On February 17, the House and Senate both passed the Middle Class Tax Relief and Job Creation Act of 2012 (H.R. 3630). The 2% payroll tax cut was extended for the full year and compromises were made by both parties.

The Republican negotiators on the committee had been seeking offsetting budget cuts for the $100 billion cost. Democratic members had sought to increase income taxes on upper-income taxpayers. Both groups dropped their negotiating positions in the final compromise.

The bill includes three major provisions that affect payroll taxes, unemployment insurance and Medicare.

1. Payroll Tax Cuts – There is a 2% reduction from 6.2% to 4.2% in the payroll tax for employees. For most taxpayers, this is a savings of $1,000 for 2012. While the Social Security fund will lose $100 billion in revenue, this amount will be transferred through increasing the debt on the general fund.
2. Unemployment Insurance – For most states, the unemployment insurance may be extended to a maximum of 63 weeks. However, states with unemployment rates over 9% may be able to extend unemployment benefits for up to 73 weeks.
3. Medicare – The increased reimbursement rate for physicians known as the "Doc Fix" is enacted. For the past decade, physician reimbursement rates have been increased to reflect inflation.

The payroll tax compromise involves additional funding to pay for the unemployment benefit extension and the "Doc Fix." There will be broadband spectrum sales to media companies, increased pension contributions by new federal employees and reductions in payments to some Medicare hospitals and certain specialists' fees. The Medicare hospital and specialists' fees changes are designed so they will not affect patient care.

The net result is a compromise between both Republican and Democratic negotiators. Both parties appear pleased that the issue has been resolved for 2012. President Obama is expected to sign the bill promptly. He has strongly supported the payroll tax reduction for this year.

Editor's Note: Members of Congress expect this to be the last major tax bill until the November election. Democratic negotiators proposed including the "tax extenders" in the bill but they were not in the final version. As a result, it is still likely that tax extenders such as the Charitable IRA Rollover will be passed but the expected bill will not clear Congress until the end of November. While tax extenders have been passed with dates retroactive to January 1, donors who hope to use the Charitable IRA Rollover for 2012 may delay taking required minimum distributions (RMDs) until the end of November.

Marital Portability Election Extension

In Notice 2012-21; 2012-10 IRB 1 (16 Feb 2012), the IRS created a special category with a six month additional period to file IRS Form 706 and elect marital portability.

In the tax bill signed December 17, 2010, Sec. 2010(c)(5)(A) created a new option called marital portability. If an executor files IRS Form 706 for a person who passes away during 2011 or 2012, the deceased spouse's unused exclusion amount (DSUEA) may be transferred to a surviving spouse. The transfer may permit a surviving spouse to have an applicable exclusion that would be double the basic amount, or over $10 million (plus indexed increases).

For some 2011 estates, IRS Form 706 may not have been filed because the estate was under $5 million and the IRS had not yet given guidance on how to qualify for marital portability. In Notice 2011-82 published on October 17, 2011, Treasury explained the applicable requirements for filing IRS Form 706 and qualifying a surviving spouse's estate to claim the DSUEA.

Executors for many 2011 decedents with estates under $5 million did not file IRS Form 706 within the required nine month period and did not file Form 4768, "Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-skipping Transfer) Taxes." In order to give fair opportunity for all executors to make the marital portability election, Notice 2012-21 grants a period of up to 15 months to file Form 4768. In essence, there is an automatic six month election that will be permitted for 2011 decedents.

Editor's Note: The Treasury position shows welcome flexibility. Decedents with estates under $5 million who passed away in January or February of 2011 may still file Form 4768. There still is a requirement to file Form 706 within 15 months of the date of death. The April deadline for the executors of January decedents will approach rapidly, but this still permits the preservation of DSUEA. Most commentators expect that marital portability will be extended after 2012.

Estate May Deduct Actual State Tax Payment

In Marshall Naify Revocable Trust v. United States; No. 10-17358 (14 Feb 2012), the Ninth Circuit considered a request for a refund of a deficiency. The refund request was based on a claim that the estate should be permitted to deduct the estimated rather than the actual state income tax payment. The Ninth Circuit denied the trust request.

Decedent Naify was a California resident who held a substantial position in Telecommunications, Inc. (TCI) notes. In 1999, TCI merged into AT&T and the notes were converted into AT&T stock, thereby creating a substantial capital gain.

To avoid potential payment of California tax on this $660 million capital gain, Naify created a Delaware corporation, Mimosa, Inc., and transferred his TCI notes to this new entity. Following his death in April of 2000, Naify's executor filed his 1999 income tax return and did not report the gain on the California return. At the time of the filing of IRS Form 706 in July of 2001, the estate noted that there was a potential $62 million California claim for income taxes on the capital gain and claimed that amount as a deduction. The IRS audited the estate tax return and denied the deduction. Subsequently, the California FTB audited the income tax return and issued a deficiency for $58 million plus interest and penalties. In 2004, the estate settled with the California FTB. It paid tax of $19 million plus $7 million in interest, for a total of $26 million.

The IRS permitted the estate to deduct the $26 million and assessed a deficiency of $11 million, which was paid by the Naify trust.

In March of 2006, the trust filed a claim for refund with the IRS for the $11 million deficiency. It was denied. In April of 2009, the trust filed an action against Treasury in District Court and sought refund of the $11 million deficiency amount. The District Court ruled against the estate and it appealed.

The Court of Appeals noted that a deduction for a claim under Reg. 20.2053-1(b)(3) is permitted only if it is "ascertainable with reasonable certainty." The trust claimed that there was a 67% probability that the California FTB would be successful in its claim. Therefore, at the District Court level, it reduced the $62 million deduction to $47 million.

The Court of Appeals stated that a claim supported by an estimate based on a probability is "not a factual allegation. Rather it is a legal conclusion." Because the amount was inherently uncertain, it was not deductible.

The FTB case was dependent upon several contingencies. The FTB needed to assert a 1999 claim, determine that Mimoso was not a valid Delaware corporation and issue a deficiency notice.

The District Court noted that the estate expert claimed a 67% probability that California would succeed. However, as the Court stated, an estimate of probability does not make the claim reasonably certain.

Finally, Reg. 20.2053-1(b)(3) states that a post-death settlement is considered dispositive of claims. In this case, the settlement with the California FTB was a fixed amount and therefore dispositive of the claim. The request for refund of the deficiency was denied.

Applicable Federal Rate of 1.4% for February – Rev. Rul. 2012-7; 2012-6 IRB 1 (19 Jan. 2012)

The IRS has announced the Applicable Federal Rate (AFR) for February of 2012. The AFR under Sec. 7520 for the month of February will be 1.4%. The rates for January of 1.4% or December of 1.6% 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 2012, pooled income funds in existence less than three tax years must use a 1.8% deemed rate of return. Federal rates are available by clicking here.