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It might seem odd, but it is possible to get the IRS to give you a straight-forward and binding answer to ambiguous tax positions in advance. How does this happen, you ask? The answer is through an IRS private letter ruling.

IRS private letter rulings provide many benefits, but they are not easy to obtain. There are costs, potential delays, and even then, you run the risk of not being granted a ruling. This dynamic might seem odd as the entire point of applying for a private letter ruling is to obtain certainty. If your position is weak from a tax law perspective, the government could refuse to rule on it. Alternatively, if the position you are seeking is obviously correct, the government might refuse to rule as well because they don’t like to issue “comfort rulings.” Essentially, the only way to get the government to rule is to make a request regarding a position that is in the middle.

If you believe the tax position in question lies somewhere in the middle, requesting a private letter ruling may make sense. If you are more likely one of the outliers, then requesting a tax opinion usually makes more sense. The problem is that tax opinion, unlike private letter rulings, doesn’t bind the IRS.

Deciding Which Path to Take

If the relative certainty of the tax position in question doesn’t provide enough guidance, how do you decide to go after a tax opinion versus a private letter ruling? To make the choice, it helps to understand more details.

First, tax opinions can cover a broader range of topics and can be written about pretty much anything; rulings cannot. In fact, the IRS has an explicit list of subjects that it will not produce private letter rulings on (they modify it occasionally, but there’s always a list). As a result, the first step is to assess the list as this might make the choice for you.

Second, don’t request a private letter ruling unless there is a good chance you think it will be granted. For one, rulings are not cheap with fees often costing upward of $25,000 to obtain a ruling. If you get a “No” ruling against your position, you can withdraw the request to take the ruling off the books, but you may or may not get the fee back. Moreover, when you withdraw a request for a ruling, the IRS sends a notice to your local IRS field office, potentially flagging your return for audit.

Third, opinions can be quick and obtained in as little as a few days or weeks. Rulings, on the other hand, often take months. Also consider that a request for a ruling must be specific and there is little room for modification after filing. Opinions have more flexibility.

Private Letter Ruling Process

Given the specificity and consequence of requesting a ruling, there are intermediate steps to help you test the water before you go all in. Nearly all ruling requests start by initiating a discussion with the IRS to get their general view on your proposed ruling. After this, the taxpayer usually submits a brief memo covering the facts and ruling they are looking to obtain. Next, there are more meetings either in person or by phone with IRS attorneys involved. At this point, if everything looks good, you can prepare and submit the actual ruling request. If you back out at this point, you avoid triggering any fees (IRS fees – not your lawyers or accountants) or audit notices.

Benefits of a Ruling Versus an Opinion

The reason taxpayers go through the time, expense and effort to obtain rulings instead of opinions is that they have several advantages. First, rulings are binding on the IRS. Second, you don’t need to consider penalty protection. Most of all, they provide certainty. Given the difficulty in obtaining a ruling, they generally make financial sense only when a taxpayer has a seriously substantial tax position in play, or at least will over time, and he wants to protect against future audits and legal challenges.

There are three big tax issues that can derail an otherwise well-executed estate plan. These include Family Limited Partnerships, Revocable Trust Swap Powers and Trust Situs. Below we explore the pitfalls with each issue.

Fixing FLPs

Family Limited Partnerships (FLP) are often created to hold investments or business assets in order to leverage a valuation discount, exert control and provide asset protection.

First, to understand the valuation discount, take the example in which an FLP owned a family business valued at $10 million. A straight 25 percent interest in this business would therefore be worth $2.5 million. However, due to valuation discounts for a non-controlling interest that would not be readily available for sale or able to control liquidation, the 25 percent might actually be valued at $1.7 million for estate tax purposes.

Second, FLPs also could be set up to allow the founder or parents to control operations even after a majority of their interest is given away.

Lastly, FLPs can protect assets. If an interest owner is sued, the claimant might not be able to exercise their claim, especially if they sued a minority interest holder. Instead, they could be limited to receiving a charging order. A charging order limits the claimant to only the distributions that interest holder would be entitled to and protects the other owners.

FLPs that ignore legal upkeep and technical legal formalities can jeopardize these the protection benefits by causing the FLP entity to be disregarded. Common errors include co-mingling personal and entity assets and ignoring the legal requirements to have current signed governing instruments.

On the valuation front, many FLPs were set up to provide valuation discounts at a time of significantly lower estate tax exemptions. Not only is this unnecessary, but the valuation discount can actually hinder the heirs by passing along a lower asset value when the basis is stepped up at death.

Swap Powers

Traditionally, irrevocable trusts are by definition trusts that cannot be altered (hence the name irrevocable). Uses include carving out assets from an estate to better protect the assets and provide tax savings.

Irrevocable trusts are often structured as “grantor” trusts for income tax benefit purposes. Grantor trusts allow the grantor to report the trust income on their individual 1040, effectively having the grantor pay the tax burden and bypass the trust. This strategy can reduce the grantor’s estate.

There are numerous ways to create grantor trust status. Including swap powers is the most common. Swap powers allow the swapping of personal assets for trust assets of equivalent value. The problem with swap powers is that little attention is paid to them and they aren’t exercised in the right circumstances, leading to adverse income tax consequences.

It’s best to review the value of trust assets annually or even more often if the grantor is in poor health so you know when to exercise the swap powers. It’s also a good idea to involve your estate planning attorney and CPA if you are going to exercise the swap powers. This will ensure the swap is handled according to the rules of the trust document and properly reported on your tax returns.

Trust Situs Selection

Trust situs is the state where your trust is based. It determines which state law administers and rules the trust. Frequently, the trust situs is simply set up in the same state where the trust creator is a resident.

While simple, using a home state as the trust situs is not always best. A person’s home state may not provide the best protections or state taxation. The way around this is to “rent” a different trust jurisdiction. Doing so can allow you to lower or altogether avoid state income taxes. You’ll have to factor in the costs to do so as there will be more legal fees and trustee fees since an institution will need to hold the trust to create the state nexus. Overall, you can often come out ahead.

Conclusion

The best thing you can do is to review your current or potential trust with your estate planning attorney and CPA. This way you can stay on top of both the formalities and mechanisms in place to maximize the protections and benefits of the trust.