produce the disclosure required in this sale disclosure as proposed, would a under existing law. As discussed below proposal? If not, what is the cost of ‘‘cigarette warning’’-style disclosure be in more detail, the Department requests developing a system to comply? as effective and less costly? For comment on whether the disclosure can • What are the costs associated with example, the disclosure could read: be designed to provide information that providing the disclosure? Investors are urged to check loads, would result in a useful comparison • Would the costs be reduced if the management fees, revenue-sharing, among Assets; whether it is feasible for Adviser and Financial Institution could commissions, and other charges before Advisers and Financial Institutions to provide the disclosure for full portfolios investing in any financial product. These fees obtain reliable information to complete of investments, rather than for each may significantly reduce the amount you are able to invest over time and may also the chart at the time it would be investment recommendation separately? • determine your adviser’s take-home pay. If required to be provided to the Would the costs be reduced if the these fees are not reported in marketing Retirement Investor; and whether the timing of the disclosure was more materials or made apparent by your disclosure, without information on closely aligned with the SEC’s investment adviser, do not forget to ask about other characteristics of the investment, disclosure requirements applicable to them. would improve Retirement Investors’ broker-dealers (i.e. at or before the 3. Individual Annual Disclosure ability to make informed investment completion of the transaction), rather decisions. than point of sale? Section III(b) of the proposal requires Design. As explained above, the • Are there particular asset classes for individual disclosure in the form of an proposal contemplates a chart with the which this kind of point of sale annual disclosure. Specifically, the following information: All-in cost of the disclosure is more feasible or less proposal requires the Adviser or Asset, and the cost if held for 1-, 5-, and feasible? What share of assets held by Financial Institution to provide each 12-76 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21975 Retirement Investor with an annual contracts that are securities (including exemption particularly difficult for written disclosure within 45 days of the variable annuity contracts) and mutual insurance companies to comply with? end of the applicable year. The annual fund shares. The fact that IRA owners Range of Investment Options (Section disclosure must include: (i) A list generally do not benefit from the IV) identifying each Asset purchased or protections afforded by the fiduciary sold during the applicable period and duties owed by plan sponsors to their Section IV(a) of the proposal requires the price at which the Asset was employee benefit plans makes it critical a Financial Institution to offer for purchased or sold; (ii) a statement of the that their interests are protected by purchase, sale, or holding and the total dollar amount of all fees and appropriate conditions in the Adviser to make available to the plan, expenses paid by the plan, participant Department exemptions. In our view, participant or beneficiary account, or or beneficiary account, or IRA, both this proposed Best Interest Contract IRA, for purchase, sale or holding a directly and indirectly, with respect to Exemption contains conditions that are broad range of investment options. each Asset purchased, held or sold uniquely protective of IRA owners. These investment options should enable during the applicable period; and (iii) a The Department has determined an Adviser to make recommendations to statement of the total dollar amount of however that PTE 84–24 should remain the Retirement Investor with respect to all compensation received by the available for investment advice all of the asset classes reasonably Adviser and Financial Institution, fiduciaries to receive commissions for necessary to serve the best interests of directly or indirectly, from any party, as IRA (and plan) purchases of insurance the Retirement Investor in light of the a result of each Asset sold, purchased or and annuity contracts that are not Retirement Investor’s objectives, risk held by the plan, participant or securities. This distinction is due in part tolerance and specific financial beneficiary account, or IRA, during the to uncertainty as to whether the circumstances. The Department believes applicable period. This disclosure is disclosure requirements proposed that ensuring that an Adviser has a wide intended to show the Retirement herein are readily applicable to range of investment options at his or her Investor the impact of the cost of the insurance and annuity contracts that are disposal is the most likely method by Adviser’s advice on the investments by not securities, and whether the which a Retirement Investor can be the plan, participant or beneficiary distribution methods and channels of assured of developing a balanced account, or IRA. insurance products that are not investment portfolio. The Department requests comment on securities fit within this exemption’s The Department recognizes, however, this disclosure, in light of the potential framework. that some Financial Institutions limit point of sale disclosure. We are The Department requests comment on the investment products that a particularly interested in comments this approach. In particular, we ask Retirement Investor may purchase, sell discussing whether both disclosures whether we have drawn the correct or hold based on whether the products would be helpful and, if not, which lines between insurance and annuity generate third-party payments or are would be more useful to Retirement products that are securities and those proprietary products, or for other Investors? that are not, in terms of our decision to continue to allow IRA transactions reasons (e.g., the firms specialize in 4. Non-Security Insurance and Annuity involving non-security insurance and particular asset classes or product Contracts. annuity contracts to occur under the types). Both Financial Institutions and Section III(a) and (b) will apply to all conditions of PTE 84–24 while requiring Advisers often rely on the ability to sell Assets as defined in the proposal. This IRA transactions involving securities to proprietary products or the ability to includes insurance and annuity occur under the conditions of this generate additional revenue through contracts that are securities under proposed Best Interest Contract third-party payments to support their federal securities law, such as variable Exemption. business models. The proposal permits annuities, and insurance and annuity In order for us to evaluate our Financial Institutions with such contracts that are not, such as fixed approach, we request public comment business models to rely on the annuities. The Department requests the current disclosure requirements exemption provided additional comment on whether the types of applicable to insurance and annuity conditions are satisfied. information required in the Section contracts that are not securities. Can The additional conditions are set forth III(a) and (b) disclosures are applicable Section III(a) and (b) can be revised with in Section IV(b) of the proposal. First, and available with respect to insurance respect to such non-securities insurance before limiting the investment products and annuity contracts that are not and annuity contracts to provide a Retirement Investor may purchase, sell securities. meaningful information to investors as or hold, the Financial Institution must In this regard, we note that PTE 84– to the costs of such investments and the make a specific written finding that the 24 36 is an existing exemption under overall compensation received by limitations do not prevent the Adviser which certain investment advice Advisers and Financial Institutions in from providing advice that is in the best fiduciaries can receive commissions on connection with the transactions? In interest of the Retirement Investors (i.e., insurance and annuity contracts and addition, the Department requests advice that reflects the care, skill, mutual fund shares that are purchased information on the distribution methods prudence, and diligence under the by plans and IRAs. Elsewhere in this and channels applicable to insurance circumstances then prevailing that a issue of the Federal Register, the and annuity products that are not prudent person would exercise based on Department has proposed to revoke securities. What are common structures the investment objectives, risk relief under PTE 84–24 as it applies to of insurance agencies? tolerance, financial circumstances, and IRA transactions involving annuity Finally, we request public input as to needs of the Retirement Investor, whether any conditions of this proposed without regard to the financial or other 36 Class Exemption for Certain Transactions Best Interest Contract Exemption, other interests of the Adviser, Financial Involving Insurance Agents and Brokers, Pension than the disclosure conditions Institution or any Affiliate, Related Consultants, Insurance Companies, Investment Companies and Investment Company Principal discussed above, would be inapplicable Entity, or other party) or from otherwise Underwriters, 49 FR 13208 (Apr. 3, 1984), amended to non-security insurance and annuity adhering to the Impartial Conduct at 71 FR 5887 (Feb. 3, 2006). products? Are any aspects of this Standards. © 2015 The Institute of Continuing Legal Education 12-77 Tax Conference, 28th Annual, May 21, 2015 21976 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules Second, the proposal provides that under the plan, provided the Adviser plans, participant and beneficiary the payments received in connection and Financial Institution did not accounts, and IRAs and is intended to with these limited menus be reasonable provide advice to the responsible plan assist the Department in evaluating the in relation to the value of specific fiduciary regarding the menu of effectiveness of the exemption. We services provided to Retirement designated investment options. In such request comment on whether these are Investors in exchange for the payments circumstances, the Adviser and the appropriate data points for the and not in excess of the services’ fair Financial Institution are not responsible covered Assets. Are the terms used clear market value. This is more specific than for the limitations on the investment enough to result in information that is the reasonable compensation options. reasonably comparable across different requirement set forth in the contract Financial Institutions? Or should we under Section II because of the EBSA Disclosure and Recordkeeping include precise definitions of inflows, limitation placed by the Financial (Section V) outflows, holdings, returns, etc.? If so, Institution on the investments available 1. Notification to the Department of please suggest specifically how these for Adviser recommendation. The Reliance on the Exemption terms should be defined. Are different Department intends to ensure that such terms needed to request comparable Before receiving prohibited additional payments received in information regarding insurance and compensation in reliance on Section I of connection with the advice are for annuity contracts that are not securities? this exemption, Section V(a) of the specific services to Retirement 3. General Recordkeeping Investors. proposal requires that the Financial The proposal additionally provides Institution notify the Employee Benefits Finally, Section V(c) and (d) of the that the Financial Institution or Adviser, Security Administration of the intention proposal contains a general before giving any recommendations to a to rely on this exemption. The notice recordkeeping requirement applicable to Retirement Investor, must give clear need not identify any specific plan or the Financial Institution. The general written notice to the Retirement Investor IRA. The notice will remain in effect recordkeeping requirement relates to the of any limitations placed by the until it is revoked in writing. The records necessary for the Department Financial Institution on the investment Department envisions accepting the and certain other entities to determine products offered by the Adviser. In this notice via email and regular mail. whether the conditions of this regard, it is insufficient for the notice This is a notice provision only and exemption have been satisfied. merely to state that the Financial does not require any approval or finding by the Department that the Financial Effect of Failure To Comply With Institution ‘‘may’’ limit investment Conditions recommendations, without specifically Institution is eligible for the exemption. disclosing the extent to which the Once a Financial Institution has sent the If the exemption is granted, relief Financial Institution in fact does so. notice, it can immediately begin to rely under the Best Interest Contract Finally, the proposal would require on the exemption provided the Exemption will be available only if all an Adviser or Financial Institution to conditions are satisfied. applicable conditions described above are satisfied. Satisfaction of the notify the Retirement Investor if the 2. Data Request Adviser does not recommend a conditions is determined on a sufficiently broad range of investment Section V(b) of the proposed transaction by transaction basis, options to meet the Retirement exemption also would require Financial however. Thus, the effect of Investor’s needs. For example, the Institutions to maintain certain data, noncompliance with a condition Department envisions the provision of which is specified in Section IX, for six depends on whether the condition such a notice when the Adviser and years from the date of the applicable applies to a single transaction or Financial Institution provide advice transaction. The data request would multiple transactions. For example, if an with respect to a limited class of require Financial Institutions to Adviser fails to provide a transaction investment products, but those products maintain and disclose to the Department disclosure in accordance with Section do not meet a particular investor’s upon request specific information III(a) with respect to an Asset purchased needs. The Department requests regarding purchases, sales, and holdings by a plan, participant or beneficiary comment on whether it is possible to by Retirement Investors made pursuant account, or an IRA, the relief provided state this standard with more to advice provided by Advisers and by the Best Interest Contract Exemption specificity, or whether more detailed Financial Institutions relying on the would be unavailable to the Adviser and guidance is needed for parties to proposed exemption. Financial Financial Institution only for the determine when compliance with the Institutions may maintain this otherwise prohibited compensation condition would be necessary. The information in any form that may be received in connection with the Department also requests comment on readily analyzed by the Department or investment in that specific Asset by the whether any specific disclosure is simply as raw data. Receipt of this plan, participant or beneficiary account, necessary to inform the Retirement additional data will assist the or IRA. More broadly, if an Adviser and Investor about the particular conflicts of Department in assessing the Financial Institution fail to enter into a interest associated with Advisers that effectiveness of the exemption. contract with a Retirement Investor in recommend only proprietary products, No party, other than the Financial accordance with Section II, relief under and, if so, what the disclosure should Institution responsible for compliance, the Best Interest Contract Exemption say. will be subject to the taxes imposed by would be unavailable solely with The conditions of Section IV do not Code section 4975(a) and (b), if respect to the investments by that apply to an Adviser or Financial applicable, if the Financial Institution Retirement Investor, not all Retirement Institution with respect to the provision fails to maintain the data or the data are Investors to which the Adviser and of investment advice to a participant or not available for examination. Financial Institution provide advice. beneficiary of a participant directed Request for Comment. The proposed However, if a Financial Institution fails individual account plan concerning the data request covers certain information to comply with a condition that is participant’s or beneficiary’s selection of with respect to investment inflows, necessary for all transactions involving designated investment options available outflows and holdings, and returns, by investment advice to Retirement 12-78 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21977 Investors, such as the maintenance of involving IRAs’ purchase of variable the purchase, sale or holding of an Asset the Web page required by Section III(c), annuity contracts and other annuity before the applicability date. The the Financial Institution will not be contracts that are securities under Department is proposing this exemption eligible for the relief under the Best federal securities law. We have therefore to provide relief for investment Interest Contract Exemption for all decided to provide an exemption for professionals that may have provided prohibited transactions entered into these transactions as part of this advice prior to the applicability date of during the period in which the failure document, both to ensure that relief is the regulation but did not consider to comply existed. available for transactions involving IRAs themselves fiduciaries. Their receipt but also for ease of compliance for after the applicability date of ongoing Supplemental Exemptions transactions involving other Retirement periodic payments of compensation 1. Proposed Insurance and Annuity Investors (i.e., plan participants, attributable to a purchase, sale or Exemption (Section VI) beneficiaries and small plan sponsors). holding of an Asset by a plan, As with the Best Interest Contract participant or beneficiary account, or The Best Interest Contract Exemption, Exemption, relief under the proposed IRA, prior to the applicability date of as set forth above, permits Advisers and insurance and annuity exemption in the regulation might otherwise raise Financial Institutions to receive Section VI would not extend to a plan prohibited transaction concerns. compensation that would otherwise be covered by Title I of ERISA where (i) the The Department is also proposing this prohibited by the self-dealing and Adviser, Financial Institution or any exemption for Advisers and Financial conflicts of interest provisions of ERISA Affiliate is the employer of employees Institutions who were considered and the Code. ERISA and the Code covered by the plan, or (ii) the Adviser fiduciaries before the applicability date, contain additional prohibitions on or Financial Institution is a named but who entered into transactions certain specific transactions between fiduciary or plan administrator (as involving plans and IRAs before the plans and IRAs and ‘‘parties in interest’’ defined in ERISA section 3(16)(A)) with applicability date in accordance with and ‘‘disqualified persons,’’ including respect to the plan, or an affiliate the terms of a prohibited transaction service providers. These additional thereof, that has not been selected by a exemption that has since been amended. prohibited transactions include: (i) The fiduciary that is Independent. The Section VII would permit Advisers, purchase or sale of an asset between a conditions proposed for the insurance Financial Institutions, and their plan/IRA and a party in interest/ and annuity exemption are that the Affiliates and Related Entities, to disqualified person, and (ii) the transfer transaction must be effected by the receive compensation such as 12b–1 of plan/IRA assets to a party in interest/ insurance company in the ordinary fees, after the applicability date, that is disqualified person. These prohibited course of its business as an insurance attributable to a purchase, sale or transactions are subject to excise tax and company, the combined total of all fees holding of an Asset by a plan, personal liability for the fiduciary. and compensation received by the participant or beneficiary account, or an A plan’s or IRA’s purchase of an insurance company is not in excess of IRA, that occurred prior to the insurance or annuity product would be reasonable compensation under the applicability date. a prohibited transaction if the insurance circumstances, the purchase is for cash In order to take advantage of this company has a pre-existing relationship only, and that the terms of the purchase relief, the exemption would require that with the plan/IRA as a service provider, are at least as favorable to the plan as the compensation must be received or is otherwise a party in interest/ the terms generally available in an arm’s pursuant to an agreement, arrangement disqualified person. In the Department’s length transaction with an unrelated or understanding that was entered into view, this circumstance is common party.37 prior to the applicability date of the enough in connection with regulation, and that the Adviser and recommendations by Advisers and Financial Institution not provide Financial Institutions to warrant 2. Exemption for Pre-Existing additional advice to the plan or IRA, proposal of an exemption for these types Transactions (Section VII) regarding the purchase, sale or holding of transactions in conjunction with the Section VII of the proposal would of the Asset after the applicability date Best Interest Contract Exemption. The of the regulation. Relief would not be provide an exemption for Advisers, Department anticipates that the extended to compensation that is Financial Institutions, and their fiduciary that causes a plan’s or IRA’s excluded pursuant to Section I(c) of the Affiliates and Related Entities in purchase of an insurance or annuity proposal or to compensation received in connection with transactions that product would not be the Adviser or connection with a purchase or sale occurred prior to the applicability date Financial Institution but would instead transaction that, at the time it was of the Proposed Regulation, if adopted. be another fiduciary, such as a plan entered into, was a non-exempt Specifically, the exemption would sponsor or IRA owner, acting on the prohibited transaction. The Department provide relief from ERISA sections Adviser’s or Financial Institution’s requests comment on whether there are 406(a)(1)(D) and 406(b) for the receipt of advice. Because the party requiring other areas in which exemptions would prohibited compensation, after the relief for this prohibited transaction is be desirable to avoid unforeseen applicability date of the regulation, by separate and independent of the Adviser consequences in connection with the an Adviser, Financial Institution and and Financial Institution, the timing of the finalization of the any Affiliate or Related Entity for Department is proposing this exemption Proposed Regulation. subject to discrete conditions described services provided in connection with below. 3. Low Fee Streamlined Exemption 37 The condition requiring the purchase to be Although there is an existing made for cash only is not intended to preclude While the flexibility of the Best exemption which would often cover purchases with plan or IRA contributions, but Interest Contract Exemption is designed these transactions, PTE 84–24, the rather to preclude transactions effected in-kind to accommodate a wide range of current Department is proposing elsewhere in through an exchange of securities or other assets. business practices and avoid the need In-kind exchanges would not be permitted as part this issue of the Federal Register to of this class exemption due to the potential need for highly prescriptive regulation, the revoke that exemption to the extent it for conditions relating to valuation of the assets to Department acknowledges that there provides relief for transactions be exchanged. may be actors in the industry that would © 2015 The Institute of Continuing Legal Education 12-79 Tax Conference, 28th Annual, May 21, 2015 21978 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules prefer a more prescriptive approach. fee products would be consistent with However, the Department lacks data The Department believes that both the prevailing (though by no means regarding the characteristics of mutual approaches could be desirable and universal) view in the academic funds with low all-in fees. could, if designed properly, minimize literature that posits that the optimal Consequently, we are exploring whether the harmful impact of conflicts of investment strategy is often to buy and the streamlined exemption should interest on the quality of advice. hold a diversified portfolio of assets contain additional conditions to Accordingly, in addition to the Best calibrated to track the overall safeguard the interests of plans, Interest Contract Exemption, the performance of financial markets. Under participants and beneficiaries, and IRA Department is also considering issuing a this view, for example, a long-term owners. For example, the streamlined separate streamlined exemption that recommendation to buy and hold a low- exemption could require that the would allow Advisers and Financial priced (often passively managed) target investment product be ‘‘broadly Institutions (and their Affiliates and date fund that is consistent with the diversified to minimize risk for targeted Related Entities) to receive otherwise investor’s future risk appetite trajectory return,’’ or ‘‘calibrated to provide a prohibited compensation in connection is likely to be sound. As another balance of risk and return appropriate to with plan, participant and beneficiary example, under this view, a medium- the investor’s circumstances and accounts, and IRA investments in term recommendation to buy and hold preferences for the duration of the certain high-quality low-fee (for 5 or perhaps 10 years) an recommended holding period.’’ investments, subject to fewer inexpensive, risk-matched balanced However, we recognize that adding conditions. However, at this point, the fund or combination of funds, and conditions might undercut the Department has been unable to afterward to review the investor’s usefulness of the streamlined operationalize this concept and circumstances and formulate a new exemption. therefore has not proposed text for such recommendation also is likely to be Request for Comment. The a streamlined exemption. Instead, we sound. Department requests comment on these seek public input to assist our If it could be constructed possible initial terms of a streamlined consideration and design of the appropriately, a streamlined exemption exemption and other questions relating exemption. for high-quality low-fee investments to the technical design of such an A low-fee streamlined exemption is could be subject to relatively few exemption and its likely utility to an attractive idea that, if properly conditions, because the investments Advisers and Financial Institutions. crafted, could achieve important goals. present minimal risk of abuse to plans, Additionally, the Department requests It could minimize the compliance participants and beneficiaries, and IRA public input on the likely consequences burdens for Advisers offering high- owners. The aim would be to design of the establishment of a low-fee quality low-fee investment products conditions with sufficient objectivity streamlined exemption. with minimal potential for material that Advisers and Financial Institutions Design. The Department requests conflicts of interest, as discussed further could proceed with certainty in their public input on the technical design below. Products that met the conditions business operations when of the streamlined exemption could be recommending the investments. The challenges in defining high-quality low- recommended to plans, participants and Department does not anticipate that fee investment products that would beneficiaries, and IRA owners, and the such a streamlined exemption would satisfy the policy goals of the Adviser could receive variable and require Advisers and Financial streamlined exemption. We are third-party compensation as a result of Institutions to undertake the contractual concerned that there may be no single, those recommendations, without commitments to adhere to the Impartial objective way to evaluate fees and satisfying some or all of the conditions Conduct Standards or adopt anti- expenses associated with mutual funds of the Best Interest Contract Exemption. conflict policies and procedures with (or other investments) and no single cut- The streamlined exemption could respect to advice given on such off to determine when fees are reward and encourage best practices products, as is proposed in the Best sufficiently low. One cut-off could be with respect to optimizing the quality, Interest Contract Exemption. However, too low for some investors’ needs and amount, and combined, all-in cost of some of the required disclosures too high for others’. A very low cut-off recommended financial products, proposed in the Best Interest Contract would strongly favor passively managed financial advice, and other related Exemption would likely be imposed in funds. A high cut-off would permit services. In particular, a streamlined the streamlined exemption. recommendations that may not be exemption could be useful in enhancing The Department has initially focused sound and free from bias. Multiple cut- access to quality, affordable financial on mutual funds as the only type of offs for different product categories products and advice by savers with investment widely held by Retirement would be complex and would risk smaller account balances. Additionally, Investors that would be readily introducing bias between the categories. because it would be premised on a fee susceptible to the type of expense In addition, it is unclear whether comparison, it would apply only to calculations necessary to implement the mutual funds with the lowest fees investments with relatively simple and low-fee streamlined exemption. This is necessarily represent the highest quality transparent fee structures. due to the transparency associated with investments for Retirement Investors. As In this regard, the Department mutual fund investments and, in noted above, the streamlined exemption believes that certain high-quality particular, the requirement that the would not expressly contain a ‘‘best investments are provided pursuant to mutual fund disclose its fees and interest’’ standard. fee structures in which the payments are operating expenses in its prospectus. To further aid in the design of the sufficiently low that they do not present Accordingly, data on mutual fund fees streamlined exemption, the Department serious potential material conflicts of and expenses is widely available. requests comments on the questions interest. In theory, a streamlined Within the category of mutual fund below. The Regulatory Impact Analysis exemption with relatively few investments, the Department is for the Proposed Regulation, published conditions could be constructed around considering whether the streamlined elsewhere in this issue of the Federal such investments. Facilitating exemption would be available to funds Register, describes additional questions investments in such high-quality low- with all-in fees below a certain amount. the Department is considering regarding 12-80 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21979 the development of a low-fee • Should ETFs be covered? Within • Would Advisers and Financial streamlined exemption. the category of mutual funds, should Institutions restrict their business • Should the streamlined exemption exchange-traded funds (ETFs) be models to offer only the low-fee mutual cover investment products other than covered under the streamlined funds that the Department envisions mutual funds? The streamlined exemption? If so, how would the covering in the streamlined exemption? exemption would be based on the commission associated with an ETF Or, would Advisers that offer products premise that low-cost investment transaction be incorporated into the outside the streamlined exemption products distributed pursuant to low-fee calculation? (higher-fee mutual funds as well as relatively unconflicted fee structures • What, if any, conditions other than other investment products such as present minimal risk of abuse to plans, low fees should be required as part of stocks and bonds) rely on the participants and beneficiaries, and IRA the streamlined exemption? If the streamlined exemption for the low-fee owners. In order to design a streamlined streamlined exemption covers only mutual fund investments and the Best exemption for the sale of such products, mutual funds, are conditions relating to Interest Contract Exemption for the the products must have fee structures their availability and transparent pricing other investments? If Advisers and that are transparent, publicly available, unnecessary? Are conditions relating to Financial Institutions had to implement and capable of being compared reliably. liquidity necessary? Should funds the safeguards required by the Best Are there other investments commonly covered by the streamlined exemption Interest Contract Exemption for many of held by Retirement Investors that meet be required to be broadly diversified to their Retirement Investor customers, these criteria? minimize risk for targeted return? would the availability of the • How should the fee calculation be Should the streamlined exemption streamlined exemption result in material cost savings to them? performed? How should fees be defined contain a requirement that the • for the fee calculation to ensure a useful investment be calibrated to provide a How do low-fee investment metric? Should the fee calculation balance of risk and return appropriate to products compensate Advisers for include both ongoing management/ the investor’s circumstances and distribution? Do low-fee funds tend to administrative fees and one-time preferences for the duration of the pay sales loads, revenue sharing and distribution/transactional costs? What recommended holding period? Should 12b–1 fees? If not, how would Advisers time period should the fee calculation the funds be required to meet the and Financial Institutions be cover? Should it cover fees as projected requirements of a ‘‘qualified default compensated within the low-fee confines of the streamlined exemption? over future time periods (e.g., one, five investment alternative,’’ as described in • What design features would be most and ten year periods) to lower the 29 CFR 2550.404c–5? • likely to enhance the utility of the low- impact of one-time transactional costs How should the low-fee cut-off be fee streamlined exemption? such as sales loads? If so, what discount communicated to Advisers and Consequences. The Department seeks rate should be used to determine the Financial Institutions? Should the the public’s views on the potential present value of future fees? initial cut-off and subsequent updates consequences of granting a streamlined • How should the Department be written as a condition of the exemption for certain types of determine the fee cut-off? If the exemption, or publicized through other investments. Department established a streamlined formats? How would Advisers and • Would a streamlined exemption exemption for low-fee mutual funds and Financial Institutions be sure that limited to low-fee mutual fund other products, how would the precise certain funds meet the low-fee cut-off? investments or other categories of fee cut-off be determined? How often By what means and how frequently investments be in the interests of plans should it be updated? What are should Advisers and Financial and their participants and beneficiaries? characteristics of mutual funds with Institutions be required to confirm that Would the availability of the very low fees? Should the cut-off be mutual funds that they recommend (or streamlined exemption discourage based on a percentage of the assets recommended in the past) continue to Advisers and Financial Institutions from invested (i.e., a specified number of meet the low-fee cut-off? offering other types of investments, basis points) or as a percentile of the • How could consumers police the including higher-cost mutual funds, market? If a percentile, how should low-fee cut-off? What enforcement even if the offering of such other reliable data be obtained to determine mechanism could be used to assure that investments would be in the best fund percentiles? Are there available the Advisers taking advantage of such a interest of the plan, participant or and appropriate sources of industry safe harbor are correctly analyzing beneficiary, or IRA owner? Would the benchmarking data? Should the whether their products meet the cut-off? streamlined exemption have the Department collect data for this Utility. In addition to seeking beneficial effect of reducing investment purpose? Is the range of fees in the comment on the technical design of the costs? On the other hand, could the market known? Are there data that streamlined exemption, the Department streamlined exemption result in some of would suggest that mutual funds with asks for information on whether the the lowest-cost investment products relatively low fees are (or are not) high low-fee streamlined exemption would increasing their fees to the cut-off quality investments for a wide variety of effectively reduce the compliance threshold? Would it expand the number Retirement Investors? burden for a significant number of of Financial Institutions that developed • Should the low-fee cutoff be Advisers and Financial Institutions. low-fee options, making them more applied differently to different types of Because of its design, the low-fee widely available? funds? Should a single fee cut-off apply streamlined exemption would generally • How would the streamlined broadly to all mutual funds, or would apply on a product-by-product basis exemption affect the marketplace for that exclude entire categories of funds rather than at the Financial Institution investment products? Would a low-fee with certain investment strategies? level, unless the Financial Institution streamlined exemption have the Would it be appropriate to develop sub- and its Advisers exclusively advise unintended effect of unduly promoting categories of funds for the fee cut-offs? retail customers to invest in the low-fee certain investment styles? Which types If so, how should the sub-categories be products. Therefore, the Department of Advisers and Financial Institutions defined? asks: would be most affected and would they © 2015 The Institute of Continuing Legal Education 12-81 Tax Conference, 28th Annual, May 21, 2015 21980 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules be likely to revise their business models in the Federal Register (Applicability without exposure to contractual liability in response? Would there be increased Date). The Department proposes to make to the IRA owners. competition among Advisers and this exemption, if granted, available on The Department does not believe that Financial Institutions to offer the Applicability Date. Further, the such additional delay would be investment products with lower fees? Department is proposing to revoke relief warranted for Advisers and Financial Would Retirement Investors have more for transactions involving IRAs from Institutions with respect to transactions choices to diversify while paying less in two existing exemptions, PTEs 86–128 involving ERISA plan sponsors and fees? Would Financial Institutions and and 84–24, as of the Applicability ERISA plan participants and Advisers offer other incentives to Date.43 As a result, Advisers and beneficiaries. Advisers and Financial Retirement Investors in order to sell Financial Institutions, including those Institutions to ERISA plans and their specific products? newly defined as fiduciaries, will participants and beneficiaries are generally have to comply with this accustomed to working within the Availability of Other Prohibited exemption to receive many common existing exemptions, such as PTEs 86– Transaction Exemptions forms of compensation in transactions 128 and 84–24, and such exemptions Certain existing exemptions, involving IRAs. would remain available to them while including amendments thereto and The Department recognizes that they develop systems for complying superseding exemptions, provide relief complying with the requirements of the with this exemption.49 Nevertheless, the for specific types of transactions that are exemption may represent a significant Department also requests comments on outside of the scope of this proposed adjustment for many Advisers and the appropriate period for phasing in exemption. A person seeking relief for a Financial Institutions, particularly in some or all of the exemption’s transaction covered by one of those their dealings with IRA owners. At the conditions with respect to ERISA plans existing exemptions would need to same time, in the Department’s view, it as well as IRAs. comply with its requirements and is essential that Advisers and Financial The Department additionally notes conditions. Those exemptions are as Institutions wishing to receive that, elsewhere in this issue of the follows: compensation under the exemption Federal Register, it has proposed to (1) PTE 75–1 (Part III),38 which institute certain conditions for the revoke another existing exemption, PTE provides relief for a plan’s acquisition of protection of IRA customers as of the 75–1, Part II(2), in its entirety in securities during an underwriting or Applicability Date. These safeguards connection with a proposed amendment selling syndicate from any person other include: Acknowledging fiduciary to PTE 86–128. The Department than a fiduciary who is a member of the status,44 complying with the Impartial requests comment on whether this syndicate. Conduct Standards,45 adopting anti- exemption is widely used and whether (2) PTE 75–1 (Part V),39 which conflict policies and procedures,46 it should delay revocation for some exempts an extension of credit to a plan notifying EBSA of the use of the period after the Applicability Date while from a party in interest. exemption,47 and recordkeeping.48 The Advisers and Financial Institutions (3) PTE 83–1,40 which provides relief Department requests comment on develop systems for complying with for certain transactions involving whether Financial Institutions PTE 86–128. mortgage pool investment trusts and anticipate that there will be existing No Relief Proposed From ERISA Section pass-through certificates evidencing contractual obligations or other barriers 406(a)(1)(C) or Code Section interests therein. that would prevent them from 4975(c)(1)(C) for the Provision of (4) PTE 2004–16,41 which provides implementing the exemption’s policies Services relief for a fiduciary of the plan who is and procedures requirement in this time If granted, this proposed exemption the employer of employees covered frame. will not provide relief from a under the plan to establish individual The Department also specifically transaction prohibited by ERISA section retirement plans for certain mandatory requests comment on whether it should 406(a)(1)(C), or from the taxes imposed distributions on behalf of separated delay certain other conditions of the exemption as applicable to IRA by Code section 4975(a) and (b) by employees at a financial institution that reason of Code section 4975(c)(1)(C), is itself or an affiliate, and also select a transactions for an additional period (e.g., three months) following the regarding the furnishing of goods, proprietary investment product as the services or facilities between a plan and initial investment for the plan. Applicability Date. For example, one 42 possibility would be to delay the a party in interest. The provision of (5) PTE 2006–16, which exempts investment advice to a plan under a certain loans of securities by plans to requirement that Advisers and Financial Institutions execute a contract with their contract with a plan fiduciary is a broker-dealers and banks and provides service to the plan and compliance with relief for the receipt of compensation by IRA customers for an additional three- month period, as well as the disclosure this exemption will not relieve an a fiduciary for services rendered in Adviser or Financial Institution of the connection with the securities loans. requirements in Sections III and the data collection requirements described in need to comply with ERISA section Applicability Date Section IX. This phased approach 408(b)(2), Code section 4975(d)(2), and applicable regulations thereunder. The Department is proposing that would give Financial Institutions compliance with the final regulation additional time to review and refine Paperwork Reduction Act Statement defining a fiduciary under ERISA their policies and procedures and to put new compliance systems in place, As part of its continuing effort to section 3(21)(A)(ii) and Code section reduce paperwork and respondent 4975(e)(3)(B) will begin eight months 43 See the notices with respect to these proposals, burden, the Department conducts a after publication of the final regulation published elsewhere in this issue of the Federal preclearance consultation program to Register. provide the general public and Federal 38 40 FR 50845 (Oct. 31, 1975). 44 See Section II(b). 39 45 Id., as amended at 71 FR 5883 (Feb. 3, 2006). See Section II(c). 49 In this regard, the Department anticipates 40 48 FR 895 (Jan. 7, 1983). 46 See Section II(d)(2)–(4). making the Impartial Conduct Standards 41 69 FR 57964 (Sept. 28, 2004). 47 See Section V(a). amendments to PTEs 86–128 and 84–24 effective as 42 71 FR 63786 (Oct. 31, 2006). 48 See Section V(c). of the Applicability Date. 12-82 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21981 agencies with an opportunity to Cosby, Office of Policy and Research, • Approximately 2,800 financial comment on proposed and continuing U.S. Department of Labor, Employee institutions 51 will take advantage of this collections of information in accordance Benefits Security Administration, 200 exemption and they will use this with the Paperwork Reduction Act of Constitution Avenue NW., Room N– exemption in conjunction with 1995 (PRA) (44 U.S.C. 3506(c)(2)(A)). 5718, Washington, DC 20210. transactions involving nearly all of their This helps to ensure that the public Telephone (202) 693–8410; Fax: (202) clients that are small defined benefit understands the Department’s collection 219–5333. These are not toll-free and defined plans, participant directed instructions, respondents can provide numbers. ICRs submitted to OMB also defined contribution plans, and IRA the requested data in the desired format, are available at http://www.RegInfo.gov. holders.52 53 Eight percent of financial reporting burden (time and financial As discussed in detail below, the PTE institutions (approximately 224) will be resources) is minimized, collection would require financial institutions and new firms beginning use of this instruments are clearly understood, and their advisers to enter into a contractual exemption each year. the Department can properly assess the arrangement with retirement investors Contract, Disclosures, and Notices impact of collection requirements on making investment decisions on behalf respondents. of the plan or IRA (i.e., plan participants In order to receive prohibited Currently, the Department is soliciting or beneficiaries, IRA owners, or small compensation under this PTE, Section II comments concerning the proposed plan sponsors (or employees, officers or requires financial institutions and information collection request (ICR) directors thereof)), and make certain advisers to enter into a written contract included in the Best Interest Contract disclosures to the retirement investors with retirement investors affirmatively Exemption (PTE) as part of its proposal and the Department in order to receive stating that they are fiduciaries under to amend its 1975 rule that defines relief from ERISA’s prohibited ERISA or the Code with respect to any when a person who provides investment transaction rules for the receipt of recommendations to the retirement advice to an employee benefit plan or compensation as a result of a financial investor to purchase, sell or hold IRA becomes a fiduciary. A copy of the institution’s and its adviser’s advice specified assets, and that the financial ICR may be obtained by contacting the (i.e., prohibited compensation). institution and adviser will give advice PRA addressee shown below or at Financial institutions would be required that is in the best interest of the http://www.RegInfo.gov. to maintain records necessary to prove retirement investor. The Department has submitted a copy that the conditions of the exemption Section III(a) requires the adviser to of the PTE to the Office of Management have been met. These requirements are furnish the retirement investor with a and Budget (OMB) in accordance with ICRs subject to the Paperwork disclosure prior to the execution of the 44 U.S.C. 3507(d) for review of its Reduction Act. purchase of the asset stating the total information collections. The The Department has made the cost of investing in the asset. Section Department and OMB are particularly following assumptions in order to III(b) requires the adviser or financial interested in comments that: establish a reasonable estimate of the institution to furnish the retirement • Evaluate whether the collection of paperwork burden associated with these investor with an annual statement information is necessary for the proper ICRs: listing all assets purchased or sold performance of the functions of the • Disclosures distributed during the year, as well as the agency, including whether the electronically will be distributed via associated fees and expenses paid by the information will have practical utility; means already used by respondents in plan, participant or beneficiary account, • Evaluate the accuracy of the the normal course of business and the or IRA, and the compensation received agency’s estimate of the burden of the costs arising from electronic distribution by the financial institution and the collection of information, including the will be negligible; adviser. Section III(c) requires the validity of the methodology and • Financial institutions will use financial institution to maintain a assumptions used; existing in-house resources to prepare publicly available Web page displaying • Enhance the quality, utility, and the contracts and disclosures, adjust the compensation (including its source clarity of the information to be their IT systems, and maintain the and how it varies within asset classes) collected; and recordkeeping systems necessary to that would be received by the adviser, • Minimize the burden of the meet the requirements of the exemption; the financial institution and any affiliate collection of information on those who • A combination of personnel will are to respond, including through the perform the tasks associated with the for private industry, September 2014 http:// use of appropriate automated, ICRs at an hourly wage rate of $125.95 www.bls.gov/news.release/eci.nr0.htm). electronic, mechanical, or other for a financial manager, $30.42 for 51 As described in the regulatory impact analysis for the accompanying rule, the Department technological collection techniques or clerical personnel, $79.67 for an IT estimates that approximately 2,619 broker dealers other forms of information technology, professional, and $129.94 for a legal service the retirement market. The Department e.g., permitting electronic submission of professional; 50 anticipates that the exemption will be used responses. primarily, but not exclusively, by broker-dealers. Comments should be sent to the 50 The Department’s estimated 2015 hourly labor Further, the Department assumes that all broker- dealers servicing the retirement market will use the Office of Information and Regulatory rates include wages, other benefits, and overhead, and are calculated as follows: mean wage from the exemption. Beyond the 2,619 broker-dealers, the Affairs, Office of Management and 2013 National Occupational Employment Survey Department estimates that almost 200 other Budget, Room 10235, New Executive (April 2014, Bureau of Labor Statistics http:// financial institutions will use the exemption. Office Building, Washington, DC 20503; www.bls.gov/news.release/pdf/ocwage.pdf); wages 52 The Department welcomes comment on this Attention: Desk Officer for the as a percent of total compensation from the estimate. Employer Cost for Employee Compensation (June 53 For purposes of this analysis, ‘‘IRA holders’’ Employee Benefits Security 2014, Bureau of Labor Statistics http://www.bls.gov/ include rollovers from ERISA plans. Administration. OMB requests that news.release/ecec.t02.htm); overhead as a multiple 54 The Department assumes that nearly all comments be received within 30 days of of compensation is assumed to be 25 percent of financial institutions already maintain Web sites publication of the proposed PTE to total compensation for paraprofessionals, 20 and that updates to the disclosure required by percent of compensation for clerical, and 35 percent Section III(c) could be automated. Therefore, the IT ensure their consideration. of compensation for professional; annual inflation costs required by Section III(c) would be almost PRA Addressee: Address requests for assumed to be 2.3 percent annual growth of total exclusively start-up costs. The Department invites copies of the ICR to G. Christopher labor cost since 2013 (Employment Costs Index data comment on these assumptions. © 2015 The Institute of Continuing Legal Education 12-83 Tax Conference, 28th Annual, May 21, 2015 21982 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules with respect to any asset that a plan, The Department assumes that limit their investment menus in some participant or beneficiary account, or financial institutions already maintain way and provide the limited menu IRA could purchase through the adviser. contracts with their clients. Therefore, disclosure. Accordingly, during the first If the financial institution limits the the required contractual provisions will year of the exemption the Department assets available for sale, Section IV be inserted into existing contracts with estimates that all of the 21.3 million requires the financial institution to no additional cost for production or plans and IRAs would receive the one- furnish the retirement investor with a distribution. page limited menu disclosure. In written description of the limitations The Department assumes that subsequent years, approximately 1.7 placed on the menu. The adviser must financial institutions will send million plans and IRAs would receive also notify the retirement investor if it approximately 24 point-of-sale the one-page limited menu disclosure. does not recommend a sufficiently transaction disclosures each year to Small defined benefit and defined broad range of assets to meet the 37,000 small defined benefit plans and contribution plans that do not allow retirement investor’s needs. small defined contribution plans that do participants to direct investments would Finally, before the financial not allow participants to direct receive the disclosure electronically at institution begins engaging in investments. All of these disclosures de minimis cost. The disclosure would transactions covered under this PTE, will be sent electronically at de minimis be distributed electronically to 75 Section V(a) requires the financial cost. Financial institutions will send percent of defined contribution plan institution to provide notice to the two point-of-sale transaction disclosures participants and IRA holders. Paper Department of its intent to rely on this each year to 1.1 million defined copies of the disclosure would be given proposed PTE. contribution plans participants and 20.2 to 25 percent of defined contribution million IRA holders. These disclosures plan participants and IRA holders. Legal Costs will be distributed electronically to 75 Further, 15 percent of the paper copies The Department estimates that percent of defined contribution plan would be mailed, while the other 85 drafting the PTE’s contractual participants and IRA holders. Paper percent would be hand-delivered during provisions, the notice to the copies of the disclosure will be given to in-person meetings. The Department Department, and the limited menu 25 percent of defined contribution plan estimates that electronic distribution disclosure will require 60 hours of legal participants and IRA holders. Further, would result in de minimis cost, while time for financial institutions during the 15 percent of the paper copies will be paper distribution would cost first year that the financial institution mailed, while the other 85 percent will approximately $922,000 during the first uses the PTE. This legal work results in be hand-delivered during in-person year and approximately $74,000 in approximately 168,000 hours of burden meetings. The Department estimates subsequent years. Paper distribution during the first year and approximately that electronic distribution will result in would also require one minute of 13,000 hours of burden during de minimis cost, while paper clerical time to print the disclosure and subsequent years at an equivalent cost distribution will cost approximately one minute of clerical time to mail the of $21.8 million and $1.7 million $1.3 million. Paper distribution will disclosure, resulting in 244,000 hours in respectively. also require one minute of clerical time the first year and 20,000 hours in to print the disclosure and one minute subsequent years at an equivalent cost IT Costs of clerical time to mail the disclosure, of $7.4 million and $595,000 The Department estimates that resulting in 204,000 hours at an respectively. If, as seems likely, many updating computer systems to create the equivalent cost of $6.2 million annually. financial institutions choose not to limit required disclosures, insert the contract The Department estimates that 21.3 the universe of investment provisions into existing contracts, million plans and IRAs will receive an recommendations, we would expect the maintain the required records, and annual statement. Small defined benefit actual costs to be substantially smaller. publish information on the Web site and defined contribution plans that do Finally, the Department estimates that will require 100 hours of IT staff time not allow participants to direct all of the 2,800 financial institutions for financial institutions during the first investments will receive a ten page would mail the required one-page notice year that the financial institution uses statement electronically at de minimis to the Department during the first year the PTE.54 This IT work results in cost. Defined contribution plan and approximately 224 new financial approximately 280,000 hours of burden participants and IRA holders will institutions would mail the required during the first year and approximately receive a two page statement. This one-page notice to the Department in 22,000 hours of burden during statement will be distributed subsequent years. Producing and subsequent years at an equivalent cost electronically to 38 percent of defined distributing this notice would cost of $22.3 million and $1.8 million contribution plan participants and 50 approximately $1,500 during the first respectively. percent of IRA holders. Paper year and approximately $100 in statements will be mailed to 62 percent subsequent years. Producing and Production and Distribution of Required of defined contribution plan distributing this notice would also Contract, Disclosures, and Notices participants and 50 percent of IRA require 2 minutes of clerical time The Department estimates that holders. The Department estimates that resulting in a burden of approximately approximately 21.3 million plans and electronic distribution will result in de 93 hours during the first year and IRAs have relationships with financial minimis cost, while paper distribution approximately 7 hours in subsequent institutions and are likely to engage in will cost approximately $6.3 million. years at an equivalent cost of $2,800 and transactions covered under this PTE. Paper distribution will also require two $200 respectively. minutes of clerical time to print and Recordkeeping Requirement 54 The Department assumes that nearly all mail the disclosure, resulting in 359,000 financial institutions already maintain Web sites hours at an equivalent cost of $10.9 Section V(b) requires financial and that updates to the disclosure required by million annually. institutions to maintain investment Section III(c) could be automated. Therefore, the IT costs required by Section III(c) would be almost For purposes of this estimate, the return data in a manner accessible for exclusively start-up costs. The Department invites Department assumes that nearly all examination by the Department for six comment on these assumptions. financial institutions using the PTE will years. Section V(c) and (d) requires 12-84 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21983 financial institutions to maintain or is not commonly invoked, and therefore, require, among other things, that a cause to be maintained for six years and the written notice is rarely, if ever, fiduciary discharge his or her duties disclosed upon request the records generated. Therefore, the Department respecting the plan solely in the necessary for the Department, Internal believes the cost burden associated with interests of the participants and Revenue Service, plan fiduciary, this clause is de minimis. No other cost beneficiaries of the plan. Additionally, contributing employer or employee burden exists with respect to the fact that a transaction is the subject organization whose members are recordkeeping. of an exemption does not affect the covered by the plan, and participants, requirement of Code section 401(a) that Overall Summary beneficiaries and IRA owners to the plan must operate for the exclusive determine whether the conditions of Overall, the Department estimates that benefit of the employees of the this exemption have been met in a in order to meet the conditions of this employer maintaining the plan and their manner that is accessible for audit and PTE, 2,800 financial institutions will beneficiaries; examination. produce 86 million disclosures and (2) Before an exemption may be Most of the data retention notices during the first year of this PTE granted under ERISA section 408(a) and requirements in Section V(b) are and 66.4 million disclosures and notices Code section 4975(c)(2), the Department consistent with data retention during subsequent years. These must find that the exemption is requirements made by the SEC and disclosures and notices will result in 1.3 administratively feasible, in the FINRA. In addition, the data retention million burden hours during the first interests of plans and their participants requirements correspond to the six year year and 620,000 burden hours in and beneficiaries and IRA owners, and statute of limitations in Section 413 of subsequent years, at an equivalent cost protective of the rights of participants ERISA. Insofar as the data retention time of $68.9 million and $21.4 million and beneficiaries of the plan and IRA requirements in Section V(b) are respectively. The disclosures and owners; lengthier than those required by the SEC notices in this exemption will also (3) If granted, the proposed exemption and FINRA, the Department assumes result in a total cost burden for materials is applicable to a particular transaction that retaining data for an additional time and postage of $8.6 million during the only if the transaction satisfies the period is a de minimis additional first year and $7.7 million during conditions specified in the exemption; burden. subsequent years. and The records required in Section V(c) These paperwork burden estimates (4) The proposed exemption, if and Section V(d) are generally kept as are summarized as follows: granted, will be supplemental to, and regular and customary business Type of Review: New collection not in derogation of, any other practices. Therefore, the Department has (Request for new OMB Control provisions of ERISA and the Code, estimated that the additional time Number). including statutory or administrative needed to maintain records consistent Agency: Employee Benefits Security exemptions and transitional rules. with the exemption will only require Administration, Department of Labor. Furthermore, the fact that a transaction about one-half hour, on average, Titles: (1) Proposed Best Interest is subject to an administrative or annually for a financial manager to Contract Exemption. statutory exemption is not dispositive of organize and collate the documents or OMB Control Number: 1210–NEW. whether the transaction is in fact a else draft a notice explaining that the Affected Public: Business or other for- prohibited transaction. information is exempt from disclosure, profit. and an additional 15 minutes of clerical Estimated Number of Respondents: Written Comments time to make the documents available 2,800. The Department invites all interested for inspection during normal business Estimated Number of Annual persons to submit written comments on hours or prepare the paper notice Responses: 85,985,156 in the first year the proposed exemption to the address explaining that the information is and 66,394,985 in subsequent years. and within the time period set forth exempt from disclosure. Thus, the Frequency of Response: Initially, above. All comments received will be Department estimates that a total of 45 Annually, and When engaging in made a part of the record. Comments minutes of professional time per exempted transaction. should state the reasons for the writer’s Financial Institution would be required Estimated Total Annual Burden interest in the proposed exemption. for a total hour burden of 2,100 hours Hours: 1,256,862 during the first year Comments received will be available for at an equivalent cost of $198,000. and 619,766 in subsequent years. public inspection at the above address. In connection with this recordkeeping Estimated Total Annual Burden Cost: and disclosure requirements discussed $8,582,764 during the first year and Proposed Exemption above, Section V(d)(2) and (3) provide $7,733,247 in subsequent years. Section I—Best Interest Contract that financial institutions relying on the Exemption exemption do not have to disclose trade General Information secrets or other confidential information The attention of interested persons is (a) In general. ERISA and the Internal to members of the public (i.e., plan directed to the following: Revenue Code prohibit fiduciary fiduciaries, contributing employers or (1) The fact that a transaction is the advisers to employee benefit plans employee organizations whose members subject of an exemption under ERISA (Plans) and individual retirement plans are covered by the plan, participants section 408(a) and Code section (IRAs) from receiving compensation that and beneficiaries and IRA owners), but 4975(c)(2) does not relieve a fiduciary or varies based on their investment that in the event a financial institution other party in interest or disqualified recommendations. Similarly, fiduciary refuses to disclose information on this person with respect to a plan or IRA advisers are prohibited from receiving basis, it must provide a written notice from certain other provisions of ERISA compensation from third parties in to the requester advising of the reasons and the Code, including any prohibited connection with their advice. This for the refusal and advising that the transaction provisions to which the exemption permits certain persons who Department may request such exemption does not apply and the provide investment advice to information. The Department’s general fiduciary responsibility Retirement Investors, and their experience indicates that this provision provisions of ERISA section 404 which associated financial institutions, © 2015 The Institute of Continuing Legal Education 12-85 Tax Conference, 28th Annual, May 21, 2015 21984 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules affiliates and other related entities, to directly or indirectly, through one or anticipated to be received by the receive such otherwise prohibited more intermediaries, controlling, Adviser, Financial Institution, Affiliates compensation as described below. controlled by, or under common control and Related Entities in connection with (b) Covered transactions. This with the Financial Institution (i.e., a the purchase, sale or holding of the exemption permits Advisers, Financial principal transaction); Asset by the Plan, participant or Institutions, and their Affiliates and (3) The compensation is received as a beneficiary account, or IRA, will exceed Related Entities to receive compensation result of investment advice to a reasonable compensation in relation to for services provided in connection with Retirement Investor generated solely by the total services they provide to the a purchase, sale or holding of an Asset an interactive Web site in which Retirement Investor; and by a Plan, participant or beneficiary computer software-based models or (3) The Adviser’s and Financial account, or IRA, as a result of the applications provide investment advice Institution’s statements about the Asset, Adviser’s and Financial Institution’s based on personal information each fees, Material Conflicts of Interest, and advice to any of the following investor supplies through the Web site any other matters relevant to a ‘‘Retirement Investors:’’ without any personal interaction or Retirement Investor’s investment (1) A participant or beneficiary of a advice from an individual Adviser (i.e., decisions, will not be misleading. Plan subject to Title I of ERISA with ‘‘robo advice’’); or (d) Warranties. The Adviser and authority to direct the investment of (4) The Adviser (i) exercises any Financial Institution affirmatively assets in his or her Plan account or to discretionary authority or discretionary warrant the following: take a distribution; control respecting management of the (1) The Adviser, Financial Institution, (2) The beneficial owner of an IRA Plan or IRA assets involved in the and Affiliates will comply with all acting on behalf of the IRA; or transaction or exercises any authority or applicable federal and state laws (3) A plan sponsor as described in control respecting management or regarding the rendering of the ERISA section 3(16)(B) (or any disposition of the assets, or (ii) has any investment advice, the purchase, sale employee, officer or director thereof) of discretionary authority or discretionary and holding of the Asset, and the a non-participant-directed Plan subject responsibility in the administration of payment of compensation related to the to Title I of ERISA with fewer than 100 the Plan or IRA. purchase, sale and holding of the Asset; participants, to the extent it acts as a (2) The Financial Institution has fiduciary who has authority to make Section II—Contract, Impartial adopted written policies and procedures investment decisions for the Plan. Conduct, and Other Requirements reasonably designed to mitigate the As detailed below, parties seeking to (a) Contract. Prior to recommending impact of Material Conflicts of Interest rely on the exemption must that the Plan, participant or beneficiary and ensure that its individual Advisers contractually agree to adhere to account, or IRA purchase, sell or hold adhere to the Impartial Conduct Impartial Conduct Standards in the Asset, the Adviser and Financial Standards set forth in Section II(c); rendering advice regarding Assets; Institution enter into a written contract (3) In formulating its policies and warrant that they have adopted policies with the Retirement Investor that procedures, the Financial Institution has and procedures designed to mitigate the incorporates the terms required by specifically identified Material Conflicts dangers posed by Material Conflicts of Section II(b)–(e). of Interest and adopted measures to Interest; disclose important information (b) Fiduciary. The written contract prevent the Material Conflicts of Interest relating to fees, compensation, and affirmatively states that the Adviser and from causing violations of the Impartial Material Conflicts of Interest; and retain Financial Institution are fiduciaries Conduct Standards set forth in Section documents and data relating to under ERISA or the Code, or both, with II(c); and investment recommendations regarding respect to any investment (4) Neither the Financial Institution Assets. The exemption provides relief recommendations to the Retirement nor (to the best of its knowledge) any from the restrictions of ERISA section Investor. Affiliate or Related Entity uses quotas, 406(a)(1)(D) and 406(b) and the (c) Impartial Conduct Standards. The appraisals, performance or personnel sanctions imposed by Code section Adviser and the Financial Institution actions, bonuses, contests, special 4975(a) and (b), by reason of Code affirmatively agree to, and comply with, awards, differential compensation or section 4975(c)(1)(D), (E) and (F). The the following: other actions or incentives to the extent Adviser and Financial Institution must (1) When providing investment advice they would tend to encourage comply with the conditions of Sections to the Retirement Investor regarding the individual Advisers to make II–V to rely on this exemption. Asset, the Adviser and Financial recommendations that are not in the (c) Exclusions. This exemption does Institution will provide investment Best Interest of the Retirement Investor. not apply if: advice that is in the Best Interest of the Notwithstanding the foregoing, the (1) The Plan is covered by Title I of Retirement Investor (i.e., advice that contractual warranty set forth in this ERISA, and (i) the Adviser, Financial reflects the care, skill, prudence, and Section II(d)(4) does not prevent the Institution or any Affiliate is the diligence under the circumstances then Financial Institution or its Affiliates and employer of employees covered by the prevailing that a prudent person would Related Entities from providing Plan, or (ii) the Adviser or Financial exercise based on the investment Advisers with differential compensation Institution is a named fiduciary or plan objectives, risk tolerance, financial based on investments by Plans, administrator (as defined in ERISA circumstances, and needs of the participant or beneficiary accounts, or section 3(16)(A)) with respect to the Retirement Investor, without regard to IRAs, to the extent such compensation Plan, or an affiliate thereof, that was the financial or other interests of the would not encourage advice that runs selected to provide advice to the Plan by Adviser, Financial Institution or any counter to the Best Interest of the a fiduciary who is not Independent; Affiliate, Related Entity, or other party); Retirement Investor (e.g., differential (2) The compensation is received as a (2) When providing investment advice compensation based on such neutral result of a transaction in which the to the Retirement Investor regarding the factors as the difference in time and Adviser is acting on behalf of its own Asset, the Adviser and Financial analysis necessary to provide prudent account or the account of the Financial Institution will not recommend an Asset advice with respect to different types of Institution, or the account of a person if the total amount of compensation investments would be permissible). 12-86 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21985 (e) Disclosures. The written contract (A) Acquisition costs. Any costs of (3) A statement of the total dollar must specifically: acquiring the Asset that are paid by amount of all compensation received by (1) Identify and disclose any Material direct charge to the Plan, participant or the Adviser and Financial Institution, Conflicts of Interest; beneficiary account, or IRA, or that directly or indirectly, from any party, as (2) Inform the Retirement Investor reduce the amount invested in the Asset a result of each Asset sold, purchased or that the Retirement Investor has the (e.g., any loads, commissions, or mark- held by the Plan, participant or right to obtain complete information ups on Assets bought from dealers, and beneficiary account, or IRA during the about all the fees currently associated account opening fees, if applicable). applicable period. with the Assets in which it is invested, (B) Ongoing costs. Any ongoing (e.g., (c) Web page. including all of the direct and indirect annual) costs attributable to fees and (1) The Financial Institution fees paid payable to the Adviser, expenses charged for the operation of an maintains a Web page, freely accessible Financial Institution, and any Affiliates; Asset that is a pooled investment fund to the public, which shows the and (e.g., mutual fund, bank collective following information: (3) Disclose to the Retirement Investor investment fund, insurance company (A) The direct and indirect material whether the Financial Institution offers pooled separate account) that reduces compensation payable to the Adviser, Proprietary Products or receives Third the Asset’s rate of return (e.g., amounts Financial Institution and any Affiliate Party Payments with respect to the attributable to a mutual fund expense for services provided in connection with purchase, sale or holding of any Asset, ratio and account fees). This includes each Asset (or, if uniform across a class and of the address of the Web site amounts paid by the pooled investment of Assets, the class of Assets) that a required by Section III(c) that discloses fund to intermediaries, such as sub-TA Plan, participant or beneficiary account, the compensation arrangements entered fees, sub-accounting fees, etc. or an IRA is able to purchase, hold, or into by Advisers and the Financial (C) Disposition costs. Any costs of sell through the Adviser or Financial disposing of or redeeming an interest in Institution. Institution, and that a Plan, participant the Asset that are paid by direct charge (f) Prohibited Contractual Provisions. or beneficiary account, or an IRA has to the Plan, participant or beneficiary The written contract shall not contain purchased, held, or sold within the last account, or IRA, or that reduce the the following: 365 days. The compensation may be amounts received by the Plan, expressed as a monetary amount, (1) Exculpatory provisions participant or beneficiary account, or disclaiming or otherwise limiting formula or percentage of the assets IRA (e.g., surrender fees, back-end involved in the purchase, sale or liability of the Adviser or Financial loads, etc., that are always applicable Institution for a violation of the holding; and (i.e., do not sunset), mark-downs on (B) The source of the compensation, contract’s terms; and assets sold to dealers, and account and how the compensation varies (2) A provision under which the Plan, closing fees, if applicable). within and among Assets. IRA or Retirement Investor waives or (D) Others. Any costs not described in (2) The Financial Institution’s Web qualifies its right to bring or participate (A)–(C) that reduce the Asset’s rate of page provides access to the information in a class action or other representative return, are paid by direct charge to the in (1)(A) and (B) in a machine readable action in court in a dispute with the Plan, participant or beneficiary account, format. Adviser or Financial Institution. or IRA, or reduce the amounts received Section IV—Range of Investment by the Plan, participant or beneficiary Section III—Disclosure Requirements Options account, or IRA (e.g., contingent fees, (a) Transaction Disclosure. such as back-end loads that phase out (a) General. The Financial Institution (1) Disclosure. Prior to the execution over time (with such terms explained offers for purchase, sale or holding, and of the purchase of the Asset by the Plan, beneath the table)). the Adviser makes available to the Plan, participant or beneficiary account, or (3) Model Chart. Appendix II to this participant or beneficiary account, or IRA, the Adviser furnishes to the exemption contains a model chart that IRA for purchase, sale or holding, a Retirement Investor a chart that may be used to provide the information range of Assets that is broad enough to provides, with respect to each Asset required under this Section III(a). Use of enable the Adviser to make recommended, the Total Cost to the the model chart is not mandatory. recommendations with respect to all of Plan, participant or beneficiary account, However, use of an appropriately the asset classes reasonably necessary to or IRA, of investing in the Asset for completed model chart will be deemed serve the Best Interests of the 1-, 5- and 10-year periods expressed as to satisfy the requirements of this Retirement Investor in light of its a dollar amount, assuming an Section III(a). investment objectives, risk tolerance, investment of the dollar amount (b) Annual Disclosure. The Adviser or and specific financial circumstances. recommended by the Adviser and Financial Institution provides the (b) Limited Range of Investment reasonable assumptions about following written information to the Options. Section (a) notwithstanding, a investment performance that are Retirement Investor, annually, within 45 Financial Institution may limit the disclosed. days of the end of the applicable year, Assets available for purchase, sale or The disclosure chart required by this in a succinct single disclosure: holding based on whether the Assets are section need not be provided with (1) A list identifying each Asset Proprietary Products, generate Third respect to a subsequent purchased or sold during the applicable Party Payments, or for other reasons, recommendation to purchase the same period and the price at which the Asset and still rely on the exemption, investment product if the chart was was purchased or sold; provided that: previously provided to the Retirement (2) A statement of the total dollar (1) The Financial Institution makes a Investor within the past twelve months amount of all fees and expenses paid by specific written finding that the and the Total Cost has not materially the Plan, participant or beneficiary limitations it has placed on the Assets changed. account, or IRA (directly and indirectly) made available to an Adviser for (2) Total Cost. The ‘‘Total Cost’’ of with respect to each Asset purchased, purchase, sale or holding by Plans, investing in an Asset means the sum of held or sold during the applicable participant and beneficiary accounts, the following, as applicable: period; and and IRAs do not prevent the Adviser © 2015 The Institute of Continuing Legal Education 12-87 Tax Conference, 28th Annual, May 21, 2015 21986 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules from providing advice that is in the Best Section V—Disclosure to the (C) Any contributing employer and Interest of the Retirement Investor (i.e., Department and Recordkeeping any employee organization whose advice that reflects the care, skill, (a) EBSA Disclosure. Before receiving members are covered by a Plan prudence, and diligence under the compensation in reliance on the described in paragraph (d)(1)(B), or any circumstances then prevailing that a exemption in Section I, the Financial authorized employee or representative prudent person would exercise based on Institution notifies the Department of of these entities; or the investment objectives, risk Labor of the intention to rely on this (D) Any participant or beneficiary of tolerance, financial circumstances, and class exemption. The notice will remain a Plan described in paragraph (B), IRA needs of the Retirement Investor, in effect until revoked in writing by the owner, or the authorized representative without regard to the financial or other Financial Institution. The notice need of such participant, beneficiary or interests of the Adviser, Financial not identify any Plan or IRA. owner; and Institution or any Affiliate, Related (b) Data Request. The Financial (2) None of the persons described in Entity, or other party) or otherwise Institution maintains the data that is paragraph (d)(1)(B)–(D) of this Section adhering to the Impartial Conduct subject to request pursuant to Section IX are authorized to examine privileged Standards; in a manner that is accessible for trade secrets or privileged commercial (2) Any compensation received in examination by the Department for six or financial information, of the connection with a purchase, sale or (6) years from the date of the transaction Financial Institution, or information holding of the Asset by a Plan, subject to relief hereunder. No party, identifying other individuals. (3) Should the Financial Institution participant or beneficiary account, or an other than the Financial Institution refuse to disclose information on the IRA, is reasonable in relation to the responsible for complying with this basis that the information is exempt value of the specific services provided paragraph (b), will be subject to the from disclosure, the Financial to the Retirement Investor in exchange taxes imposed by Code section 4975(a) Institution must, by the close of the for the payments and not in excess of and (b), if applicable, if the data is not thirtieth (30th) day following the the services’ fair market value; maintained or not available for request, provide a written notice (3) Before giving investment examination as required by paragraph advising the requestor of the reasons for recommendations to Retirement (b). Investors, the Adviser or Financial (c) Recordkeeping. The Financial the refusal and that the Department may Institution gives the Retirement Investor Institution maintains for a period of six request such information. clear written notice of the limitations (6) years, in a manner that is accessible Section VI—Insurance and Annuity placed on the Assets that the Adviser for examination, the records necessary Contract Exemption may offer for purchase, sale or holding to enable the persons described in (a) In general. In addition to by a Plan, participant or beneficiary paragraph (d) of this Section to account, or an IRA. Notice is prohibiting fiduciaries from receiving determine whether the conditions of compensation from third parties and insufficient if it merely states that the this exemption have been met, except Financial Institution or Adviser ‘‘may’’ compensation that varies on the basis of that: the fiduciaries’ investment advice, limit investment recommendations (1) If such records are lost or ERISA and the Internal Revenue Code based on whether the Assets are destroyed, due to circumstances beyond prohibit the purchase by a Plan, Proprietary Products or generate Third the control of the Financial Institution, participant or beneficiary account, or Party Payments, or for other reasons, then no prohibited transaction will be IRA of an insurance or annuity product without specific disclosure of the extent considered to have occurred solely on to which recommendations are, in fact, the basis of the unavailability of those from an insurance company that is a limited on that basis; and records; and service provider to the Plan or IRA. This (4) The Adviser notifies the (2) No party, other than the Financial exemption permits a Plan, participant or Retirement Investor if the Adviser does Institution responsible for complying beneficiary account, or IRA to purchase not recommend a sufficiently broad with this paragraph (c), will be subject an Asset that is an insurance or annuity range of Assets to meet the Retirement to the civil penalty that may be assessed contract in accordance with an Investor’s needs. under ERISA section 502(i) or the taxes Adviser’s advice, from a Financial (c) ERISA plan participants and imposed by Code section 4975(a) and Institution that is an insurance company beneficiaries. Some Advisers and (b), if applicable, if the records are not and that is a service provider to the Plan Financial Institutions provide advice to maintained or are not available for or IRA. This exemption is provided participants in ERISA-covered examination as required by paragraph because purchases of insurance and participant directed individual account (d), below. annuity products are often prohibited Plans in which the menu of investment (d) (1) Except as provided in purchases and sales involving insurance options is selected by an Independent paragraph (d)(2) of this Section, and companies that have a pre-existing party Plan fiduciary. In such cases, provided notwithstanding any provisions of in interest relationship to the Plan or the Adviser and Financial Institution ERISA section 504(a)(2) and (b), the IRA. did not provide investment advice to records referred to in paragraph (c) of (b) Covered transaction. The the Plan fiduciary regarding the this Section are unconditionally restrictions of ERISA section composition of the menu, the Adviser available at their customary location for 406(a)(1)(A) and (D), and the sanctions and Financial Institution do not have to examination during normal business imposed by Code section 4975(a) and comply with Section IV(a)–(c) in hours by: (b), by reason of Code section connection with their advice to (A) Any authorized employee or 4975(c)(1)(A) and (D), shall not apply to individual participants and representative of the Department or the a fiduciary’s causing the purchase of an beneficiaries on the selection of Assets Internal Revenue Service; Asset that is an insurance or annuity from the menu provided. This exception (B) Any fiduciary of a Plan that contract by a non-participant-directed is not available for advice with respect engaged in a purchase, sale or holding Plan subject to Title I of ERISA that has to investments within open brokerage of an Asset described in this exemption, fewer than 100 participants, participant windows or otherwise outside the Plan’s or any authorized employee or or beneficiary account, or IRA, from a designated investment options. representative of such fiduciary; Financial Institution that is an 12-88 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21987 insurance company and that is a party 406(a)(1)(D) and 406(b) and the (3) Any corporation or partnership of in interest or disqualified person, if: sanctions imposed by Code section which the Adviser or Financial (1) The transaction is effected by the 4975(a) and (b), by reason of Code Institution is an officer, director or insurance company in the ordinary section 4975(c)(1)(D), (E) and (F), shall employee or in which the Adviser or course of its business as an insurance not apply to the receipt of compensation Financial Institution is a partner. company; by an Adviser, Financial Institution, and (c) An ‘‘Asset,’’ for purposes of this (2) The combined total of all fees and any Affiliate and Related Entity, for exemption, includes only the following compensation received by the insurance services provided in connection with investment products: Bank deposits, company and any Affiliate is not in the purchase, holding or sale of an certificates of deposit (CDs), shares or excess of reasonable compensation Asset, as a result of the Adviser’s and interests in registered investment under the circumstances; Financial Institution’s advice, that was companies, bank collective funds, (3) The purchase is for cash only; and purchased, sold, or held by a Plan, insurance company separate accounts, (4) The terms of the purchase are at participant or beneficiary account, or an exchange-traded REITs, exchange-traded least as favorable to the Plan, participant IRA before the Applicability Date if: funds, corporate bonds offered pursuant or beneficiary account, or IRA as the (1) The compensation is not excluded to a registration statement under the terms generally available in an arm’s pursuant to Section I(c) of the Best Securities Act of 1933, agency debt length transaction with an unrelated Interest Contract Exemption; securities as defined in FINRA Rule party. (2) The compensation is received 6710(l) or its successor, U.S. Treasury (c) Exclusion: The exemption in this pursuant to an agreement, arrangement securities as defined in FINRA Rule Section VI does not apply if the Plan is or understanding that was entered into 6710(p) or its successor, insurance and covered by Title I of ERISA, and (i) the prior to the Applicability Date; annuity contracts, guaranteed Adviser, Financial Institution or any (3) The Adviser and Financial investment contracts, and equity Affiliate is the employer of employees Institution do not provide additional securities within the meaning of 17 CFR covered by the Plan, or (ii) the Adviser advice to the Plan regarding the 230.405 that are exchange-traded and Financial Institution is a named purchase, sale or holding of the Asset securities within the meaning of 17 CFR fiduciary or plan administrator (as after the Applicability Date; and 242.600. Excluded from this definition defined in ERISA section 3(16)(A)) with (4) The purchase or sale of the Asset is any equity security that is a security respect to the Plan, or an affiliate was not a non-exempt prohibited future or a put, call, straddle, or other thereof, that was selected to provide transaction pursuant to ERISA section option or privilege of buying an equity advice to the plan by a fiduciary who is 406 and Code section 4975 on the date security from or selling an equity not Independent. it occurred. security to another without being bound to do so. Section VII—Exemption for Pre- Section VIII—Definitions Existing Transactions (d) Investment advice is in the ‘‘Best For purposes of these exemptions: Interest’’ of the Retirement Investor (a) In general. ERISA and the Internal (a) ‘‘Adviser’’ means an individual when the Adviser and Financial Revenue Code prohibit Advisers, who: Institution providing the advice act with Financial Institutions and their (1) Is a fiduciary of a Plan or IRA the care, skill, prudence, and diligence Affiliates and Related Entities from solely by reason of the provision of under the circumstances then prevailing receiving variable or third-party investment advice described in ERISA that a prudent person would exercise compensation as a result of the section 3(21)(A)(ii) or Code section based on the investment objectives, risk Adviser’s and Financial Institution’s 4975(e)(3)(B), or both, and the tolerance, financial circumstances, and advice to a Plan, participant or applicable regulations, with respect to needs of the Retirement Investor, beneficiary, or IRA owner. Some the Assets involved in the transaction; without regard to the financial or other Advisers and Financial Institutions did (2) Is an employee, independent interests of the Adviser, Financial not consider themselves fiduciaries contractor, agent, or registered Institution or any Affiliate, Related within the meaning of 29 CFR 2510– representative of a Financial Institution; Entity, or other party. 3.21 before the applicability date of the and (e) ‘‘Financial Institution’’ means the amendment to 29 CFR 2510–3.21 (the (3) Satisfies the applicable federal and entity that employs the Adviser or Applicability Date). Other Advisers and state regulatory and licensing otherwise retains such individual as an Financial Institutions entered into requirements of insurance, banking, and independent contractor, agent or transactions involving Plans, participant securities laws with respect to the registered representative and that is: or beneficiary accounts, or IRAs before covered transaction. (1) Registered as an investment the Applicability Date, in accordance (b) ‘‘Affiliate’’ of an Adviser or adviser under the Investment Advisers with the terms of a prohibited Financial Institution means— Act of 1940 (15 U.S.C. 80b–1 et seq.) or transaction exemption that has since (1) Any person directly or indirectly under the laws of the state in which the been amended. This exemption permits through one or more intermediaries, adviser maintains its principal office Advisers, Financial Institutions, and controlling, controlled by, or under and place of business; their Affiliates and Related Entities, to common control with the Adviser or (2) A bank or similar financial receive compensation, such as 12b–1 Financial Institution. For this purpose, institution supervised by the United fees, in connection with the purchase, ‘‘control’’ means the power to exercise States or state, or a savings association sale or holding of an Asset by a Plan, a controlling influence over the (as defined in section 3(b)(1) of the participant or beneficiary account, or an management or policies of a person Federal Deposit Insurance Act (12 IRA, as a result of the Adviser’s and other than an individual; U.S.C. 1813(b)(1)), but only if the advice Financial Institution’s advice, that (2) Any officer, director, employee, resulting in the compensation is occurred prior to the Applicability Date, agent, registered representative, relative provided through a trust department of as described and limited below. (as defined in ERISA section 3(15)), the bank or similar financial institution (b) Covered transaction. Subject to the member of family (as defined in Code or savings association which is subject applicable conditions described below, section 4975(e)(6)) of, or partner in, the to periodic examination and review by the restrictions of ERISA section Adviser or Financial Institution; and federal or state banking authorities; © 2015 The Institute of Continuing Legal Education 12-89 Tax Conference, 28th Annual, May 21, 2015 21988 Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules (3) An insurance company qualified (k) ‘‘Related Entity’’ means any entity participant or beneficiary account, or to do business under the laws of a state, other than an Affiliate in which the IRA, associated with the sale; provided that such insurance company: Adviser or Financial Institution has an (3) The revenue received by the (A) Has obtained a Certificate of interest which may affect the exercise of Financial Institution and any Affiliate in Authority from the insurance its best judgment as a fiduciary. connection with the sale of each Asset commissioner of its domiciliary state (l) ‘‘Retirement Investor’’ means— disaggregated by source; and which has neither been revoked nor (1) A participant or beneficiary of a (4) The identity of each revenue suspended, Plan subject to Title I of ERISA with (B) Has undergone and shall continue authority to direct the investment of source (e.g., mutual fund, mutual fund to undergo an examination by an assets in his or her Plan account or to adviser) and the reason the Independent certified public accountant take a distribution, compensation was paid. for its last completed taxable year or has (2) The beneficial owner of an IRA (c) Holdings. At the Financial undergone a financial examination acting on behalf of the IRA, or Institution level for each Asset held at (within the meaning of the law of its (3) A plan sponsor as described in any time during each quarter: domiciliary state) by the state’s ERISA section 3(16)(B) (or any (1) The aggregate number and identity insurance commissioner within the employee, officer or director thereof), of of shares/units held at the end of such preceding 5 years, and a non-participant-directed Plan subject quarter; (C) Is domiciled in a state whose law to Title I of ERISA that has fewer than (2) The aggregate cost incurred by the requires that actuarial review of reserves 100 participants, to the extent it acts as Plan, participant or beneficiary account, be conducted annually by an a fiduciary with authority to make or IRA, during such quarter in Independent firm of actuaries and investment decisions for the Plan. connection with the holdings; reported to the appropriate regulatory (m) ‘‘Third-Party Payments’’ mean (3) The revenue received by the authority; or sales charges when not paid directly by Financial Institution and any Affiliate in (4) A broker or dealer registered under the Plan, participant or beneficiary connection with the holding of each the Securities Exchange Act of 1934 (15 account, or IRA, 12b–1 fees and other Asset during such quarter for each Asset U.S.C. 78a et seq.). payments paid to the Financial disaggregated by source; and (f) ‘‘Independent’’ means a person Institution or an Affiliate or Related that: Entity by a third party as a result of the (4) The identity of each revenue (1) Is not the Adviser, the Financial purchase, sale or holding of an Asset by source (e.g., mutual fund, mutual fund Institution or any Affiliate relying on a Plan, participant or beneficiary adviser) and the reason the the exemption, account, or IRA. compensation was paid. (2) Does not receive compensation or (d) Returns. At the Retirement other consideration for his or her own Section IX—Data Request Investor level: account from the Adviser, the Financial Upon request by the Department, a (1) The identity of the Adviser; Institution or Affiliate; and Financial Institution that relies on the (2) The beginning-of-quarter value of (3) Does not have a relationship to or exemption in Section I shall provide, the Retirement Investor’s Portfolio; an interest in the Adviser, the Financial within a reasonable time, but in no Institution or Affiliate that might affect event longer than six (6) months, after (3) The end-of-quarter value of the the exercise of the person’s best receipt of the request, the following Retirement Investor’s Portfolio; and judgment in connection with information for the preceding six (6) (4) Each external cash flow to or from transactions described in this year period: the Retirement Investor’s Portfolio exemption. (a) Inflows. At the Financial during the quarter and the date on (g) ‘‘Individual Retirement Account’’ Institution level, for each Asset which it occurred. or ‘‘IRA’’ means any trust, account or purchased, for each quarter: For purposes of this subparagraph (d), annuity described in Code section (1) The aggregate number and identity ‘‘Portfolio’’ means the Retirement 4975(e)(1)(B) through (F), including, for of shares/units bought; Investor’s combined holding of assets example, an individual retirement (2) The aggregate dollar amount held in a Plan account or IRA advised account described in section 408(a) of invested and the cost to the Plan, by the Adviser. the Code and a health savings account participant or beneficiary account, or (e) Public Disclosure. The Department described in section 223(d) of the Code. IRA associated with the purchase; reserves the right to publicly disclose (h) A ‘‘Material Conflict of Interest’’ (3) The revenue received by the information provided by the Financial exists when an Adviser or Financial Financial Institution and any Affiliate in Institution pursuant to subparagraph Institution has a financial interest that connection with the purchase of each (d). If publicly disclosed, such could affect the exercise of its best Asset disaggregated by source; and judgment as a fiduciary in rendering (4) The identity of each revenue information would be aggregated at the advice to a Retirement Investor source (e.g., mutual fund, mutual fund Adviser level, and the Department regarding an Asset. adviser) and the reason the would not disclose any individually (i) ‘‘Plan’’ means any employee compensation was paid. identifiable financial information benefit plan described in section 3(3) of (b) Outflows. At the Financial regarding Retirement Investor accounts. the Act and any plan described in Institution level for each Asset sold, for Signed at Washington, DC, this 14th day of section 4975(e)(1)(A) of the Code. each quarter: April, 2015. (j) ‘‘Proprietary Product’’ means a (1) The aggregate number of and Phyllis C. Borzi, product that is managed by the identity of shares/units sold; Assistant Secretary, Employee Benefits Financial Institution or any of its (2) The aggregate dollar amount Security Administration, Department of Affiliates. received and the cost to the Plan, Labor. 12-90 © 2015 The Institute of Continuing Legal Education Fiduciary Responsibilities for Employer Stock - Employee Benefits Committee Exhibit E Proposed Fiduciary Regulation: Notice of Proposed Class Exemption for Best Interest Contracts Federal Register / Vol. 80, No. 75 / Monday, April 20, 2015 / Proposed Rules 21989 APPENDIX I FINANCIAL INSTITUTION ABC—WEB SITE DISCLOSURE MODEL FORM Transactional Ongoing Provider, Type of in- Affiliate Special rules vestment name, Charges to Compensation Compensation Charges to Compensation Compensation sub-type investor to firm to adviser investor to firm to adviser Non-Pro- XYZ MF [ • ]% sales [ • ]% dealer [ • ]% of trans- [ • ]% expense [ • ]% 12b–1 [ • ]% of ongo- N/A ...... Breakpoints prietary Large load as ap- concession. actional fee ratio. fee, revenue ing fees. (as applica- Mutual Cap plicable. Extent con- sharing (paid Extent consid- ble) Fund Fund, sidered in by fund/affil- ered in an- Contingent de- (Load Class A annual iate). nual bonus. ferred Fund). Class B bonus. shares Class C. charge (as applicable) Propri- ABC MF No upfront N/A ...... N/A ...... [ • ]% expense [ • ]% asset- [ • ]% of ongo- [ • ]% asset- N/A etary Large charge. ratio. based an- ing fees Ex- based in- Mutual Cap nual fee for tent consid- vestment ad- Fund Fund. shareholder ered in an- visory fee (No servicing nual bonus. paid by fund load). (paid by to affiliate of fund/affiliate). Financial In- stitution. Equities, ...... $[ • ] commis- $[ • ] commis- [ • ]% of com- N/A ...... N/A ...... N/A Extent N/A ...... N/A ETFs, sion per sion per mission Ex- considered Fixed transaction. transaction. tent consid- in annual Income. ered in an- bonus. nual bonus. Annuities Insurance No upfront $[ • ] commis- [ • ]% of com- [ • ]% M&E fee $[ • ] Ongoing [ • ]% of ongo- N/A ...... Surrender (Fixed Com- charge on sion (paid by mission Ex- [ • ]% un- trailing com- ing fees Ex- charge and pany A. amount in- insurer). tent consid- derlying ex- mission tent consid- Vari- vested. ered in an- pense ratio. (paid by un- ered in an- able). nual bonus. derlying in- nual bonus. vestment providers). APPENDIX II FINANCIAL INSTITUTION ACTION: Notice of Proposed Class ADDRESSES: All written comments XZY—TRANSACTION DISCLOSURE Exemption. concerning the proposed class MODEL CHART exemption should be sent to the Office SUMMARY: This document contains a of Exemption Determinations by any of Total cost of your in- notice of pendency before the U.S. the following methods, identified by Your Department of Labor of a proposed in- vestment if held for: ZRIN: 1210–ZA25: vest- exemption from certain prohibited Federal eRulemaking Portal: http:// 1 5 10 transactions provisions of the Employee ment year years years www.regulations.gov at Docket ID Retirement Income Security Act of 1974 number: EBSA–EBSA–2014–0016. Asset 1 (ERISA) and the Internal Revenue Code Follow the instructions for submitting Asset 2 (the Code). The provisions at issue comments. generally prohibit fiduciaries with Asset 3 Email to: [email protected]. Account respect to employee benefit plans and fees individual retirement accounts (IRAs) Fax to: (202) 693–8474. from purchasing and selling securities Mail: Office of Exemption Total when the fiduciaries are acting on Determinations, Employee Benefits behalf of their own accounts (principal Security Administration, (Attention: D– [FR Doc. 2015–08832 Filed 4–15–15; 11:15 am] transactions). The exemption proposed 11713), U.S. Department of Labor, 200 BILLING CODE 4510–29–P in this notice would permit principal Constitution Avenue NW., Suite 400, transactions in certain debt securities Washington, DC 20210. DEPARTMENT OF LABOR between a plan, plan participant or Hand Delivery/Courier: Office of beneficiary account, or an IRA, and a Exemption Determinations, Employee Employee Benefits Security fiduciary that provides investment Benefits Security Administration, Administration advice to the plan or IRA, under (Attention: D–11713), U.S. Department conditions to safeguard the interests of of Labor, 122 C St. NW., Suite 400, 29 CFR Part 2550 these investors. The proposed Washington, DC 20001. exemption would affect participants and Instructions. All comments must be [Application Number D–11713] beneficiaries of plans, IRA owners, and received by the end of the comment fiduciaries with respect to such plans period. The comments received will be ZRIN 1210–ZA25 and IRAs. available for public inspection in the Proposed Class Exemption for DATES: Comments: Written comments Public Disclosure Room of the Principal Transactions in Certain Debt concerning the proposed class Employee Benefits Security Securities between Investment Advice exemption must be received by the Administration, U.S. Department of Fiduciaries and Employee Benefit Department on or before July 6, 2015. Labor, Room N–1513, 200 Constitution Plans and IRAs Applicability: The Department Avenue NW., Washington, DC 20210. proposes to make this exemption Comments will also be available online AGENCY: Employee Benefits Security available eight months after publication at www.regulations.gov, at Docket ID Administration (EBSA), U.S. of the final exemption in the Federal number: EBSA–2014–0016 and Department of Labor. Register. www.dol.gov/ebsa, at no charge. © 2015 The Institute of Continuing Legal Education 12-91 Federal Tax Issues in Taxable Transactions - Federal Income Tax Committee by Michael P. Monaghan Plante & Moran PLLC Clinton Township NOTES NOTES NOTES NOTES NOTES