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Tax Report

The Tax Report summarizes the most recent Tax Court cases, Revenue Rulings, and IRS Regulations dealing with closely-held and/or family companies and provides a personal viewpoint as to how the case or ruling applies to closely-held companies. Six reports come out each year. 

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Read below some of the tax cases that have come out recently. 

Replacement Refund Check

 In a Federal Court case, the executors of an estate were determined not to be entitled to a replacement refund check.  The decedent’s estate spanned the Atlantic Ocean from the United States to France.  Executors were named in both France and The U.S.  The U.S. Executors paid $17.5 million in estate tax. Meanwhile, the French Executor, the son of the decedent as well, filed a tax return reporting 10.4 million overpayments and requesting a refund. Subsequently, the U.S. executor filed a tax return, reporting a 5.1 million dollar overpayment.  The IRS received Son’s request first, processed it, and issued a check to the son for $10.4 million.  The son then cashed the check and the United States estate then went to court, in an attempt to get the check reissued to the United States estate.

The court ruled that because the IRS reviewed the French return first, as it arrived first, and acted properly in issuing the check, the IRS was under absolutely no obligation to reissue the check to the estate in the United States.  The son properly negotiated the check, did not commit forgery, or have any other indefensible position upon his actions of cashing the check.  Hence, no check will be issued. (M. Curtin, Pers Rep, FedCl, 2010-1 USTC Para 60,587)


Editor’s Comment:  While it is not necessarily a stated doctrine in tax law, “first in time, first in right” does happen with the IRS.  Many taxpayers and tax preparers have experienced situations where one taxpayer will file a return and enjoy the benefits, while the second to file is stuck with an adverse tax situation.  Promptly filing a tax return is always a good strategy when facing tax situations.


Valuation of Limited Partnership Affirmed

The Tax Court has ruled that a US Court of Appeals properly ruled on the valuation of a limited partnership.  In 2000, a family formed a limited partnership with the intent of reducing estate taxes, preserving and resisting fragmentation, and being a financial educational media for the children.  An internal buy-sell agreement was created to reduce the value of the shares under a right of transfer that was retained


The taxpayer’s side argued that the LP was properly valued due to deep discounts for lack of control and marketability.  The Appellate Court ruled that the taxpayer failed to establish its burden of proof in achieving the three-part test for limited partnerships, and this assessed a higher value.  The tax court agreed to see the real substance over the form of the valuation and ruled it was properly valued at the Appellate Court. (T. Holman, CA-8, 2010-1 USTC Para 60,592)


Editor’s Comment: Family Limited Partnerships have their place in tax planning; however, they have their very serious limitations as well.  The business purpose for forming FLPs has to be legitimate and buy-sell agreements have to be valid, enforceable, and reasonable to escape skepticism.  FLPs are not one size fits all and there are many other valid tax and estate planning vehicles available to achieve the goals taxpayers desire.


A US District Court ruled that gifts of memberships in an LLC did not qualify for the annual gift tax exclusion as they were grants of future interests.  In this case, a married couple put land in a Limited Liability Company and subsequently granted the children a 5% interest apiece, to their children.  The terms of the operating agreement gave the parents essentially full control of the assets currently and running up until the point of their death, even.  The underlying assets were of no use to the children until a future time, thus making the grant a future interest.  The District Court ruled that such interest lacking all powers currently and only granting them upon a future time was most certainly not within the scope of the annual gift exclusions current interest requirement.  (J. Fisher, DC Ind 2010-1 USTC Para 60588)


Editor’s Comment: Once again, taxpayers lost when they try to bend the laws too far in their favor.  Utilizing an LLC or Limited Partnership for family tax planning has its place.  There are legitimate uses and then there is tax avoidance such as here.  When using these instruments, pay attention to what is going where and what the fair market values are, and whether such a transaction makes sense from a business perspective.



The IRS has privately ruled that a stock redemption qualified for sale or exchange treatment.  In this case, the decedent will instruct the estate to place shares from the estate into a trust for the lifetime benefit of the children with the shares then going to the grandchildren.  As part of a settlement agreement between the children and grandchildren, the children became the sole beneficiary of the trust and requested distribution of the trust shares to him.  In exchange, the child himself would be liable for the estate taxes, alleviating the legal liability of the grandchildren.  The IRS ruled that this was a fair exchange of value and thus qualified for sale or exchange treatment. (IRS Letter Ruling 201013024)


Editor’s Comment:  The use of competent tax counsel here made the transaction a better tax event as opposed to not having good tax counsel.  When performing a complex transaction, be sure to employ those who are well-credentialed and experienced.  Had this taxpayer not done this, this event could have been far more taxing.


Beneficiary Protection Laws

It has been observed that 2010 presents an anomaly in the estate planning world.  Ordinarily, and in every other year in the recent past, there has been an explicit estate tax exemption.  Under the assumption that an estate tax exemption exists, many estate plans make reference to this fact for various purposes, including limiting estate tax liability when the time comes.  The problem is that this year, 2010, there is no estate tax exemption to reference.  With potentially thousands of documents referencing and coming into use (Due to someone dying), certain problems have appeared.   Without the exemption, certain formulas in calculating death taxes do not work properly.  Just imagine if everything decision in your day had to be multiplied by 0 or an infinitely high number to achieve a result.  Life and the use of the document would be frustrating and damaging.


In response, many states have enacted laws to protect the beneficiaries from the unintended consequences of the estate tax repeal.  The laws allow the beneficiary to use the numbers in place in 2009 to avoid damage.  In 2011, the states allow the federal exemption to be used once again in the calculation.


Like-Kind Exchanges

The U.S. Supreme Court has refused to review a case involving like-kind property exchanges.  The Ninth Circuit had affirmed a Tax Court decision that denied IRC Sec. 1031 tax-deferred treatment to exchanges of real property.  In this case, the taxpayer intended to sell real property at a gain to an unrelated party and buy other property from a related party.  The taxpayer used a “qualified intermediary” to accomplish both transactions.  The intermediary bought the first piece of property from the taxpayer and then sold it to the third party.  The intermediary then used that cash to buy the second piece of property from the related party and sell it to the taxpayer. 


The Ninth Circuit held that the transactions were not between related parties and were a nontaxable like-kind exchange.  However, the transactions were structured to avoid the related-party restrictions.  Thus, the transactions were denied nontaxable treatment.  The taxpayer was trying to use IRC Sec. 1031 to shift gain to the related party, which had a separate loss to offset.  (Teruya Brothers, Ltd., S. Ct., Cert. Denied, February 22, 2010)


Editor’s Comment: IRC Sec. 1031 is a very taxpayer-friendly portion of the code as it allows property that is used in a trade or business to be sold without incurring capital gains taxes as long as the property is replaced with a “like-kind” piece of property.  If the property is exchanged with a related party and then sold within two years, the transaction then loses its tax-deferred status.   The present case is another illustration of what the IRS calls “substance over form”.  While the form of the transaction may have been with the intermediary, the substance of the transaction was between two related parties. 


LIFO Recapture

The IRS has determined that LIFO recapture would not be required for a sole proprietorship converting to an S corporation.  Under the LIFO (last in first out) inventory method, inventory is valued as if the last inventory purchased is the first inventory sold.  In periods of inflation, this allows the taxpayer to defer income to later periods.  When converting from an S corporation to a C corporation, the amount of income deferred by using the LIFO method becomes taxable under what is known as “LIFO recapture”.  LIFO recapture intends to prevent C corporations from avoiding the built-in gains tax.  The IRS determined that LIFO recapture did not apply in this case because the taxpayer would never be a C corporation.  (LTR 201010026)


Editor’s Comment: LIFO is one of the reasons that many C corporations chose not to convert to S corporation status.  There are advantages and disadvantages to both classes of corporations and this ruling allows a sole proprietorship with substantial inventory flexibility in choosing which class of corporation to select.  The sole proprietorship is generally considered the least desirable way to operate a business.  Unlike corporations, the sole proprietorship will not protect personal assets from debts of the business. 


Covenant Not to Compete

The Tax Court ruled that a corporation must amortize the cost of a covenant not to compete over 15 years.  An owner of 23% of a corporation sold his stock back to the corporation.  In addition purchase of the stock, the corporation paid the owner $400,000 for a one-year covenant not to compete.  The case was decided by the interpretation of Internal Revenue Code Sec. 197, which applies to intangible assets used in a business.  The court ruled that Sec. 197 did apply because the covenant not to compete was entered into in connection with the acquisition of a business interest.  Sec. 197 does not require the business interest in question to be 100% ownership, as the taxpayer argued.  (Recovery Group, Inc., TC Memo. 2010-76)


Editor’s Comment: Generally, things like goodwill and other intangibles fit into Section 197.  Covenants not to compete are usually considered as part of ordinary income to the taxpayer in business sales.  When selling a business, of any kind, be sure to properly allocate assets to get the best outcome possible.  Personal Goodwill is useful and popular in many cases; and, it avoids ordinary income treatment.


Settlement Taxable

The Sixth Circuit Court ruled that a settlement from injury due to false imprisonment is taxable as ordinary income and not subject to the physical injury rule.  In this case, the taxpayer passed a bad check to a car dealer.  He was subsequently arrested and jailed for a short time.  When the charges were dropped, the taxpayer received a settlement and believed them to be tax-free as part of a personal injury reward.  Not so, said the Sixth Circuit Court.  Amounts payable for jail time settlements that may involve loss of liberty, and freedom are indeed taxable as ordinary income.  The rule involving personal injury awards is to be strictly followed and did not apply in this case (Stadnyk, CA-6, February 22, 2010)


Editor’s Comment:  The rule regarding personal injury rewards being not taxable is very narrowly applied.  Had this been an instance of a broken leg, loss of a limb, or else, such loss is subject to not being taxable.  Here, loss of liberty was not found to be a personal injury as it should not be.  The important thing is to be aware that personal injury awards are not taxable.  Though they are not taxable, the rule is relatively narrow, and specifying court documents should be written to indicate as much as to how much is for personal injury and how much is for what else.


Fifth Amendment Privacy

A District Court ruled that taxpayers were not entitled to Fifth Amendment privileges as far as trust documents were concerned.  In this case, the taxpayers had two trusts that were created for the benefit of their children.  The IRS demanded production of the trusts, but the taxpayers denied production based upon the summons.  The court ruled that such trust documents were not available for Fifth Amendment protection. (Oshea, DC W Va. 2010-USTC 50,266)


Editor’s Comment:  While people benefit in criminal procedure from constitutional protections such as the Fifth Amendment, the Fifth Amendment is not as comprehensive in its capacity in civil cases.  This is one example of when such papers are not protected.  The same is true as far as tax returns are concerned, supporting documents, and such.  It must also be realized that many times the burden of proof may be shifted upon the taxpayer to support his or her situation.  Simply put, playing hide the ball does not necessarily work with tax situations.


Invalid Like-Kind-Exchange

In a Memo, the IRS rejected a like-kind exchange attempt by two taxpayers.  In the fact, the taxpayers purchased a property and made attempts to rent it out.  They were unsuccessful and then occupied the property as a personal residence for a short time (not long enough to qualify for the personal residence exclusion).  Upon selling the property, a like-kind exchange was set up meeting statutory requirements.  However, the IRS ruled that the facts, as given were more indicative of an attempt to disguise the property as an investment, with the true intention and actions indicating it was a personal residence.  Such an attempt did not work and the Like-kind exchange was nullified. (Goolsby, TC Memo 2010-64)


Editor’s Comment:  Had the taxpayer been successful in renting the property, even for a few weeks, and had they not moved in, such exchange would have been allowed.  Generally, occupying an investment property for any length of time endangers the tax treatment of such property as an investment property.  In business and investment, keep your assets personal, and your business assets business in appearance and character.

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