Washington News

On June 8, 2023, the Internal Revenue Service (IRS) published a letter to encourage an estimated 1.5 million people to submit tax returns and receive over $1.5 billion in refunds. The refunds are for the 2019 tax year, and the deadline for filing is July 17, 2023.

Most of the individuals due refunds are modest income taxpayers who have not filed a 2019 tax return. Many taxpayers are potentially eligible for refunds. The average refund in 2019 was $893.

IRS Commissioner Danny Werfel stated, "Time is running out for more than a million people to get their tax refunds for 2019. Many people may have overlooked filing a 2019 tax return due to the pandemic. We do not want people to miss their window to receive their refund. We encourage people to check their records and act quickly before the deadline. The IRS has several important ways that people can get help."

Normally, there is a three-year period to file and receive a tax refund. However, the return due date was delayed, and the deadline was changed from April 15 to July 17, 2023. A taxpayer must address, mail and ensure that the tax return is postmarked by July 17, to receive a refund.

Some low and moderate-income workers may also be eligible for the Earned Income Tax Credit (EITC). This could be worth up to $6,557 in 2019. Married couples filing jointly who have three children may qualify if their income is up to $55,952. Married couples filing jointly with two children can qualify with incomes up to $52,493 and those with one child can qualify with incomes up to $46,884. Finally, married couples filing jointly with no qualifying children can qualify with incomes up to $21,370.

The IRS reminds taxpayers that their refund may be held up if they have not filed their returns for 2020 or 2021 or owe the IRS additional tax. Some taxpayers may need additional help or assistance to prepare their return. There are several ways the IRS could help.

1. Copies of Key Documents — If you are missing Forms W-2, 1098 or 1099, you may request copies from an employer or bank.

2. Online Transcript — Taxpayers may obtain a transcript from IRS.gov by using the "Get Transcript Online" tool.

3. Request a Printed Transcript — Taxpayers may use IRS Form 4506-T to request the IRS send them a "wage and income transcript." This transcript shows all the tax forms received by the IRS. However, this printed copy could take several weeks to receive in the mail. The other options are much quicker and therefore recommended.

Corporate-Owned Life Insurance Included in Taxable Estate

In Thomas A. Connelly et al. v. United States; No. 21-3683 (8th Cir. 2023), a C corporation owned by two brothers purchased life insurance to fund a stock-purchase agreement. When one brother passed away, the life insurance proceeds were included in the valuation of the corporation.

Michael and Thomas Connelly owned Crown C Corporation (Crown). The ownership shares of the St. Louis building-materials company were 77.18% for Michael and 22.82% for Thomas. They created a stock-purchase agreement and Crown acquired $3.5 million in life insurance on each brother. They also signed a stock-purchase agreement. The agreement required them to create a Certificate of Agreed Value each year. However, there were never any valuations or appraisals completed.

Michael passed away in 2013 and Crown received $3.5 million of insurance proceeds. Surviving brother Thomas and Michael's son agreed that the value of Michael's stock would be $3 million. There was no appraisal, but this valuation established the company value at $3.89 million.

In 2014, the estate filed IRS Form 706 Estate Tax Return and reported that the value of Michael's shares was $3 million. They treated the life insurance as an asset and the requirement to purchase Michael's shares as a liability. Therefore, the insurance value was offset. However, the IRS included the value of the life insurance proceeds and determined that the augmented value of the company was approximately $6.8 million. It assessed a notice of deficiency for $1 million of additional tax. The estate paid the tax and sued for a refund.

The estate claimed the redemption transaction was sufficient to create the Crown fair market value and therefore an appraisal was not required. While the insurance proceeds were an asset, they were immediately offset by the liability to pay the estate of Michael. The District Court determined that the life insurance proceeds should be included in the Crown valuation.

An estate includes the fair market value of all shares of stock. If there is a stock-purchase agreement with specific parameters, it may control valuation. Section 2703(b) provides that the stock-purchase agreement must be a bona fide business arrangement, not a device to transfer property for less than full value and have terms that are comparable to arms-length transactions.

The problem with the Crown stock-purchase agreement is that it did not have a specific valuation method. A stock-purchase agreement must have a fixed or determinable price to be effective for estate tax purposes. Because the Crown agreement did not prescribe a fixed price or specific formula, it failed the determinable price requirement.

The estate argued that the payment of $3 million was sufficient to determine the value. However, the $3 million did not result from the stock-purchase agreement, but from a family "amicable agreement" by Thomas and son Michael Connelly, Jr. Therefore, the stock-purchase agreement does not govern valuation.

The basic issue is the fair market value of the stock. The 8th Circuit stated, "The fair market value depends on the company's net worth, prospective earning power and dividend-paying capacity, and other relevant factors like 'the goodwill of the business; the economic outlook in the particular industry; the company's position in the industry and its management; [and] the degree of control of the business represented by the block of stock to be valued.'" Reg. 20.2031-2(f)(2).

If life insurance is paid to a corporation, it may be included in the valuation. While Section 2042 generally includes life insurance proceeds in an estate if there are "incidents of ownership," there is an exception if the corporation is the sole owner and beneficiary of the policy. However, even in that case, the value of the proceeds may be included under Reg. 20.2031-2(f)(2).

The estate argued that the obligation to redeem the shares was a liability. The 8th Circuit noted this is a reduction in surplus and not a liability in the ordinary business sense. If a buyer were to purchase Crown after the receipt of the insurance proceeds, the buyer would pay the augmented amount. In addition, ignoring the increased value does not reflect economic reality. The shares of surviving brother Thomas increased from $7,720 per share before the death of Michael to $33,800 after receipt of the insurance proceeds. Thomas's stock quadrupled in value. Because there is an actual increase in the value of the corporation and the surviving shareholder's stock, the corporate-owned insurance was includable in the estate valuation.

Risks for IRS With Artificial Intelligence (AI)

During an American Bar Association Section of Taxation meeting on May 4, there was discussion of the use of AI in the tax community and by the IRS. Nina E. Olson, a spokesperson for the Center for Taxpayer Rights, noted, "I really like the idea of AI and its capacity to improve… tax administration and government and activities. But I am a deeply skeptical human being about the ability of other human beings and myself to manage technology and really understand its impact."

The IRS has indicated that a substantial amount of Inflation Reduction Act funding will be used for "data and analytics to drive operations and decision making. Improved data analytics will better position us to optimize operations for taxpayers and employees alike."

The IRS has signaled a significant commitment in the IRS budget to AI development. IRS Commissioner Daniel Werfel sent an email to staff and stated the new commitment "will allow the IRS to continue on a positive trajectory and build on our recent successes to improve taxpayer service, rebalance our enforcement work to increase our capacity to review complex returns from wealthy filers and large corporations, and update our technology needed to modernize all aspects of our operations."

The IRS acknowledges it has a vast store of information. However, the Government Accountability Office (GAO) indicated the IRS currently lacks "systems, skills and ability to really leverage those data with modern information technology systems."

A former chief of the IRS Criminal Investigation division stated the IRS was "woefully underutilizing data." He indicated that they had created an AI program to help detect payroll tax fraud and there were a number of cases discovered through better analytics.

However, the GAO report continues, "AI systems pose unique challenges to accountability, especially as they relate to civil liberties, ethics, and social disparities."

Nina Olson commented on a recent controversy in the Netherlands. The entire Dutch government resigned in 2021 after a scandal over an AI tool. The AI tool selected applicants with foreign origin and was designed to find fraud in childcare subsidies. Unfortunately, the algorithm wrongfully accused thousands of families of fraud and led to the resignation of many government officials.

AI is a powerful tool, but it is important that it be used in an appropriate manner. One survey by Stanford University indicated a certain racial minority was approximately four times more likely to be audited. IRS Commissioner Werfel stated he is reviewing the research findings and promised "appropriate corrective actions" by the IRS. The IRS continues to explore the use of AI, but also is attempting to create appropriate guardrails.

A GAO report stated, "AI is evolving at a pace at which we cannot afford to be reactive to its complexities, risks and societal consequences. [It] is necessary to lay down a framework for independent verification of AI systems, even as the technology continues to advance."

Editor's Note: With its massive data on American taxpayers, the IRS will continue to develop and incorporate AI technology. It will need both technical talent and, in the opinion of Nina Olson, data ethicists and privacy experts in this process.

Applicable Federal Rate of 4.2% for June — Rev. Rul. 2023-10; 2023-23 IRB 1 (15 May 2023)

The IRS has announced the Applicable Federal Rate (AFR) for June of 2023. The AFR under Sec. 7520 for the month of June is 4.2%. The rates for May of 4.4% or April of 5.0% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2023, pooled income funds in existence less than three tax years must use a 2.2% deemed rate of return.