Section 1: 2011 Federal Estate and Gift Planning - Tax Act Provisions and Planning
Section 2: 2011 Federal Estate and Gift Planning - Selected Planning Vehicles for 2011
Section 3: 2011 Federal Estate and Gift Planning - State Estate Tax Update 

Section 2. Review of Selected Planning Vehicles for 2011 Implementation 

1. Qualified Personal Residence Trust (QPRT) 

A QPRT is an irrevocable trust that has only one asset: an interest in a personal residence of the trust’s donor.  When an individual conveys his residence to a QPRT, he makes a gift to his descendants, but reserves the right to live in the residence for a certain period of time.  When that period of time ends, ownership of the residence passes to the remainder beneficiaries of the trust.  If the donor decides to remain in the residence after the trust terminates, he must pay rent to the beneficiaries, at a fair market value.  Since the beneficiaries have to wait a number of years to receive the gift of the residence, the amount of the actual gift (the FMV of the residence when placed in the trust) is discounted for the “retained interest” or the value of the donor’s right to live in the residence during the trust’s term.  In addition, a “retained reversion” discount can also be taken on the gift value.  This discount is allowed since the donor retains the right to get the property back if he or she should die within the trust’s term.  Because of these discounts, the actual gift tax is only on a fractional part of the value of the residence. However, if the donor survives the trust’s term, the entire asset is out of the donor’s estate.

A QPRT is a tax-favored way for a donor to use his or her gift tax exemption.  Although the IRS can quibble over details of any gift, the QPRT is a "safe harbor" technique, laid out by the IRS in Treasury regulations, so there is no risk of IRS challenge to a basic QPRT plan design. Although the QPRT is most favorable in a high-interest rate climate, it is still a tax bargain  when interest rates are low.  The success of a QPRT does not depend on achieving a particular investment return; it can be successful even if the asset stays flat (or declines somewhat) in value.

Why are QPRTs Prominent in 2011 ? 

Is this a good time to establish a QPRT, or unwind a QPRT ? In the past, QPRTs have generally not been considered an effective estate planning technique in a low interest rate environment. The IRC Sec. 7520 interest rate (3% for April 2011) is used to value the donor’s  right to use and occupy the residence during the current use period. Therefore, the lower the interest rate, the lower the parent’s retained interest and the larger the value of the remainder interest. In other words, as interest rates decline, the value of the gift increases; however with an increased 2011 and 2012 gift tax exemption to $5 million, a gift value (the retained interest amount) can be increased substantially (up to $5 million) before a gift tax would occur  Further, the broad decline in the U.S. real estate market presents a unique situation: not only does a low interest rate environment exist but we also have depressed real estate values. Therefore, implementing a QPRT now, when real estate values and interest rates are low, will allow the appreciation of the real estate to escape gift and estate taxation.

Observation: Accordingly, considering low residential real estate values in otherwise desirable areas of the U.S., now could be an excellent time to consider this estate planning technique. Presently, it is also prudent to review QPRT structures established in prior years, and as discussed in this section, to determine if QPRT restructuring is appropriate. 

Before reviewing Institute panelists QPRT commentary, the review of a March 2011 Tax Court decision is appropriate. In Estate of Sylvia Riese et al. v. Commissioner (T.C. Memo. 2011-60; No. 5388-08 (14 Mar 2011)), the Tax Court determined that a QPRT did exclude a valuable residence from an estate. The decedent survived six months after the termination of a three-year QPRT. Even though she failed to pay rent, the court determined that her intent and actions discussing payment of rent had created an obligation under the law of New York. In this case, the decedent inherited a residence in 1990 when her husband passed away.

In 2000 the decedent was advised to create a QPRT. In April 2000, the decedent transferred her residence into a three-year QPRT. When the QPRT terminated in April 2003, there was discussion of the amount of rent that should be paid. The decedent’s advisors then indicated that the rent paid (by the decedent) should be at fair market value and could be determined by the rents charged for similar residences in the area. The decedent was also advised that rent be paid by December 31, 2003.

The decedent unexpectedly had a stroke and quickly passed away in October 2003; as a result, the rent payments were not determined and paid prior to her demise. When the IRS Form 706 Estate Tax Return was filed, the estate determined the rent payable for the six- month period following termination of the QPRT to be $46,298. The form 706 excluded the residence from the taxable estate and claimed a debt obligation of the estate in the amount of $46,298. The IRS rejected the estate claim and determined a deficiency based on inclusion of the $6,138,000 residence in the estate.

The court noted that Reg. 20.2036-1(c)(1)(i) states that there is inclusion of a retained interest if "there was an understanding, express or implied, that the interest or right would later be conferred." In a number of cases, the IRS has successfully contended that attempted agreements to transfer a family residence through a life estate or QPRT were not effective because the decedent lived in the home until death without formally making payments for rent or otherwise treating the home as the property of heirs.

After reviewing the applicable law, the court noted that the factual basis existed for upholding the agreement to pay rent. The key factors include the following: 

1. Rent Discussions – On several occasions the decedent, daughters and counsel discussed rent.
    
2. Decedent's Agreement – The decedent indicated that she was willing to pay rent at the appropriate rate.
    
3. Discussion with Counsel – The decedent’s advisors discussed and communicated to the decedent the appropriate method for determining a fair rent, the rent amount, and when the rent should be paid.
    

The court noted that the advisors’ plan to determine the appropriate amount and advice to the decedent to make a rent payment by December 31 of that year was "not the most prudent course of action." However, in the view of the court, there "was an agreement among the parties for decedent to pay fair market rent" and this good-faith intent created an obligation. The factual circumstances are different from cases in which there was no documentation and no expressed intention to pay rent.

Observation: The QPRT was valid and there was sufficient expression of intent to pay rent. The rent obligation existed and the estate is permitted to exclude the home from the taxable estate and to consider the rent owed in the amount of $46,298 as a valid Sec. 2053 debt. Further, the court cited the importance of a lease agreement that takes effect upon termination of the QPRT. There shouild always be in place an agreement that immediately requires payment of a fair market value rent from the donor (a parent) to the remainder beneficiaries (children). 

What 2011 Conditions Could Cause a QPRT to be Unwound or Restructured ? 

While QPRTs are a safe and effective way to remove assets from an estate, the recent economic downturn and erosion of the housing market (compared to conditions in prior years when a QPRT was established), along with other factors, have made the unwinding of QPRTs a matters that professionals should aware of. Following are examples of situations where clients may need to consider QPRTs be unwound or restructured.

Situation 1:  Due to a decline in the value of the donor's assets and/or increase in the estate tax exemption, the donor no longer is concerned about reducing federal estate taxes.  In fact, the potential estate tax savings is less than the potential loss of the "stepped-up basis" the children would receive for income tax purposes if they inherited the residence rather than receiving it as a gift.  In this situation the QPRT no longer makes senseas a tax-saving proposition. 

Situation 2:  Regardless of the tax effects,based onthe donor’s financial resources he or she  can no longer afford to give up the real estate in the QPRT and/or pay rent to live in the residence. The donor needs to sell the house, keep the proceeds, and downsize or live in the house rent-free. 

Situation 3: Even though the donor has adequate financial resources, thedonor is no longer comfortable with the idea of giving away his home, and/or paying rent to his children in order to continue to live in the residence.  

Situation 4:  Thedonor has become estranged from the children (remainder beneficiaries), even though the donor can afford the gift and benefit from the estate tax savings. The donor no longer wants the children to get the residence, or does not want the children to receive it outright. 

Situation 5:  Due to adecline in the donor's health, there is concern that the donor may not survive the QPRT term and the expected tax savings may thereby be lost. 

What are 2011 Alternatives to Existing QPRT Structures?  

The Institute suggested the following alternatives to existing QPRTs, and where honoring QPRT terms is no longer acceptable scenario. 

A.  Convert a QPRT to a GRAT 

If the QPRT-owned residence is sold and the sales proceeds are not reinvested in a replacement residence for the donor within two years of sale, or if the residence ceases to be used or held for use as the donor's residence, the QPRT is required to pay an annuity to the donor for the rest of the QPRT term.  This is called "converting to a GRAT (Grantor Retained Annuity Trust)." (See Reg. § 25.2702-5 (c)(8)(i).)  The donor can trigger this GRAT conversion by selling the residence and not reinvesting the proceeds in a residence, or by moving out of the residence and causing it to be rented to someone else.

The payments the trust must pay to the donor are the payments the donor would have received if the trust had been a GRAT from inception, with the donor's retained GRAT interest equaling the same value as the donor's retained interest in the QPRT.  These GRAT payments are calculated using the section 7520 rate and IRS estate/gift tax mortality rates that were in effect at the time of the original gift to the QPRT,not at the time of the conversion to a GRAT.

The conversion normally has the effect of reducing the transfer tax savings of the QPRT, because the GRAT annuity payments to the donor accumulate in the donor's estate, and each GRAT payment reduces the value of the GRAT remainder ultimately passing to the donee. However, this result can be acceptable if the donor needs the money (Situation 2 above), or no longer cares about estate tax savings (Situation 1 above), and/or needs to take an action that does not require the children's consent (because they are not cooperating with the donor’s objectives). 

If the donor has unanticipated financial needs (Situation 2 above), the donor may want to accelerate the GRAT (annuity) payments.  If the trust permits amendments, the GRAT could be amended to permit such acceleration.  Even without a formal amendment, possibly the GRAT trustee could allow the donor to receive (the GRAT would pay) a lump sum equal to the present value of the future annuity payments. If the donor dies during  the GRAT term, such a prepayment harms no one, assuming the entire trust assets revert to the donor's estate in either circumstance.  If the donor survives the GRAT term, the remainder beneficiaries have also not lost anything, assuming the lump sum paid to the donor in lieu of his future GRAT annuity payments was correctly valued. 

B.  Amend or revoke the trust 

Since a QPRT is irrevocable, the donor cannot simply revoke the gift, unless (possibly) the QPRT was entered into under duress or undue influence, or while the donor was mentally incompetent or laboring under a misapprehension regarding the facts or legal effects.  See applicable state law for grounds for undoing (or amending) a trust or gift. 

C.  Commute the beneficiaries' interests 

Since commutation would be an obvious remedy in case of the donor's declining health (Situation 5 above), the regulation requires a QPRT to prohibit commutation. The concern however with commutation is the income the donor would realize as a result (see PLR 2007-33014 (not a QPRT ruling); in this instance the IRS ruled that, upon commutation of the interest of the donor and life beneficiary of a charitable remainder trust, the donor- beneficiary realized long-term capital gain equal to the entire commutation proceeds; the donors were not allowed to offset any basis against the recognized gain.

D.  Donor buys the remainder interest from the children  

The value of the children's remainder interest at the time of the transaction is determined using the IRS's gift tax valuation methods; therefore in this alternative structure the donor would purchase the remainder interest from the children, thus causing the donor to become the sole immediate owner of the residence and terminating the trust.  As a result, the donor gets his house back, the children are fairly compensated, and there is no gift.  However, the children may have to pay income tax on the entire sale proceeds received.  This approach can work well for Situation 3 above (the donor has adequate financial resources however he wants his house back) or Situation 5 (the donor is in declining health).  This approach may not be helpful if the donor cannot afford the purchase price (Situation 2), although depressed real estate values and low mortgage interest rates may make the property’s future rental value more affordable  compared to the home’s  rental value when conveyed to the QPRT. 

E.  Donor sells his retained interests to the children   

The value of the donor's retained interests at the time of funding the QPRT are determined using the IRS's gift tax valuation methods. When the donor then sells these retained interests  to the children, it causes them to become the sole immediate owners of the residence, thus   terminating the trust.  This alternative can address Situation 2 (the donor needs funds) where i) the children are richer than the parent, and ii) the donor either moves out of the house or starts paying fair market value rent to continue to live there. The income tax consequences need to be analyzed, and this alternative is probably not a preferable choice in Situation 5 (the donor is in declining health) because it would be better for the donor to die with the residence (rather than cash) in his estate so as to obtain a stepped-up basis in the residence. 

F. Donor gives his retained interests to the children  

This alternative could make sense in Situation 5 (the donor's health is declining) where the following circumstances exist i) the donor's retained interests can be valued using the IRS actuarial tables (i.e., he is not "terminally ill”) and ii) the donor is expected to live for three or more years beyond the date of the gift (see section 2035(a)) but does not have a good chance of surviving to the end of the QPRT term. 

G. Children give their reminder interests back to the parent  

This alternative sacrifices the expected estate tax savings of the QPRT, however it costs "extra" in terms of transfer taxes because the children typically have to either pay gift tax, or use up some of their lifetime gift tax exemptions, to make the gift.

The children may be using this alternative because they want to obtain a stepped-up basis for the property when they inherit it from the parent.  However, the basis step-up under section 1014(a) does NOT apply to property that the decedent acquired, within a year prior to his death, from the heir of the property (or such heir's spouse); see Section 1014(e).  Thus, if the children give the residence back to the parent, and the parent then dies leaving the house to the children, the children will get a stepped-up basis only if the parent survived for at least a year following the gift-back. 

H. Donor stays on in the residence after the term, without paying rent  

In this scenario, the residence will be included in the donor’s estate under section 2036 as “a gift with retained possession.” Some families use this approach in Situation 1 because they want the estate tax inclusion in order to obtain a stepped-up basis for income tax purposes, however this basis step-up result is not guaranteed, as the following discussion shows. 

Generally, for income tax purposes, "the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent" is "the fair market value of the property at the date of the decedent's death." Section 1014(a)(1). This IRC section lists various types of property deemed to be acquired from a decedent, including "property acquired from the decedent by reason of death, the form of ownership at the decedent’s death, orother conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property isrequired to be included in determining the value of the decedent's gross estate under chapter 11 of subtitle B...."  Although section 2036 is not specifically mentioned in section 1014(b), it is generally recognized that property includible in a decedent's estate under section 2036(a) is considered property acquired from the decedent for purposes of the basis provisions of section 1014(a).  See Rev. Rul. 66-283 (1966-2 C.B. 297, and PLR 2002-40018). 

As noted previously forestate tax purposes, there is a presumption that a parent who continues to reside in a residence he has transferred to his children does so pursuant to an "understanding" that he would do so.  Therefore, forestate tax purposes the IRS enforces a legal presumption that the continued occupancy was "retained" by the parent-donor, thus causing estate inclusion (of the donor) of the property under IRC section 2036(a).  However, the children cannot simply assume that estate inclusionautomatically entitles them to a stepped-up basis under section 1014(a).  A tax rule  that theIRSis entitled to, and applies for,  estate tax purposes cannot be used by the taxpayer to establishincome tax treatment.  .  For income tax purposes, the taxpayer has the burden of proving that the property wasrequired to be included in the estate (See Hahn v. Comm'r, 110 T.C. 140 (1998), § 3(b)). Thus, even if the parents stay in residence for life (rent-free) after expiration of the QPRT term, the burden of proof would be on the children to establish that the parents "retained" possession of the residence.

I. PLR 2006-17002:  A great example of good QPRT results for the wrong reasons 

This is an extraordinary ruling, where everything was done right to fix a situation where everything had gone wrong.

A. Husband and wife each conveyed a one-half interest in their joint principal residence to mirror-image eight-year QPRTs; husband and wife were QPRT trustees.  Under both trusts, upon expiration of the terms the residence was to pass outright to the couple's four daughters.

B. If all daughters were deceased upon the expiration of the QPRT term, the remainder would pass to the estate of the last daughter to die.

C. Subsequent to establishing the QPRTs, the wife "developed severe health problems and became distressed regarding the loss of residence on the termination of the QPRTs."  So, eight months before the two trusts were to expire, the spouses as trustees wrongfully conveyed the residence (as owned by the QPRTs) to their own respective revocable trusts.  The daughters were not consulted, advised of, or aware of the transfer from the QPRTs to the revocable trusts.  The daughters were also apparently not aware of the original QPRT transfer.  The daughters became aware of both transfers only several years later, when the residence was being sold.  At that time on advice of legal counsel, the daughters demanded that the sale proceeds be paid to them. In the interim the father had died, and his estate and the mother agreed to settle the matter by paying the sale proceeds to the daughters.

The IRS ruled that there was no gift from parents to the daughters in the disposition of the settlement proceeds, because the daughters were legally entitled to the sale proceeds.  The IRS also ruled there was no gift from the daughters to the mother and father arising from the parents' wrongful re-taking of the property, because the daughters were not aware of the transfer to the revocable trusts and did not consent to it; therefore they did not "relinquish or otherwise transfer" their remainder interests.

When parents retain possession of the gifted property on a rent-free basis following the "gift" to a QPRT, the IRS normally imputes an implied agreement that the parents could remain in the property, thus causing inclusion of the property in the parent's estate under Section 2036.  That presumption did not apply in this PLR, , apparently because the daughters were not aware of the QPRTs’ existence and therefore, were not parties to any such "agreement."

The daughters accepted in full settlement of their claims the sale proceeds of the residence.  Apparently they were not compensated for the rent the parents never paid for the parents' post-QPRT-term occupancy. 
 

Observation: Thus, by doing absolutely the wrong thing (the parents misappropriating the residence to their revocable trusts from their QPRTs), the parents achieved an estate plan outcome denied to the rest of us – they enjoyed life-long (in the case of the father at least) rent-free occupancy of the residence, and still kept the property out of their estate!  

2. Installment Sale to Grantor Trusts 

Asset valuation freezing techniques are used in estate planning as a way to fix (or freeze) an asset value when determining the transferor’s estate tax base. One such freezing technique is an installment sale to a grantor trust; sometimes referred to as a “sale to defective grantor trust.”  This technique freezes the value of the assets transferred at the then-current fair market value of the note receivable that is created at the time of sale. Further, the grantor receives from the trust i) interest payments on the installment note that is expected to be at a percentage rate (and note principal) that is less than ii) the expected forecasted percentage rate of asset growth and yield in the value of the transferred assets.  There is no income tax consequence upon the sale since it is disregarded (for federal income tax purposes), and treated as a sale to oneself because the trust is owned by the grantor.  An additional benefit is that the installment sale allows the trust to pay the principal over time, and expectedly from the trust’s earnings. 

A.            Provisions that Trigger Grantor Trust Treatment for Federal Income Tax Purposes 

• The grantor has retained a right to enjoy, or to control the enjoyment of, the income or principal of the trust’s assets, or to revoke the trust, or if someone who is subordinately related to the transferor has a right to control the enjoyment of the income or principal of the trust’s assets, the exercise or non-exercise of the right will not affect such person’s interest in the trust;
 
• The grantor has retained certain administrative rights or powers with respect to the transferred assets; for example, the right to vote shares of stock transferred to the trust, the right to control the investment of the trust’s assets, the right to substitute assets in the trust for other assets of equal value, or the right to borrow from the trust; or the trust income can be used to satisfy the transferor’s support obligations or to pay premiums on life insurance on his or her life. The trust’s ability to purchase life insurance is also an attribute of a grantor trust. 

However, even though a person is treated as owning the trust assets for income tax purposes, he or she may not be treated as owning the assets for estate tax purposes.

Therefore, with a proper sale of assets to a defective grantor trust:

1. A transfer of assets to a trust may be a completed gift for transfer tax purposes (but not for income tax purposes).
2. An individual will be considered the owner of the assets for income tax purposes but not for estate tax purposes.

Where an installment sale to defective grantor trust is not properly structured, the sale to a grantor trust will not have the desired result of excluding the transferred assets from the transferor's gross estate while avoiding recognition of income as a result of the sale. 

There are several methods to use to ensure that the grantor would be treated as the trust owner for income tax purposes but not for transfer tax purposes.  The safest methods give someone other than the grantor a substitution power, or provide a nonadverse person the power to add beneficiaries. Revenue Ruling 2008-22, (2008-16, I.R.B. 796 (April 21, 2008)) provided the most recent clearest guidance on substitution powers that will be permitted. 

B.             A sale to a grantor trust will provide the following tax benefits  

• When the grantor of a grantor trust later sells appreciated assets to the same trust, he or she will not recognize any taxable income as a result of the sale, since for income tax purposes he or she is treated as selling the assets to himself or herself (See Rev. Rul. 85-13, S 1985-1 C.B. 184, which rejected the holding in Rothstein v. UnitedStates, 735 F.2d. 704 (2d. Cir. 1984) that a sale between a grantor and a trust treated as a grantor trust under I.R.C. section 675 was a taxable event).
• Where the seller takes back an installment note in exchange for the transferred assets, the trust can pay for the assets over a period of time (with an IRC Section 7872 interest rate, for example over a term certain amortization period or with a balloon payment note structure) rather than at the immediate time of the sale.
• From an estate planning perspective, unless the grantor has retained certain rights that would cause the trust assets to be included in his or her estate after death, the sale will remove the gross asset appreciation and the asset’s income retained by the trust (less note payments by the trust to the grantor) from his or her estate, thereby resulting in a gift tax-free transfer of the net appreciation or income (post trust distributions) to the trust beneficiaries.
• Furthermore, the grantor will further reduce his or her taxable estate by paying income tax on the earnings from the trust's investments, even though the earnings inure to the benefit of the trust beneficiaries and not the grantor. No gift results to the grantor with regard to these tax payments.
• Finally, the ability to allocate the grantor’s generation-skipping transfer (GST) exemption to the gift of the seed money to fund the trust (the trust should be capitalized with at least 10% of the value of the asset it is purchasing)  means that the trust will have a zero inclusion ratio as long as no additional gifts are made to the same trust (and to which additional GST exemption is not allocated).

Observation: We advise that sales to defective grantor trust note terms be compared to available commercial transaction terms, and that asset values be evidenced by an appraisal. We advise these attributes be considered so to avoid the IRS sustaining that the sale was a gift, or conducted devoid of arm’s length conditions. Note that IRC Sec. 7872 interest rates are generally considered safe harbor interest rates for sales (with notes) to defective grantor trusts. This approach also helps to document that the sale was conducted based on “fair and adequate consideration” (See Frazee v. Commissioner (98 T.C. 554 (1992), discussed in D. below). 

C.         A sale to grantor trust can provide certain non-tax benefits—examples 

• An individual owns a business and has multiple children, and wishes to transfer most, if not all, of the business to one of his children. An installment sale of business stock (or LP or LLC interests) to a grantor trust can be used to transfer the family business to one or more of his or her children. Equalizing assets transfers to children can be a subsequent estate plan project. 
• By using the installment sale technique, the individual receives a note (payable by the trust) that can then be left under his will to the other children (those children who will not be a beneficiary of the trust that purchased the business) if the individual dies before the note is paid. Or, the note proceeds can be invested in another asset that can be left to the other children. No gain is triggered inside the trust or to the grantor upon the death of the grantor, or when the note is satisfied by the trust.
• While the value of the business will be frozen (in the form of the note payable to the grantor) at the time of the sale for purposes of determining the individual's taxable estate, any note principal and interest received by the grantor and earnings appreciation thereon will increase the donor’s taxable estate, although perhaps at a reduced compared to the valuation increase attributable to the growth of the business.
• For equalizing estate asset distributions to all estate beneficiaries, it could be argued that if the children receiving the business (trust beneficiaries) are actively participating in the business, any increase in the value of the business after the sale is attributable to their efforts and any future equalizing distributions would be in addition to value they created.

 D.        Estate, gift and GST tax benefits 

• Gift Tax

  If the sale of the assets to the trust is considered made for “full and adequate consideration” the seller should not be treated as making a taxable gift. The IRS will treat the installment note received in exchange for the assets as full and adequate consideration if the face amount of the note is equal to the fair market value of the assets sold to the trust and the interest paid on the outstanding balance of the note is equal to the applicable federal rate (AFR) under I.R.C. section 1274. See Frazee v. Commissioner, 98 T.C. 554 (1992). 

• Estate Tax

  Unless the transferor has retained rights over the assets in the trust that would cause the assets to be included in his or her estate, the assets in the trust including the assets sold in exchange for an installment note should be excluded from the transferor's estate at his or her death, regardless of whether he or she dies before or after the note has been paid in full.  Many commentators advise that before the sale, the trust should already hold assets having a value equal to at least 10% of the amount of the asset purchase price (the installment note amount) so to prevent an argument that the grantor has retained an interest in the sold assets that would cause the assets to be included in the grantor's estate under I.R.C. section 2036(a)(1).

• Generation Skipping Transfer tax (GST Tax)

  Because the assets initially given to a trust to establish it as a grantor trust will not be included in the grantor's estate, the estate tax inclusion period (ETIP) rules will not prevent the grantor from immediately allocating his or her GST tax exemption ($5,000,000 for transfers in 2011) to the gift.  An ETIP is a period during which assets transferred to a trust will be included in the transferor's estate, and not because of the transferor's death within three years of the transfer (see I.R.C. section2642(f)(3).  A transferor's GST tax exemption may not be allocated to a transfer during an ETIP.

In conclusion, an installment sale to a grantor trust may be a very effective vehicle to transfer assets to younger family members at the current asset value, as opposed to a transfer at the assets’ presumably appreciated date-of-death value. Properly structured, this vehicle also does not cause any gift or income tax due to the transfer. The value of the principal and interest payments received on the note will remain in the grantor's transfer tax base. A  disadvantage of this vehicle is that the trust beneficiaries will end up with the same carryover basis that the grantor had in the assets sold to the trust. 

Observation: If a sale to a defective grantor trust vehicle is to be used, the formalities should be followed to the letter, including a properly drafted and executed trust agreement, independent asset valuations and arm’s length sale terms, the presence of an exectuted interest-bearing installment note, and any other documents required under state law to transfer ownership of the assets to the trust and to support the grantor's status as a bona fide creditor of the trust. 

3. Incentive gifting  

Trusts have been an integral part of estate planning for decades.  Trusts provide numerous advantages such as: 

• Control over distributions to beneficiaries and restrictions on the disposition of assets
• Deferral of receipt of assets or income
• Creditor protection
• Achieving tax goals such as charitable planning, marital planning, gift and GST planning

Trusts, however, can possess a variety of disadvantages:

• Complications and rigidity
• Possibly expensive to establish and administer
• Possibly depriving beneficiaries of the responsibility of ownership, and inferring to beneficiaries they are not properly suited to manage their own affairs
 

Incentive gifting both during the donor’s lifetime and at death is currently a way wealthy individuals are controlling the disposition of the wealth that was carefully accumulated over their lifetime.  For these individuals, their focus is on gifting with a purpose and to compel behaviors that will sustain family values. While properly benefitting future generations, families do not want to imperil beneficiaries with unfettered access to wealth devoid of appropriate responsibility

1. Incentive Gifts During Lifetime 

I.  Two principal issues that impact the design and implementation of an incentive gift are defining goals and properly coordinating and documenting defined goals in an overall asset transfer plan.  

a. Goals.  The starting point is to determine the results that donors desire for beneficiaries with regard to asset transfer objectives.  Examples are:  finishing college, encouraging philanthropy and/or religious activity, discouraging drug use, and other behaviors. 
 

b. Coordination and documentation.  Incentive gifts need to be coordinated with and documented within the family’s wealth transfer plan.

1. If a donee will soon have access to trust funds, the objective of the financial incentive may be reduced or eliminated.
2. It is important to make sure the gift is consistent with the rest of the family’s planning.
3. Setting forth the criteria to determine whether the incentive has been satisfied should be documented, however this may be difficult.

II.  Promise to Exercise a Power of Appointment.  A donor’s promise to exercise a power of appointment in favor of the donee in exchange for certain actions on the part of the donee generally is not an enforceable contract (See Northern Trust v.Porter, 368 III. 256 (I11. 1938); Linsner v. Chicago Title, 582 F.2d 1092 (7^th Cir. 1978)).

a. Donor Intent.  The Porter and Linsner cases adopt the position of Section 340 of the Restatement of Property, which provides that enforcing a contract to exercise a power of appointment nullifies the donor’s intent, that the discretion of the donee of the power to appoint the property be retained until the time set forth in the granted power of appointment.

b. Restitution.  Section 16.2 of the Restatement (Second) of Property states:  Donative Transfers provide that a donee of a power of appointment not presently exercisable cannot contract to make an appointment in the future that is enforceable by the promisee.  Though the promisee cannot obtain damages or the specific property if the promise is not preformed, the promisee may obtain restitution of value that the promisee gave for the promise, from the person who received the value.

III.  Conditional Gifts.  Generally the law regarding conditional gifts, though discussed in different terms, is consistent with contract law.

a. Donor Intent.  The determination of whether a gift is absolute or conditional focuses on the intent of the donor. Inter vivos gifts subject to a condition precedent generally are invalid, but conditions subsequent may cause a gift to fail.

1) Conditions.  Inter vivos gifts “usually must go into immediate and absolute effect with the donor relinquishing all control,” which is consistent with the tax law regarding gifts. A condition placed on a gift negates the promised performance by the donor.

IV.  Taxation of Promised Gifts.  A promised gift becomes taxable in the calendar year that the obligation becomes binding, which is not necessarily the same calendar year when the payment is made (See Rev. Rul. 69-347, (169-1 C.B. 227); Harris v. Comm’r, (178 F.2d 861 (2^nd Cir. 1949)), which was reversed on other grounds, (340 U.S. 106)).

a. Consideration.  Although the action of a donee might be consideration for state law purposes, it does not qualify as consideration in money or money’s worth for federal gift tax purposes.  See Rev. Rul. 79-384, (179-2 C.B. 344).

Example.  In Revenue Ruling 79-384, Donor A promised to give $10,000 to B if he graduated from college.  The IRS determined that the promise became binding upon B’s graduation date, thus the graduation date was the date of the gift.  B ended up having to go to court to enforce the promise, so the payment was not actually made until several years after the graduation date and the occurrence of the taxable gift.   

2. Incentive Gifts Upon Death 

Testators have also tried to control assets from the grave since the beginning of time.  The rationale behind permitting such control is very basic:  It is the testator’s assets and he (she) should be able to dispose of it in the way that he or she sees fit.  For the most part, the U.S. courts have agreed with this principle.  

1. Conditions Restraining Marriage.  Courts will hold conditions in total restraint of marriage to be against public policy; therefore, a testator cannot state that he or she leaves his estate to A provided A never marries (see, e.g., E. LeFevre, Annotation, Validity of Provisions of Will or Deed Prohibiting, Penalizing, or Requiring Marriage To One of A Particular Religious Faith, 50 A.L.R.2d 740,*2 (2010)). 

a. Partial Restraint.  If a testator only applies a partial restraint that limits, for example, a class of persons or the period of time in which marriage must occur, courts are more inclined to uphold the intent of the testator. 

b. Restriction Within Faith.  A survey of cases addressing partial marriage restraints indicates that restriction of a beneficiary’s marriage to persons of a designated faith generally is regarded as reasonable. 

c. The Feinberg Case.  In one of the more visible recent cases on this issue, Estate of Feinberg, (892 N.E.2d 549, 550 (I11. App. Ct. 2008)), the testator included a provision that required any descendants (excluding his already grown children) to marry within the Jewish faith in order to benefit under his trust.  The Appellate Court of Illinois held the provision was invalid because it interfered with an individual’s right to marry.  On appeal, the Illinois Supreme Court reversed the holding of the Appellate Court and affirmed the validity of the provision. 

     II.Conditions Involving Divorce.  Suppose a testator bequeaths property to A for life, remainder to B; but if A should divorce her husband, or A’s husband should predecease A, the property shall thereupon pass to A absolutely.  A few early courts did not see a problem with this condition, noting that divorce was not unlawful and argued that a lawful act cannot be against public policy.

a. Intent.  Today, courts tend to investigate the intent of the testator. 

• If a testator actually intended to induce divorce, the condition will be held void
• If the testator’s intention was economic, perhaps an effort to protect A from her husband’s extravagant spending, then the condition will be upheld (see, e.g., Jeffrey G. Sherman, Posthumous Meddling: An Instrumentalist Theory of Testamentary Restraints on Conjugal and Religious Choices, 99 U.111. L. Rev. 1273, 1308 (1999)).

b.  Remarriage. In Lewis v. Colorado National Bank (652 P.2d 1106, 1197 (Colo. Ct. App. 1982)), the decedent established a trust that directed the trustee to pay the income to his then wife for as long as she lived, or until she remarried. After sixteen years of receiving income, the widow wanted to remarry; the trustee informed the widow that upon her remarriage the trust income to her would stop. The court was forced to weigh two public policy issues--the policy that favored marriage and the policy that favored the intent of the testator of a trust. The court determined that the argument supporting the intent of the testator was the stronger

c.  Underlying Public Policy. Perhaps the distinction between marriage cases and second marriage cases results from the desire to encourage spouses to provide for one another following death.

d.  Surviving Spouses of a Second Marriage. Although many of the marriage restriction cases reflect parents’ attempts to control their children's lives from the grave, the second marriage cases generally reflect a desire not to support a surviving spouse's new spouse with assets that the testator ultimately wants his descendants or other beneficiaries to receive.

e.  Religious Restrictions.  Testators often place religious restraints on bequests that require the beneficiary to follow or reject a certain religion. For example, a testator might make a bequest to A; but if A should fail to raise her children in the Episcopalian faith, then there would be a gift to B. The courts almost always uphold conditions that contain a religious constraint. In fact, one study noted that from 1925 through the 1999 publication date of the study, no state appellate court invalidated a testamentary religious restraint (Jeffrey G. Sherman,Posthumous Meddling: An Instrumentalist Theory of Testamentary Restraints on Conjugal and Religious Choices, 99 U. 111. L. Rev. 1273, 1312(1999)). 
 

III.   Other Conditions on Gifts at Death  

a.    Encouraging Positive Life Choices.  Employing a combination of sensible and amusing conditions, a Connecticut testator made a bequest that required his son (and those taking after his son, including the husbands of his granddaughters) to abstain from the use of tobacco and all kinds of intoxicating liquors; additionally the son had to spell correctly the family name at all times (Holmes v. Conn. Trust & Safe Deposit Co103 A. 640 (Conn. 1918).

• The conditions that were placed on the testator's son and his heirs were valid. Those same conditions, when placed on the husbands of the granddaughters, were held invalid with respect to those husbands and against public policy. The court opined that conditioning a gift on the behavior of an heir's husband potentially penalized the wife for actions she could not control.

b. Virtous Behavior.  A Nebraska testator directed the executors of his estate to review his son's behavior ten years after testator's death. If his son was living a virtuous and commendable life without bad habits, immoral relationships, and evil associations, the executors were to give the lands and trust-funds to the son. Additionally, the executors had to obtain proof that the son no longer associated with Mrs. G., a notorious and disreputable woman (Hawke v. Euyart, 46 N.W. 422 (Neb. 1890)). 

1. The court held the condition that required the son to live a virtuous and commendable life was valid.
 
2. The condition that required the son to refrain from any association with Mrs. G., however, was void as against public policy because the son was married to Mrs. G. at the time of the publication of the will. It is interesting to note, however, that the court also stated it would have upheld the condition regarding the allegedly disreputable Mrs. G. if the son had been single at the publication of the will.

c.  Financial Responsibility.  In Rushmore v. Rushmore (12 N.Y.S. 776 (1891)), a beneficiary could not receive his legacy until he possessed such traits of character and business habits as to assure the executor that the beneficiary would use the money wisely. In a suit that asked for construction of the will, the court simply said there was nothing ambiguous or uncertain about the clause.

d. Productive Memberof Society. In Webster v. Morris (28 N.W. 353, 355 (Wis. 1886)), the testator left a gift of $10,000 conditioned on proof that by the age of thirty the beneficiary learned a useful trade, business, or profession, and was of good moral character. The beneficiary argued the clause was against public policy and the court disagreed. Expressly stating a testator can dispose of his property as he sees fit, the court also noted that contrary to the beneficiary's contention that the clause was against public policy, the clause actually promoted good moral character.

Whether the incentive of a financial gift can change a person’s lifestyle remains to be seen but the wealthy are hoping that by placing these restrictions on future gifts, they will be helping the process along. 

4. The Three Forces that Threaten Endowments 

Although there is no legal definition for “endowment,” we think of them as a gift to a nonprofit organization to be used for a specific purpose.  Endowments can be of different types:  true endowments, quasi-endowments, and other endowments, depending on the restrictions placed on the contribution by the donor.

The economic downturn, the Bernie Madoff matter and other unfortunate events have caused some negative publicity on some of this country’s largest endowment funds.  There are three major areas that currently threaten endowments.

A. Loss of Investment Value 

During the last decade, the quick run-up of the investment markets created large investment pools which then led to endowment funds accepting more risk and aggressive investing.  They began to invest in “alternative investments” such as hedge funds, private equity funds, and real estate.  The steep declines in the stock market that occurred in 2007-2009 hit these endowments hard.  The investment losses were broadly publicized, and the additional risk the managers of these endowments permitted was viewed as a contradiction to the goal of asset preservation.  The top 10 university endowment funds saw asset value decreases of 23% to 30% between 2008 and 2009.  Needless to say, the individuals whose money was contributed to these universities for specific long term benefits were outraged by the losses.   Many endowment funds have been forced to make budget cuts or eliminate the very programs they were established to fund. This has caused investment fund committees to take a very close look at where the money is, who is investing the money, and how monies are invested and monitored against investment policy statements objectives and appropriate investment benchmarks considering also investment fees paid.

B. Taxation of Endowments 

Some state and local governments now falling short of tax receipts have targeted the taxation of endowments as a possible solution.  Several states have been working on passing an “endowment tax” on the largest funds.  In addition, there has been discussion that funds holding real estate should be subject to property taxes.

C. Conflict of Interest, Mismanagement or Misuse of Funds 

There have been many stories in the press regarding congressional conflicts of interest and trustee conflicts of interest.   The focus put on these funds disclosed a variety of situations where public and private university board members were involved with the investment house that held the funds, or held employment positions that were in conflict.  There have also been situations where companies who have received huge government contracts then made large donations to the endowment fund supported by the government official who assisted in the transaction.

Observation: Many of our clients are individual donors who create or contribute to endowment funds.  The Institute outlined primary concerns of focus for individual donors, which follow below. 

• Accurately describing both the short-term and long-term goals and purpose of the fund in a manner flexible enough to maximize its charitable use.  For example, a donor may be involved in a program instituted in many communities that provides support for children most at risk before they enter school, and these donors may want to fund the program in perpetuity.  However, funding a specific program is almost always going to run into a wall when the charity no longer exists, or becomes ineffective.  The donor should articulate the goal in a manner that is broader than a specific program, and consider naming a successor charity.

• Understanding the mechanics of how the funds will be invested.  This includes knowing who will hold (custody) the funds, who will oversee the funds and related performance, how the funds will be accounted for, and similar questions. 
   
• Selecting the appropriate entity to hold (custody) the endowment.  Purpose and priorities impact the form of the gift.  If the donor is concerned about long-term flexibility and accountability, turning the endowment over to the charity it will benefit may not be the right choice.  An independent custodian to hold endowment assets may be more appropriate.

• Building in investment accountability, and a mechanism to enforce accountability.  While relationships between donors and donees are generally positive when endowments are first established, the relationship could become more tenuous over time as staff contacts leave the organization and other family members assume the role of the original donor.  Identifying ways to require accountability or create a long-term reporting nexus are important.
   
• Creating a non-judicial remedy for reform when purposes are no longer appropriate.  Perpetuity is a long time.  It is virtually impossible to outguess social changes, economic changes, or even entity changes that impact the value of specified endowment purposes.
   
• Creating a provision allowing transfer to another entity form if the current entity form becomes ineffectual or too costly.  This option is more specific than the one suggested above, but may allow an escape from tax provisions, distribution requirements, or other penalties imposed.  It still must involve discretion placed in the hands of individuals or entities that can make the decisions with relevant facts.

Observation: Clients are also being asked to serve as trustees for endowment funds.  While this can be a rewarding position to hold, they should be aware of some of the potential issues trustees need to be aware of, as follows. 

• Oversight of the endowment and investment management.  The investigations stemming from the financial crises of the last few years have made it clear that many nonprofits had taken on considerable risk in the alternative investment markets that have led to cuts in staff, programs, aide, and charitable impact.  There may yet be additional lawsuits filed by state Attorneys General alleging endowment fund oversight mismanagement.  Many large funds may easily be able to make the case that investments were appropriate for large pools of funds, especially where there is good documentation about how and why the choices were made (in keeping with state laws).
   
• Conflicts of interest.  The potential for liability for board members/trustees has more potential for personal liability where board members had personal interests in firms offering, and being paid for, alternative investment products and or advice.  Again, document disclosure and abstention from voting on investment matters may minimize problems due to real or perceived conflicts; however these relationships appear to be conflicted at face value in any event. 

• Oversight of the use of the funds.  Board members have a duty to establish policies and ensure oversight of funds committed to charitable use.  Ultimately, these policies protect the institution at the establishment of the gift and ensure accountability over the life of the gift.  Consider the complaint filed by the Attorney General of California against the board of the Monterey County AIDS Project, alleging joint and several liability for intentional acts of misuse by others because of the failure to exercise oversight.

While no one can foresee the future, when speaking to clients about endowment gifts it is important to think about the best ways to make the gift successful.  Clarifying the goals of the gift, anticipating change and assuring proper oversight of the fund can help to achieve this. 

Section 1: 2011 Federal Estate and Gift Planning - Tax Act Provisions and Planning
Section 2: 2011 Federal Estate and Gift Planning - Selected Planning Vehicles for 2011
Section 3: 2011 Federal Estate and Gift Planning - State Estate Tax Update 

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This article cites many topics discussed at the 2011 Heckerling Institute, and 2011 and 2012 estate and trust and wealth planning opportunities. If you wish to discuss these topics or other tax planning issues, please contact the article’s authors Marie Arrigo, Partner and Barbara Taibi, Director.

Additionally, you may contact the additional members of EisnerAmper LLP’s Estate and Trust and Wealth Planning Group.

Jack Meola, Partner
Robert Harrison, Partner
Brent Lipschultz, Principal
Cristina Wolff, Director
Peter Michaelson, Partner
Richard Lichtig, Partner
Kurt Peterson, Director
Milton Kahn, Partner
Howard Klein, Partner
Timothy Speiss, Partner
Joel Steinberg, Partner
Kenneth Weissenberg, Partner
David Fields, Partner
Michael Weiss, Partner 

This article was edited by Timothy Speiss, MST CPA PFS RIA, Chair of EisnerAmper LLP’s Personal Wealth Advisors Practice

Any tax advice in this communication is not intended or written by EisnerAmper LLP to be used, and cannot be used, by any person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer, or (ii) promoting, marketing, or recommending to another party any matters addressed herein. With this publication EisnerAmper LLP is not rendering any specific advice to the reader.

This Outline should not be reproduced in any form without the express permission of the University of Miami, School of Law Heckerling Institute on Estate Planning or EisnerAmper LLP.