2010 Federal Trust and Estate Planning Opportunities

Comments from the 44th Annual Philip E. Heckerling Institute on Estate Planning

The 44th Annual Heckerling Institute (Institute) on Estate Planning was held this year in Orlando, Florida. The Institute is one of the largest annual estate and trust planning conferences held in the United States as a forum to discuss current and emerging income and transfer tax planning developments as well as selected topics of interest to tax professionals and financial advisors.

This Outline summarizes 2010 Institute income and transfer tax highlights for consideration by our clients and professional relationships including trust officers and attorneys, family office directors, investment advisors, insurance professionals, and additional financial advisors. This Outline is presented in two sections. The first section summarizes recent tax developments, and the second section summarizes topics and recent developments that could present significant opportunities in the current economic climate, and in this year and beyond.

I. Recent developments 

Institute panelists discussed significant developments that should be considered in 2010, including the following.

1. Status of the Federal Estate and Gift Tax: Developments for Consideration in 2010  

The Economic Growth and Tax Relief Reconciliation Act of 2001 (“2001 Act”) introduced a phased-in reduction of the highest marginal Federal estate tax rate from 55% to 45%, and an increase in the estate tax exemption amount from $1 million to $3.5 million. The 2001 Act also provided for no estate or generation-skipping tax after December 31, 2009; the gift tax remains applicable in 2010. A “sunset” provision also provided that the Act would terminate as of December 31, 2010; therefore, if no legislation is enacted in 2010, the federal estate and generation-skipping taxes would be reinstated as of January 1, 2011 and will revert to the 2001 $1 million estate tax exemption and a 55% top marginal rate (as in effect prior to the 2001 Act).

Many Institute panelists expressed the view that Congress would have enacted legislation in 2009 to preclude the 2010 repeal, and the subsequent reinstatement of the estate tax regime as existing prior to the 2001 Act. As of the date of this Outline however, Congress has not passed any estate tax legislation that would be applicable in 2010 or beyond. Last year, however the U.S. House passed a permanent extension of the 2001 Act that would have been applicable for 2010. However the U.S. Senate took no action due to both indecision regarding what would be appropriate estate tax legislation and the focus on President Obama’s health care reform initiatives.

Congressional action to resolve the status of the estate tax in 2010 and future years remains uncertain. Congress could act in 2010 to reinstate retroactively an estate tax effective at January 1, 2010; however many commentators have expressed the view such action could be unconstitutional. Alternatively, Congress may not act at all this year, thereby allowing pre 2001 Act estate tax provisions to become effective in 2011. Another scenario could be Congress passing estate tax legislation that has a prospective effective date, with such action taking place after the 2010 mid-term Congressional elections. Panelists stated that future estate tax legislation could have the following features: 

  • The generation-skipping transfer tax exemption and rate remaining tied to the estate tax exemption and rate. The gift tax exemption and rates may be recoupled with the estate tax and GST exemptions and rates. 
  • No reenactment of the federal estate tax credit for state inheritance (estate) taxes paid. The 2001 Act incrementally reduced the credit during the years 2002-2004, and eliminated the credit completely for decedents dying after December 31, 2004; instead a federal estate tax deduction for the full amount of state inheritance taxes paid was permitted. 
  • Portability between spouses of the exemption amount enacted as a mechanism to provide estate tax relief to the low and middle ranges of taxable estates. 
  • A stepped-up basis to fair value for appreciated assets owned at death. 
  • An increase in the special use valuation provision for family-owned businesses, including farms and ranches. 
  • After any phase-in period of a reenacted estate tax, exemptions and tax brackets may be indexed for inflation.

Uncertainty regarding the federal estate tax has in turn resulted in uncertainty regarding states’ estate (inheritance) tax. Many states apply the federal estate tax regime as a basis for computation of an applicable state estate tax. Some states have tied the state estate tax solely to the federal estate tax, so that the elimination in 2010 of the federal estate tax has resulted in the elimination of those states’ estate tax. After the elimination in 2005 of the federal estate tax credit for state estate tax liabilities, about 50% of the states retained some form of a state estate tax. For example, certain states such as New York, and separately the District of Columbia, tied their state inheritance tax amount to the allowable federal tax credit amount as it existed prior to 2002; this resulted in an automatic retention of the state tax even when the federal estate tax regime changed, while eliminating the state estate tax in 2010. Other states, such as Connecticut, implemented independent state estate tax regimes that are not correlated to the federal estate tax credit for state estate taxes. The impact of the currently non-existent federal estate tax and the state budget shortfalls in the current economic climate has resulted in large budget deficits for many states. These two developments have provided a compelling argument for states to increase their estate taxes as a mechanism to close or reduce state budget deficits.

Still other states have enacted legislation (such as done by the state of Virginia) whereby the decedent resident is deemed to have died on December 31, 2009 for purposes of computing a 2010 state estate tax; while this state provision provides for certainty with regard to state estate tax planning, the legislation may not provide for planning opportunities that that families may desire.

Given the current uncertainty regarding the federal estate tax and considering state estate tax, panelists agreed that individuals should have their estate plans reviewed currently, and possibly amended, to make sure their documents, including any formula clauses contained in such documents, are appropriate in light of the current legislative uncertainty while mindful of testamentary planning objectives. Asset transfer opportunities under the current federal gift tax regime should be considered.

Additionally, certain other intervivos and testamentary agreements, such as prenuptial and settlement agreements which follow formula provisions, may contain provisions that are not appropriate under current estate tax law. All planning documents should be reviewed and amended where appropriate. Many opportunities exist in 2010 to effectuate lifetime gifts and generation skipping transfer (“GST”) tax planning objectives. Consider the following in 2010 and before any new federal estate tax legislation would be passed by Congress this year:

  • Property can be transferred to grandchildren devoid of GST exposure. 
    • Transfer property to a trust. If a GST is later reenacted, distributions to the grandchildren from the trust should not be subject to the GST then in effect. 
  • Minimize asset transfers (gifts) or distributions to beneficiaries in 2010 where the transfer of carryover basis is not desired. 
    • As an alternative to 2010 gifts or distributions resulting in carryover basis, make loans to intended transferees (or donees or beneficiaries). 
    • However, be aware that Internal Revenue Code (“IRC”) Section 1040 (transfers of certain real property) remains in effect, and this year applies to any distribution of appreciated property in satisfaction of a pecuniary bequest (Sec. 1040 formerly applied only to special use valuation property). As a consequence, a premortem gain shall not be recognized and an asset basis step-up to fair value not attained; this may be a desired result for beneficiaries. 
  • From an investment diversification and income tax planning perspective, estates with large concentrations of assets in single holdings may want to consider other ways to hedge risk without selling off the assets; the use of a collar may be such an alternative. 
  • Considering states that have imposed an independent estate or inheritance tax (and without regard to a federal estate computation), to help minimize state tax exposure it may be desirable to transfer property to a nonmarital “QTIP type” trust. With such a trust, partial elections could be made for federal and state purposes where an estate tax could be applicable. 
  • Since gift and estate tax conformity cannot be assumed, it could be beneficial to make gifts in excess of the current $1 million life-time exemption amount. Remember that, as the current gift tax rate is only 35%, the use of leveraged gift strategies, such as grantor retained annuity trusts (“GRATS”), sales to grantor trusts, and charitable lead trusts, remain beneficial planning vehicles. Defined-value gifts could also achieve intended results. Also, consider gifts of intervivos QTIP trusts with disclaimer provisions, as well as formula gifts via asset transfers to trusts. 
    • In a release subsequent to the Heckerling Institute, on March 16, 2010 (TSB-M-10(1)M) the New York State Department of Taxation and Finance announced the availability of a QTIP election when no federal estate tax return is required. In this instance a QTIP election will permit a marital deduction for a qualifying marital trust, and allow an estate in excess of $1 million to avoid New York Estate Tax. The qualifying trust for which the QTIP election is made must be included in the estate of the surviving spouse. This announcement was in partial response to the fact that there is presently no federal estate tax; however, New York will also allow a QTIP election in a situation where no federal estate tax return is required because the decedent’s estate is under $3,500,000 (or at the applicable federal estate tax exemption amount when the federal estate tax is reimposed). 
  • If the gap between the gift tax exemption and the GST exemption persists, implementation of lifetime GST tax planning techniques can result in additional gift taxes. 
  • Although future estate tax legislation may allow the transferability of a predeceased spouse’s exemption to the surviving spouse and result in simplified estate planning for some estates, establishing a credit shelter trust (using a decedent’s estate tax exemption) instead would offer the following benefits: 
    • Holding assets for the benefit of children from first or second marriages and blended families; 
    • Sheltering post-death asset appreciation growth and accumulated income from estate tax; 
    • Permitting use of a predeceased spouse’s GST exemption; and 
    • Permitting tax-free “gifts” to be made to children and other beneficiaries during the surviving spouse’s life, which is especially beneficial if the gift tax exemption remains lower than the estate tax exemption. This result occurs because trust distributions (taxfree) to trust beneficiaries are taxable only to the extent the distribution carries distributable net income.

2. Current Year Treasury-IRS Priority Guidance Plan  

The Treasury-Internal Revenue Services (IRS) Priority Guidance Plan for the 12 months beginning July 1, 2009 was released on November 24, 2009 and listed 17 projects in the trust, estate and gift tax arena. Most of 17 projects are carryovers from previous years’ plans, however one exception is a project for the Treasury and IRS to provide guidance on whether a grantor’s retention of a power to substitute trust assets in exchange for assets of equal value, held in a nonfiduciary capacity, will cause insurance policies held in the trust to be included in the grantor’s gross estate (see IRC section 2042). The panelists also highlighted two of the other 16 projects and guidance to be provided applicable to: 

  • Procedures for filing and perfecting protective claims for refunds for amounts deductible under IRC Section 2053. 
  • Restrictions on the liquidation of an interest in a corporation or partnership under IRC Section 2704.

3. Powers of Appointment: Technical Advice Memorandums (“TAM”) 200847015 and 200907025 and Private Letter Ruling (“PLR”) 200832015  

In TAM 200847015, the IRS concluded a decedent’s power over property held in trust was not a general power of appointment under IRC Sec. 2041. The decedent was both the beneficiary and trustee with discretionary powers of distribution. The decedent’s late husband’s will had provided that the residue of his estate be held in trust with the decedent entitled, during her lifetime, to receive “so much of the net income as the Trustee in its sole discretion reasonably exercised, taking into account other income and resources she may have, deems necessary and appropriate to provide for the health, support and maintenance of my wife, [Decedent], in the manner to which she is accustomed at the time of my death.” The trust further provided that if the trustee determined that the net income was insufficient to maintain and support the wife, the Trustee may, in "its sole discretion, use so much of the principal of said Trust as it deems necessary to make up such deficiency.” Upon the wife’s death, the net proceeds of the trust, if any, would be divided into two trusts: one for the husband’s nephew and nieces or their issue, and the other for the wife’s nephews or their issue. A spendthrift clause included for any trust created by the husband’s will provided that anytime the trustee believed it appropriate in order to fulfill the intent of the clause “payment to any beneficiary named herein may be discontinued, and in lieu thereof, the Trustee may expend for the account of such beneficiary and for his or her support, comfort, happiness and welfare, such amounts as would otherwise be paid over directly to such beneficiary.”

The issue in question was whether the decedent possessed at death a general power of appointment within the meaning of IRC Sec. 2041, over the property held in the trust since she was both discretionary beneficiary and trustee. The Service determined that the decedent's power as trustee “to distribute trust income to herself was limited to those amounts necessary to provide for Decedent's health, support and maintenance” and her power “to distribute trust corpus is limited to amounts necessary to ‘maintain and support’ the decedent in her accustomed station in life. Since the powers granted… are restricted in such a manner as to satisfy the criteria of IRC Sec.2041(b)(1)(A), neither power is a general power of appointment.”

The Service also ruled that the trustee’s broad distributive powers for the benefit of the beneficiary in the spendthrift clause in lieu of making payments to the beneficiary did not constitute a general power of appointment that she possessed at her death. The IRS said “We believe this broad distributive power becomes exercisable, only if the beneficiary triggers the spendthrift provision, for example, by attempting to assign the trust interest or if a third party attempts to garnish or execute against the trust interest, or the beneficiary otherwise becomes financially distressed in some manner. There is no indication that, at the time of Decedent's death, she met any criteria that would trigger the spendthrift provision and the ability to exercise the power. Thus, at the time of her death, Decedent's exercise of the… power was conditioned on the occurrence of events or contingencies that were not in existence on the date of Decedent's death. In accordance IRC Reg. Sec. 20.2041-3(b), a power, which by its terms is exercisable only upon the occurrence during the decedent's lifetime of an event which did not in fact take place is not a power in existence at Decedent's death. Accordingly, Decedent did not possess at death a general power of appointment within the meaning of IRC Sec. 2041 over property held in Trust.” The author acknowledges the December 2008 edition of “The Estate Planner” as published by Westlaw Thompson Reuters.

TAM 200907025 concluded that a decedent possessed a general testamentary power of appointment over an entire trust under IRC Section 2041, resulting in estate inclusion. The estate had argued against this result on the grounds that the decedent during his lifetime had only been entitled to income distributions at the discretion of the trustees, and had not been entitled to principal distributions. The estate also argued that the trust was to continue for a period of years after the decedent’s death. The IRS determined that the power of appointment language in the trust instrument permitted the decedent to determine at his death, without restriction, who would receive his entire interest in the trust. As a consequence, the TAM concluded the value of the entire trust property was includible in the decedent’s gross estate. TAM 200907025 emphasizes that language that otherwise creates a general power of appointment will not be disregarded because other interests of the powerholder in the trust are limited. The panelists commented that granting a beneficiary a testamentary general power of appointment can be effective estate planning; for example, avoiding imposition of GST, providing flexibility for the powerholder, having asset-protection benefits, or avoiding a violation of the rule against perpetuities.

However, there is estate tax exposure that must be considered when powers of appointment are held by a decedent.

Panelists also discussed the concept that a pre-1942 power of appointment causes estate tax inclusion in the powerholder’s estate only to the extent that the power is both general and exercised. This presents a planning opportunity for pre-1942 powers of appointment with a disclaimer aspect. If the disclaimer is not exercised, then there is no taxability in the estate, and assets can be effectively moved to the next generation.

4. Domestic Asset Protection Trusts: PLR 200944002  

In this PLR the grantor created an irrevocable trust governed by Alaska law, and directed that income and principal be distributed at the trustee’s discretion, to and among the grantor, his spouse, and descendants. Additional trust provisions stated that a) after the death of the grantor and his spouse, the trust continued for the grantor’s descendants; b) when there are no living descendants, the trust assets will be distributed to charities selected by the trustee; c) the trustees are not related or subordinate to the grantor and his spouse, and the grantor has no right to remove the trustees; and d) the grantor has a power to reacquire trust assets by substituting assets of equivalent value.

Alaska trust law provides that a person who in writing transfers property in trust, may provide that the interest of a beneficiary of the trust, including a beneficiary who is the grantor, may not be either voluntarily or involuntarily transferred, before payment or delivery of such interest to the beneficiary by the trustee. A trust instrument containing such a transfer restriction prevents a creditor, existing when the trust is created or a person who subsequently becomes a creditor, from satisfying a claim out of the beneficiary’s interest in the trust, unless certain exceptions apply.

The IRS concluded that the transfers to the trust were completed gifts (transfers) for gift tax purposes, noting that the grantor retained no powers to retain or have reverted to him beneficial title, or to name new beneficiaries or change the interests of the beneficiaries within the meaning of Treasury Regulations Section 25.2511-2.

The IRS further stated that with respect to the estate tax, the grantor’s retention of the power to acquire property held in the trust by substituting other property of equivalent value would not by itself cause the value of the trust corpus to be includible in the grantor’s gross estate upon the grantor’s death. The retained power (to reacquire trust property by substituting property of/with equivalent value) will not cause adverse estate tax consequences if the trustee has a fiduciary obligation under local law to ensure the grantor’s compliance with the terms of the power of substitution by satisfying itself that the properties acquired and substituted are, in fact, of equivalent value. The IRS stated the trust specifically charged the trustee with such a fiduciary obligation.

In addition the IRS noted that because the trustee was prohibited from paying any income or principal of the trust in discharge of any income tax liability of the grantor, the grantor had not retained a right for reimbursement of income taxes that would cause trust property to be included in the grantor’s gross estate under IRC Section 2036. Nevertheless, the IRS stopped short of definitively ruling that the trustee’s discretion to distribute trust income and principal would not cause inclusion of trust assets in the grantor’s gross estate under IRC Section 2036. The IRS also did not rule on whether the trust was a grantor trust.

5. Inclusion of the Value of Grantor Retained Annuity Trust (“GRAT”) Assets in the Decedent’s Estate  

Annuity payments that do not terminate at a decedent’s death trigger IRC Section 2039(a) inclusion of the discounted present value of any remaining annuity amounts that are payable to a beneficiary who is entitled to receive payments by reason of surviving the decedent. For IRC Section 2039 to apply, the annuity must have been payable to the decedent for life, for a period not ascertainable without reference to the decedent’s death, or for a period that did not in fact end before the decedent’s death. IRC Sec. 2036 provides that estate inclusion of the value of property will occur where a) the decedent has made a transfer (except in the instance of a bona fide sale) and b) retains for lifetime the possession or enjoyment of the property or the income therefrom, or c) retains the right (alone or with others) for lifetime to designate who shall possess the property or income therefrom. Unlike IRC Section 2036, however, nothing is includible under IRC Section 2039 if the annuity does not continue after the taxpayer’s death. Under IRC Section 2039(a), the discounted present value of annuity payments that survive the taxpayer’s death may exceed the amount that would be includible if some other inclusion provision were applicable; some previous TAMs and rulings seem to indicate that this would be the case when an individual created a GRAT and died before the retained term expired.

Considering the above however, in a surprise move, the IRS has now issued in final form IRC Regulations Sections 20.2036-1(c)(2) and 20.2039-1(e)(1), which state that IRC Section 2036 does not apply to trusts or other contractual arrangements resulting from the decedent’s employment, or to annuities purchased by the decedent. However, IRC Section 2036(a) only applies to a GRAT, grantor retained income trust (“GRIT”), grantor retained unitrust (“GRUT”), charitable remainder annuity trust (“CRAT”), charitable remainder unitrust (CRUT”), qualified personal residence trust (“QPRT”) or personal residence trust (“PRT”). The new regulations give an algebraic formula for determining the portion of the trust that is IRC Section 2036(a) includible.

As a separate comment, panelists suggested that perhaps a donor’s contribution by gift of a 10% amount (as measured against a notional trust value) to a trust will help to substantiate the trust as a bona fide purchaser, in conjunction with other attributes and provisions that are applicable to formalizing trust attributes under the IRC Sec. 2036 “full and adequate consideration” exception. However, where a trust is held to be in adequately funded, IRC Sec. 2036 still can apply to cause estate inclusion.

6. Special Valuation Rules in Case of Transfers of Certain Interests in Corporations or Partnerships (PLR 200934013)  

IRC Section 2701 has significantly reduced the use of valuation freezes in connection with valuation limitations and the transfer of family-owned corporations and businesses. This ruling provides that, notwithstanding the fact that IRC Section 2701 did not apply in the particular case, a distribution right (and the value of such transfer) was not a gift where an election under IRC Section 2701( c)(3)(C )(ii) treated a distribution right as a right to a “qualified payment.”

A qualified payment is a distribution that is a dividend payable on a periodic basis, but at least annually, under any cumulative preferred stock, to the extent such dividend is determined at a fixed rate or as a fixed amount. A qualified payment right includes any distribution right for which an election has been made pursuant to Treasury Regulations 25.2701-2 (c)(2), which provides that a transferor holding a distribution right in a controlled entity that is not a qualified payment right may elect to treat the distribution right as a qualified payment right, to be paid in the amounts and times specified in the election. The election can be a partial election, in which case the election must be exercised with respect to a consistent portion of each payment right in the class as to which the election has been made.

The election is only effective with respect to the payments specified in the election. Further, the payments specified in the election must be permissible under the instrument giving rise to the right and the payment must be consistent with the legal right of the entity to make the payment. If the transferor makes the election, then in determining the value of the transferor’s gift, the distribution rights with respect to the applicable retained interest are not valued at zero. The right is subject to the recapture rules. In general, if a taxable event occurs with respect to any applicable right, the taxable estate or taxable gifts of the individual holding the interest are increased by the amount determined under the regulations. A taxable event is the transfer of a qualified payment interest, either during life or at death, or any termination of an individual’s rights with respect to a qualified payment interest, as per Regulations Section 25.2701-4(b)(1).

7. Business-Related Discounts  

In the Estate of Litchfield v. Commissioner (T.C. Memo 2009-21), the court addressed discounts for a real estate corporation and a marketable securities corporation, including the built-in gains discount. The estate owned minority stock interests in both companies, and both companies elected S corporation status one year before the decedent died, therefore at the time of death nine years remained on the ten year period applicable to income taxation on the disposition of property that had built-in gains (BIGs) at the time of the S corporation election (and conversion from C corporation to S Corporation status).

There are two general approaches to determining the built-in gains discount: the dollar-for-dollar approach or the present value analysis. These approaches are applicable when the corporation might sell appreciated assets, so to determine the present value of the additional S corporation level capital gains costs attributable to the asset sale. The taxpayer’s valuation expert considered an assumed appreciation of the assets during the decedent’s one-year holding period, as well as additional capital gains attributable to that appreciation.

While there is no resolution as to whether future appreciation (post date-of-death) should be considered in determining a valuation discount, it is agreed generally that a corporation should be valued as of a particular valuation date, for example at a purchase date. However, a purchaser of S corporation stock (a former C corporation) where the S corporation owns appreciating assets will incur an S corporation built-in gains tax on future appreciation at the time of the future asset sale, and would therefore consider the present value of a related asset sale tax liability as a current reduction to a present purchase price. The court agreed that such a negative adjustment (attributable to the present value of the tax liability)would be appropriate.

The court also adopted the taxpayer’s valuation expert’s analysis, whereby the valuation used a weighted average for the lack of control discount attributable to certain property and then applied a valuation reduction due to a lack of marketability discount, because the combined lack of marketability and minority discounts were too high. All three discounts (including a discount for the built-in gains tax liability discount) on a combined basis resulted in a 52.25% and 53.8% discount (respectively) for the stock of the two corporations. The panelists suggested that this case could be litigated further.

8. Update on Family Limited Partnerships (“FLP”) Cases  

The Institute reviewed the facts of a successful FLP case: Estate of Murphy v United States, Case No. 07-CV-1013 (W.D. Ark. El Dorado Division Oct. 2, 2009). In Murphy, the decedent established a FLP to centralize management and protect against dissipation of certain family assets, and for this purpose transferred to the FLP his interests in a publicly traded oil company (where he had served as the CEO and Chair of the Board), a timberland and farmland company, and a bank. The decedent was involved in the management of all three companies. The value of the total business interests transferred to the FLP was approximately $90 million. The decedent had additional assets he held outside the FLP totaling approximately $130 million.

The decedent acquired a 96.75% FLP limited partnership interest, while a new limited liability company (“LLC”), owned 49% by the decedent and 51% by two of his children, held a 3.25% FLP general partnership interest. The value of the FLP limited partnership interest was calculated by determining the net asset value of the stock of the three companies, taking into consideration Rule 144 and blockage discounts as well as lack of control and lack of marketability discounts. 

Considering the LLC interests, the overall discount of the tiered entity was 52% of the net asset value. Further, the estate was allowed an estate tax deduction for all of the interest on a 9-year Graegin note (as defined in the Murphy case, a “Graegin note” is a note with a fixed term and interest rate that prohibits prepayment) for amounts borrowed from the FLP and for the interest actually paid on another note.

The Court held that the decedent’s transfer to the FLP satisfied the bona fide sale exception to IRC Section 2036 and no FLP estate inclusion resulted. The Court recognized that two of the decedent’s four children had sold and pledged in a bona fide manner various family assets properly and separately previously given to them and to trusts for their benefit, and then transferred these assets to the FLP to accomplish the goal of pooling the family’s assets under centralized management, and to protect those assets from being dissipated. The transaction was part of a comprehensive process whereby with the FLP the decedent transferred management of the family assets to the next generation. The two children who shared the decedent’s business/investment philosophy became actively involved in the management of the FLP. The decedent retained significant assets personally to support his lifestyle.

The decedent did not treat the FLP assets as his own and did not commingle his personal assets with the FLP assets.

Let’s contrast the Murphy “good facts” case with two “bad facts” cases, the first of which was Estate of Jorgensen, T.C. Memo 2009-66. In the Jorgensen case, the only evidence as to the reason the FLP was created was an attorney letter citing estate tax savings. In addition, the decedent had control of the FLP’s checkbooks even though she was not the general partner; she also wrote checks out of the partnership account for personal purposes. The Court pointed to the post-death payment of the decedent’s estate taxes as reflecting an implied agreement of retained enjoyment of partnership assets, thus triggering IRC Section 2036. The court also found that there were significant transactions between the decedent and the FLP that were not at arm’s length, and that the partnership held a largely untraded portfolio of marketable securities.

The Murphy case highlights the importance of having a nontax reason for the FLP’s formation and purpose, such as management succession, financial education of the family, promoting family unity, pooling of assets, creditor protection or perpetuating an investment or business philosophy. In addition, the presence of the following factors does not secure the bona fide sale exception under IRC Section 2036: 

  • Contemporaneous advice referring to tax savings 
  • A disregard of partnership formalities 
  • No arm’s length transfers

Additionally, the case asserts that there can be an implied agreement of retained IRC Section 2036(a)(1) enjoyment if the partnership assets are used for the decedent’s personal expenses, post-death payments are made from the partnerships, and a substantial amount is distributed to the decedent (an FLP partner) in a non pro rata manner.

The second “bad facts” case, Estate of Malkin v Commissioner, T.C. Memo 2009- 212, involves the decedent’s creation and sales of interests in two different FLPs to two different sets of trusts for the benefit of his daughter and son. The decedent was the general partner of both FLPs. After funding one of the FLPs and selling the limited partnership interests to trusts for the children, the decedent learned he had a serious illness and then one year later, the partnership pledged almost all of its assets toward a personal debt of the ecedent, with the decedent paying a small fee to the partnership for doing so. The assets were included in the estate under IRC Section 2036, as the pledge was evidence of an implied agreement of retained enjoyment and the purported non-tax purposes did not meet the bona fide sale exception to IRC Section 2036.

With respect to the second FLP, the court viewed the purported sales of limited partnership interests to the trusts as sham transactions and treated the transfers as gifts. Thus, the FLP interests were treated as indirect gifts to the trusts. A legitimate and significant nontax reason could not be identified; estate tax savings is not an acceptable FLP formation purpose.

In Estate of Miller v Commissioner, T.C. Memo 2009-119, the results were mixed. The bona fide sale for full and adequate consideration exception to IRC Section 2036 applied to transfers of marketable securities by the decedent to an FLP that took place approximately 13 months prior to the decedent’s death. The court ruled that there were legitimate and significant nontax reasons for the formation of and contributions to the partnership, including the purpose to continue the management of family assets in accordance with the decedent’s investment strategy. Further, there was active management of the partnership assets by the decedent’s son as the general partner, and there was a change in the investment activity after formation of the FLP, and the decedent retained sufficient assets outside of the partnership to fund living expenses.

However, the Court did not apply the bona fide exception to additional contributions to the FLP made only 13 days prior to the decedent’s death, because the reason for the contributions was clearly to reduce the decedent’s taxable estate in contemplation of her death due to a decline in her health. The Court held that IRC Section 2036(a)(1) applied, primarily pointing to pro rata post-death distributions from the partnership 8 months after the date of death, where the estate used its 92% pro rata portion of the distributions to pay estate taxes. The Court also observed that the decedent’s additional contribution of assets to the FLP 13 days prior to death represented almost all of the decedent’s remaining assets, and that there was an implied agreement that the assets would be made available to her for living expenses, if needed.

Clearly, cases in the FLP arena are being won or lost depending on the facts of the particular situation. However, when FLPs are properly formed and operated, and possess a business, investment, or asset management purpose, they remain viable planning vehicles where additional requirements are met and diligently followed. Further, compared to FLPs, trusts should be considered as more effective to accomplish a family’s objectives (a business or investment or asset management purpose); however, while trusts may be operated and managed more formally and not need a business purpose compared to a FLP, trusts can be far less flexible compared to FLPs and still require no retained interests or control by a decedent in order to be effective asset transfer vehicles.

9. Step Transactions  

Contributions of property to an LLC and gifts of LLC interests on the same day resulted in an indirect gift and step transaction, precluding any discounts for gift tax purposes, as concluded by the Court in Linton v. United States, 638 F. Supp. 2d 1277 (W.D. Wash. 2009). This case illustrates how the step transaction doctrine applies to gifts of partnerships or LLC interests, and the estate tax risks that are manifested when a taxpayer cannot prove that the steps were in the right order.

The Court applied the same approach as in Holman, 130 T.C. 170 (2008) and Gross, T.C. Memo 2008-221 (2008).  

Generally, three separate tests have been applied in determining if the step transaction doctrine applies: 

  • Whether there is a binding commitment to undertake subsequent steps at the time the first step is undertaken. 
  • Whether the series of separate steps are really pre-arranged parts of a single transaction, intended from the outset to reach the ultimate result. 
  • Whether the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series’ of transactions.

In Heckerman v. United States, 104 AFTR 2d 2009-5551 (W.D. Wash. July 27, 2009), contributions of cash to an LLC and gifts of LLC interests on the same day was treated as indirect gifts and as a step transaction, therefore precluding discounts for gift tax purposes. Heckerman is very similar to the Linton case, and indicates that there may be situations in which taxpayers can avoid the step transaction doctrine by establishing that there are non-tax reasons for the initial transfer of assets to an LLC, and not to merely obtain an LLC (and asset) valuation discount.

The IRS frequently argues and asserts that a donor makes an indirect gift of contributed assets to other LLC members in proportion to their percentage interests in the LLC, without a discount being allowed as attributable to the LLC and being applied to the interests held by LLC members.

Commentators disagree with the IRS position as LLC members do not end up actually owning outright proportionately the underlying LLC assets and related undivided value, rather, they acquire and own an LLC interest that has inherent restrictions thus reducing the value of the underlying proportionate asset value held by the LLC. Additionally, the length of a delay between steps is dependent upon the types of assets involved; the minimum delay seems to be 15 days, but the longer the delay between steps the better.

10. Discount Allowed in Case with Missing Transaction Steps  

In Keller v. United States, 104 AFTR 2d 2009-6015 (S.D. Tex. Aug. 20, 2009), the court recognized a limited partnership (LP) holding a bond portfolio as a bona fide entity, even though the LP was not formally funded before the decedent’s death. The Court allowed a 47.5% estate valuation discount for an assignee interest in the partnership.

The decedent had signed a partnership agreement and expressed the intent to fund the partnership with a specifically identified bond portfolio, and cash, but the funding did not formally occur before her unexpected death. Based on Church, the advisor executed the LP funding and filed an estate tax refund claim for a discount. The Court concluded that the decedent had expressed a clear intent to fund the partnership with the identified assets, and under Texas law, the intent caused the assets to become partnership assets. There was no application of IRC Sections 2036 and 2038 because there was a legitimate business purpose for the partnership—protecting family assets from divorce proceedings and facilitating the administration of family assets. Also, the decedent had retained significant assets and separated from assets earmarked for the partnership. 

11. Nature of Interest Valued for a Disregarded Entity  

In Pierre v. Commissioner, 133 T.C. No. 2 (2009), the Tax Court rejected an IRS attempt to disregard an LLC for gift and estate tax purposes on the grounds the LLC was a “disregarded entity” for income tax purposes. The significance of this case is the rejection of the IRS effort to apply the “check-the-box” regulations to a gift tax valuation.

12. Annual Gift Exclusion Not Allowed for Gifts of FLP Interests  

In the Price Case, Tax Court Memorandum 2010-2, it was held that a gift of an FLP interest does not qualify for the annual gift exclusion as there is no transfer of a present interest.

13. Defined Value Formulas Cases  

In Estate of Christiansen v. Commissioner (ID 4 AFTR 2d 2009-7352 Nov. 13, 2009), the Eight Circuit Court of Appeals upheld a partial disclaimer to a private foundation (by a disclaimant) of an amount determined by formula. In drafting the disclaimer, a defined value fractional formula was used, so that if the value of the estate was increased for federal estate tax purposes, the excess would go to the CLAT and the private foundation. The excess would escape the federal estate tax because of the estate tax charitable deduction. The Tax Court held that the disclaimer of the property to the CLAT was invalid because the disclaimant was also the remainder beneficiary of the CLAT.

For a disclaimer to be effective under IRC Section 2518, the disclaimed property must pass to someone other than the disclaimant. The exception to IRC Section 2518 is the surviving spouse exception.

With respect to the disclaimer to the foundation, the IRS argued that the use of the defined value fractional formula made the disclaimer ineffective because any increase in the amount disclaimed was contingent on a condition subsequent and that the use of the phrase “as finally determined for federal estate tax purposes” for determining the amount of disclaimed property was void as contrary to public policy. The IRS also argued that to qualify for the estate tax charitable deduction, the amount passing to charity must be ascertainable as of the date of the decedent’s death. The Court disagreed with the IRS, noting that the value of property passing to charity is routinely increased or decreased on audit without affecting the charitable deduction.

In Petter v. Commissioner, T.C. Memo 2009-280, the Tax Court approved a defined value clause dividing a gift and sale between charitable donees, noncharitable donees and purchasers. The Court approved all aspects of the use of the defined value clauses, and held that Ms. Petter was entitled to deduct the finally determined charitable contribution for income tax purposes as of the date of the initial gift.

Separately, panelists suggested the consideration of an allocation formula, with the excess going to charity via a donor advised fund.

14. Administration’s Legislative Proposal on Section 2704(b) Regulations  

The Treasury Department’s “General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals” (“Greenbook”) was released on May 11, 2009. One of the revenue raising proposals was the modification of the rules on valuation discounts. IRC Sections 2701 through 2704 were enacted to prevent the reduction of estate taxes though the use of “estate freezes” and other techniques, designed to reduce the value of the transferor’s taxable estate and discount the value of the taxable transfer to the beneficiaries of the transferor. IRC Section 2704(b) generally provides that certain “applicable restrictions” that would normally justify discounts in the value of the interests transferred are to be ignored in valuing interests in family-controlled entities, if those interests are transferred to or for the benefit of family members. This application results in an increase in the transfer tax value of those interests above the price that a hypothetical willing buyer would pay a willing seller, because IRC Section 2704(b) generally directs an appraiser to ignore the rights and restrictions that would otherwise support significant discounts for lack of marketability and control.

The Treasury feels that there is a reason for change, as judicial decisions and the enactment of new statutes in most states have effectively made IRC Section 2704(b) inapplicable in many situations. This is especially the case where there are recharacterization restrictions such that they no longer fall within the definition of an “applicable restriction.”

The proposal would create an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family, if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family.

Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.

The proposal was estimated to raise revenue by $19.038 billion over the ten fiscal years from 2010 through 2019.

15. Administrative Proposal for Minimum 10-year term for GRATs  

The Greenbook proposes to increase the mortality risk of GRATs by requiring a minimum trust term of 10 years. Further, on September 8, 2009, the Joint Committee on Taxation released a publication entitled “Description of Revenue Provisions in President’s Fiscal Year 2010 Budget” which also discussed the 10-year GRAT term and opined that a GRAT could be used as a gift tax avoidance tool by younger taxpayers. The JCT staff publication suggested a valuation of the remainder interest for gift tax purposes at the end of the GRAT term when the remainder is distributed.

16. Sale of a Remainder Interest—PLR 200919002  

The IRS approved the sale of a remainder interest in a qualified principal residence trust (“QPRT”). A couple created an irrevocable trust for the benefit of their descendants. The trust was funded with cash and marketable securities, and was called the “Purchasing Trust.” A residence was transferred to another trust that qualified as a QPRT, and the husband and wife had rent-free use of the residence for their lives. After executing the QPRT, the couple proposed to sell the remainder interest in the QPRT to the Purchasing Trust for the fair market value of the remainder interest under the 7520 valuation tables. Upon the death of the survivor, the trustee distributed the assets of the QPRT to the Purchasing Trust.

The IRS ruled the personal residence was to be valued under the 7520 valuation tables, but did not rule as to whether it should be included for estate tax purposes.

II. Review of Selected Topics for Implementation in 2010  

1. Estate Planning Using Disclaimers  

Disclaimers can be an effective technique for tax and nontax purposes, provide flexibility in an estate plan, and have the ability to correct errors that are discovered after the date of death. It is possible to disclaim tangible assets and intangible interests and powers, in both an individual and fiduciary capacity. However, the disclaimer rules are complex.

IRC Section 2518(a) provides that a disclaimed interest (of tangible or intangible property) is treated as if the interest had never been transferred to the disclaimant. A qualified disclaimer must meet the following requirements: 

  • The disclaimer must be in writing, 
  • The disclaimer must be received by the transferor of the interest or the holder of legal title to the property within nine months after the later of: 
    • The date on which the transfer creating the interest was made, or 
    • The date on which the disclaiming person attains age 21, 
  • The disclaiming person must not have accepted the interest or any of its benefits, 
  • The interest must pass without any direction on the part of the disclaiming person, and 
  • The interest passing as a result of the disclaimer must pass either: 
    • To a person other than the disclaiming person, or 
    • To the spouse of the decedent.

Timing of Disclaimers: The initial consideration to be addressed is when does a transfer occur. Treasury Regulations Section 25.2518-2 (c)(3) provides that the nine-month period for making a disclaimer generally is determined with respect to the date of the transfer that creates an interest in the disclaimant. For instance, in the case of an intervivos transfer, a transfer occurs when there is a completed gift for federal gift tax purposes, regardless of whether a gift tax is imposed on the completed gift.

For transfers made by a decedent at death, or transfers that become irrevocable at death, the transfer occurs on the date of the decedent’s death even if no estate tax is imposed. The regulations indicate that the holder of a general power of appointment has nine months from the date of the creation of the power to disclaim the power. The person to whom an interest in property passes by reason of the exercise or lapse of a general power of appointment must make a disclaimer within nine months after the exercise, release, or lapse of the power, regardless of whether the exercise, release, or lapse is subject to a gift or estate tax.

IRS Private Letter Ruling 200825037 demonstrates the application of the rule determining when a transfer occurs for determining a lapse of a general power of appointment created prior to October 22, 1942. This ruling involved an irrevocable trust created prior to this date, and where the grantors created a trust for a child for life, with the remainder passing to that child’s descendants. The child held a general power of appointment which was not exercised at the time of the child’s death. After the child’s death, the child’s daughter and former spouse and their children wished to disclaim a portion of their interests in the trust. The IRS ruled that the lapse of a pre-October 22, 1942 general power of appointment is not an exercise of the power, therefore the value of the trust is not includible in the deceased child’s gross estate for federal estate tax purposes. Because the power was not included in the child’s estate, the period for making the disclaimers is measured from the date of the deceased child’s death, which is the date the interest is deemed to be created. Accordingly, the daughter and other trust beneficiaries were able to disclaim portions of their interests in the trust within the nine-month period after the death of the deceased child.

An interest arising pursuant to a prior disclaimer must still be disclaimed within nine months of the creation of the initial interest. IRS Private Letter Ruling 200442027 illustrates the timing for successive disclaimers.

Issues Surrounding Acceptance: A disqualified disclaimer results if the interest had never been transferred to the disclaiming person. If the disclaiming person had already enjoyed the benefits of the property, or had accepted some portion of the interest, the interest could no longer be treated as if it had never been transferred to the disclaiming person. The regulations focus on the acceptance of the benefits of the property, and describe acts that are indicative of acceptance of property, such as: 

  • Using the property, 
  • Accepting dividends, interest or rent from the property, or 
  • Directing others to act with respect to the property.

On the other hand, merely accepting delivery of an instrument of title does not constitute acceptance, nor does the operation of state law that indicates that title vests immediately upon the death of the prior owner as may arise with respect to real estate. Acceptance of one interest in property will not in itself constitute an acceptance of other separate property interests created by the same transferor. So, in the case where a residence is held in joint tenancy, continuing to reside in the residence does not constitute acceptance.

Passage Without Direction: Treasury Regulation Section 25.2518-2(e) provides that a disclaimed interest must pass to a person other than the disclaimant or to the surviving spouse, without any direction on the part of the disclaimant. If there is an express or implied agreement that the disclaimed interest in property is to be given to a person specified by the disclaimant, the disclaimer will not be a qualified disclaimer. The regulations also provide that a disclaimer made by a surviving spouse may be a qualified disclaimer as long as the interest passes as a result of the disclaimer, and without direction on the part of the surviving spouse, to another person. The surviving spouse may not retain the right to direct the beneficial enjoyment of the disclaimed property unless the power is limited by an ascertainable standard.

The Institute highlighted two cases that illustrate additional examples of disclaimers and the results thereof. In Drye v. United States (528 U.S. 49 (1999)), the court was split on whether a taxpayer’s disclaimer of an inheritance could defeat a federal tax lien. The court ruled that holding a disclaimer does not avoid a federal tax lien under IRC Section 6321. In Re Costas (555 F.3d 790(9th Cir. 2009)), the court held that a disclaimer was not a transfer of property within the meaning of the bankruptcy statutes, and therefore the disclaimed property was not part of the bankruptcy estate. Local law governs whether a disclaimant’s creditor may reach the disclaimed property.

IRC Section 2518 is silent as to the ability of a fiduciary or trustee to make a qualified disclaimer. Section 2518(a) states a person may make a qualified disclaimer with respect to any interest in property, and the interest passes as if the interest had never been transferred to such person. The regulations discuss certain fiduciary powers that cannot be retained by a beneficiary who disclaims an interest in a trust, however the regulations do not provide direction as to the authority of a trustee to disclaim such powers. In IRS TAM 9818005, the trustee attempted to disclaim a bequest to a surviving spouse which was not upheld by the IRS. In the TAM, the decedent’s will cited an outdated marital deduction, and bequeathed one-half of the adjusted gross estate to the surviving spouse. The bequest was disclaimed (by the trustee) as the surviving spouse wanted to establish a QTIP with the bequeathed assets. The trustee’s asset disclaim was held to be invalid because such rights were not granted to the trustee or surviving spouse (nor additional family member beneficiaries) under the decedent’s will. While disclaimers can be an effective planning tool, it is important to understand the rules surrounding its use.

2. Roth IRA Conversions in 2010  

In 2010 a conversion of a traditional individual retirement account (TIRA) to a Roth individual retirement account (RIRA) is available without regard to the TIRA owner’s adjusted gross income (as determined for federal income tax purposes).

A TIRA conversion to a RIRA is more favorable where income tax rates will increase in future (post-conversion) years. Conversely, if a TIRA owner’s tax rate is expected to decrease, the value of converting a TIRA balance to a RIRA is diminished. As the top ordinary income tax rate is expected to be 39.6% in 2011 compared to 35% in 2010, TIRA conversions have become very popular.

Generally, younger IRA owners can attain greater after-tax RIRA balances post conversion, compared to older IRA owners that convert. This observation assumes for each (younger and older) IRA owner over a planning horizon the same tax rate and investment asset rate of return (appreciation and yield).

A 2010 TIRA conversion to a RIRA is taxable in 2011 and 2012 (50% of the 2010 conversion is taxable in each year). However, prior to the taxpayer filing his or her 2010 federal tax return in April 2011, a taxpayer may elect to include in 2010 taxable income the full amount of the income attributable to the 2010 conversion; if such an election is made, taxpayers should review the applicability of 2010 estimated tax underpayment penalties.

A TIRA conversion to a RIRA will be less beneficial where income tax from the conversion will be paid from the TIRA distribution. Therefore, a TIRA to RIRA conversion is most beneficial when the income tax attributable to the conversion is paid from non-TIRA and non-RIRA investments. This condition is also true where 401(k) plan balances are transferred to a Roth IRA. A conversion to a RIRA is not permitted for an IRA that is inherited from a person other than the IRA owner’s spouse.

RIRAs are funded with after-tax contributions (from a taxable TIRA conversion). After-tax contributions can be withdrawn anytime devoid of penalties or taxes.

If you receive a distribution of earnings from a RIRA, you're required to pay tax (and possibly penalties) unless you received a qualified distribution, which is based on a (i) type of distribution test, or (ii) five year test. The five-year test is satisfied beginning on January 1 of the fifth year after the first year you establish a Roth IRA. If you established a Roth IRA in 2004, for example, any distribution from a Roth IRA will satisfy the five-year test if the distribution occurs on or after January 1, 2009. Even after you meet the five-year test, only certain types of distributions are treated as qualified distributions. There are five types of qualified distributions, those that are (1) of after-tax contributions, (2) made on or after the date you reach age 59½, (3) made to your beneficiary after your death, (4) in the event you become disabled, distributions attributable to your disability, and (5) qualified first-time homebuyer distributions.

RIRAs have no minimum distribution requirements. TIRAs require minimum distributions commencing at age 70½ years of age. RIRAs are generally not subject to income in respect of a decedent (IRD) tax liabilities in the event of a RIRA owner’s death. Also, if the IRA owner does not need the IRA assets to fund retirement or other cash flow needs, a larger asset balance could be available to beneficiaries devoid of income tax with distributions made over the beneficiaries’ life expectancies.

401(k) account balances from a former employer’s plan can be transferred to a Roth IRA (RIRA). 401(k) plan participants should review with plan administrators the availability of such a transfer. This transfer is taxable to 401(k) account owner.

There is no 10% penalty for a Roth IRA conversion before age 59½ but the penalty can apply if a converted amount is distributed to the owner of a Roth IRA within 5 years of the conversion, if the Roth IRA owner is under age 59½. Until 2010, a Roth IRA conversion was prohibited if a person’s modified adjusted gross income exceeded $100,000. There is no income limitation in 2010 or in later years.

IRS Notice 2008-30 provides that a beneficiary can make a Roth IRA conversion from an inherited retirement account, but not from an inherited IRA. Further, a traditional 401(k) account cannot be converted into a Roth 401(k) account.

Roth IRAs are subject to the estate tax, however no income tax in respect of a decedent is applicable.

The Institute cited five advantages of a Roth IRA:

i. Distributions are tax-free if made more than five years after a taxpayer made his or her first contribution to any Roth IRA and it was made after the individual attained age 59½ or has died.
ii. Greater wealth can be accumulated in a tax-sheltered environment since Roth contributions are made with after-tax dollars.
iii. Roth IRA contributions are possible even after the individual has attained the age 70½. By comparison, contributions cannot be made to a traditional IRA by an individual during or after the year the individual attains age 70½.
iv. There are no required distributions from a Roth IRA after the individual has attained age 70½.
v. Roth accounts can reduce the size of an individual’s taxable estate, thereby reducing federal and state estate taxes.

However, the Institute cited as a disadvantage the fact that income might be taxed at a higher rate with a Roth account. Although each situation is unique, many people will be in a lower income tax bracket at retirement. A Roth IRA conversion accelerates the payment of income taxes, usually during years where the individual is in a higher income tax bracket. Therefore, conversion will only make sense if the anticipated taxfree growth of the Roth IRA outweighs the up-front cost of the income taxes.

Another disadvantage is that a Roth IRA must be liquidated faster than a traditional retirement account if an individual dies between ages 71 and 91, and the Roth IRA fails to qualify for “stretch” treatment.

A “stretch” arrangement is possible where a Roth IRA is liquidated over a designated beneficiary’s life expectancy. Stretch treatment is not possible if one of the beneficiaries is not a human being, such as the decedent’s estate. In that case, the Roth IRA must then be liquidated within just 5 years after the owner’s death.

Mechanics of a Roth IRA conversion: The best way to effectuate a TIRA conversion to a RIRA is to contact the administrator of the TIRA, and have the entire account transferred to a RIRA with the same administrator. Alternatively, a trustee-to-trustee transfer from a traditional retirement plan to a RIRA will also accomplish the conversion. The least desirable method is the “60-day rollover”, where the individual receives a distribution from a traditional retirement account and has up to 60 days to deposit the amount into a RIRA. There is no one-rollover-per-year limitation for RIRA conversions as there is with a traditional IRA 60-day rollover. This method may require withholding by the distributing plan, and there could be a situation where the individual fails to do the transaction within 60 days.

Tax Planning Strategies: The Institute suggested individuals consider the following when contemplating a TIRA conversion to a RIRA: 

  • Determine whether it is better to elect to have the entire conversion taxed in 2010, or report 2010 TIRA income equally in 2011 and 2012. It is important to consider the income tax rates applicable in 2010 and 2011 and 2012. 
  • Try to convert when the market values of the TIRA assets are lower. 
  • Avoid using assets in the RIRA to pay the income tax liability. Instead, use non-TIRA/non-RIRA resources. 
  • Convert to a Roth when there are tax deduction carryforwards in 2010-2012 (such as net operating loss carryforwards). 
  • Accelerate income tax deductions into a Roth IRA conversion year in order to maximize tax savings of deductions. For instance, one can secure charitable deductions such as a gift of appreciated securities or establishing a charitable remainder trust.

Consider asset protection issues. An IRA balance is protected up to $1 million in bankruptcy court, regardless whether it is a TIRA or RIRA. The Roth IRA provides greater protection since it holds after-tax dollars. Rollovers from a qualified retirement account have greater protection from creditors, whereas an inherited IRA has virtually no protection from creditors.

Recharacterization rules: Once an IRA conversion to a Roth is completed, undoing the conversion later is available where the amount is transferred to a traditional IRA. The recharacterization must be done by October 15 in the year following the year of the initial (TIRA to RIRA) conversion.

There are some situations where recharacterization makes sense--for example, where the value of the assets that were part of the conversion plummeted after the conversion which would have triggered inflated income tax liabilities at the time of the conversion. Also, a recharacterization can occur where the converting individual may not have the cash to pay the income tax attributable to the original conversion.

The best way to accomplish the recharacterization is to instruct the trustee of the Roth IRA to make a trustee-to-trustee transfer of the converted amount to the trustee of a new traditional IRA. On the individual’s federal income tax return, the original conversion is reported as having been transferred to the traditional IRA, rather than transferred to the Roth IRA. The transfer must be completed prior to the due date for filing the tax returns, including extensions (for example, by October 15, 2011 where there is a conversion in 2010).

The price for making a recharacterization is that the taxpayer is not eligible to make another Roth IRA conversion until the later of (1) the first day of the following taxable year, or (2) 30 days after the trustee-to-trustee transfer.

Conclusion: Roth IRA conversions can be an effective income tax and estate planning tool, although the perceived benefits are not free from doubt; analysis and financial modeling with appropriate assumptions must be undertaken.

3. Grantor Retained Trusts (“GRATs and GRUTs”)  

With a grantor trust, the grantor contributes assets thereto and retains the right to receive an annuity interest from the trust for a term of years.

The annuity interest can be expressed either as a fixed percentage of the initial fair market value of the trust assets (an annuity trust (GRAT)), or as a percent of the annual fair market value of assets (a unitrust (GRUT)). When the retained term ends, the trust terminates, and any remaining assets are distributed to the remainder beneficiaries.

Generally, GRATs (and GRUTs) are an effective means to transfer wealth. However, there could be resulting consequences attributable to the improper design of the GRAT instrument. In these circumstances it may be possible to make any corrections by modifying the trust instrument under applicable state law; however, the IRS may not be bound by such modifications. As a remedy in certain circumstances, a drafting suggestion might be to include a savings clause in the trust document. The trust document must have all required provisions in order to qualify as a GRAT, otherwise, the trust assets would be considered a taxable gift. The balance of this discussion will refer to GRAT planning strategies.

GRATs with Troubled Assets: Additional problems result if the GRAT holds troubled assets such as an interest valued under IRC Section 2701, and where it is determined there is a gift tax value in excess of the fair market value (as determined on the date of the asset transfer or gift to the trust). In this instance, a solution could be to add a provision that allows an annuity percentage to be applied to gift tax value rather than the fair market value. Alternatively, one can provide a transfer of a vertical slice of the grantor’s interest in a corporation or partnership (as transferred to the trust), which is a proportionate part of each class of equity interest held by the grantor, and not just the subordinate interest which is presumed to carry an appreciation element as defined under IRC Sec. 2701.

Other problematic assets include restricted insider stock that is transferred to a trust. The inherent restrictions can cause undesired valuation discounts, or sale/transferability limitations. The solution is to omit an inherent swap power, or include an ordering rule and prohibit use of a grace period. Another problem asset is stock subject to IRC Section 2036(b).

To resolve this issue, the underlying entity can effectuate a recapitalization, or eliminate the grantor’s voting power, or swap out the IRC Section 2036(b) stock for other assets of equivalent value which would avoid IRC Section 2035, or sell the asset to the grantor. Other problem assets are stock options and community property.

Burned-out GRATs: A GRAT will effectuate a wealth transfer only if the combined income and appreciation of the GRAT’s assets exceed the applicable IRC Sec. 7520 rate. As we have seen in the recent economic climate, GRAT asset appreciation can fail to perform as intended and trust asset valuations do not exceed the original trust value plus the IRC Sec. 7520 rate-–therefore a net asset valuation transfer to remainder beneficiaries is not accomplished.

A possible solution in this instance might be to swap property and re-GRAT, whereby the grantor can reacquire the GRAT assets by substituting assets of equivalent value; accordingly, if the GRAT assets still have appreciation potential and the grantor has retained a swap power in the trust instrument, the grantor can reacquire the asset by substituting cash or other assets of equivalent value and transfer the assets to a new GRAT. Alternatively, there could be a sale of the trust assets to the grantor, followed by a re-GRAT, or a direct sale to a grantor trust can be effectuated. If a spendthrift clause is not in a GRAT, then remaining annuity amounts can be transferred to a new GRAT. Finally, if the underlying assets of a GRAT have no further appreciation potential it might be best to do nothing and let the GRAT run its course; this will most likely lead to the ultimate distribution of all GRAT assets to the grantor in partial satisfaction of the annuity payments and the GRAT will simply terminate.

Home-Run GRATs: Sometimes trust assets may realize significant appreciation in excess of the Sec. 7520 rate and the trust is poised to transfer significant wealth to the remainder beneficiary. However, if a gain has inured to the trust, considering today’s uncertain capital markets valuation gains could reverse; as a defensive strategy, it may be prudent to lock in the trust’s appreciation to avoid a potential decline in the GRAT’s market value. If the grantor has retained a swap power, a defensive strategy would be for the grantor to substitute the appreciated asset in the trust for assets with less market risk. The property acquired via swap from the trust can be transferred to a new GRAT. Another solution might be to simply sell the appreciated asset and then reinvest the proceeds in less risky assets.

The sale can be made to the grantor or another grantor trust, resulting in no income tax consequences on the transaction. Another solution might be to purchase a collar on publicly-traded securities, thereby securing a hedge.

Grand Slam Home Run GRATs: In these instances, the GRAT’s assets are appreciating so much that the GRATs might shift more wealth to remainder beneficiaries than the grantor intended. Solutions include exercising a swap power, purchasing the appreciating asset, adding or changing beneficiaries, or turning off grantor trust status.

Illiquid GRATs: The GRAT may find itself without the liquidity necessary to make annuity payments to the grantor. To address this issue, possible solutions include making in-kind distributions of trust assets, or borrowing from a third party. A drafting solution is to use a long-term, back-end-loaded GRAT, where the annuity amount increases over the years of the GRAT term so as to minimize payments in the earlier years. Alternatively, some swapping (substituting) liquid assets into the trust can be undertaken. Again, an effective trust instrument will include these provisions for maximum planning flexibility.

Changes in the Grantor’s Objectives: Sometimes the grantor may have a change of heart regarding beneficiaries. Solutions include swaps, purchase of assets, settling a new GRAT, adding or changing beneficiaries, or turning off the grantor trust status.

Problems Relating to Poor Administration:  

The Institute discussed:

  • An annuity amount payable based on the anniversary date of the creation of the GRAT must be paid to the annuitant (grantor) not later than 105 days after the anniversary date. An annuity amount payable based on the taxable year of the GRAT must be paid no later than the due date for the trust’s income tax return for that year, without regard to extensions. If the trustee fails to make the payment, the IRS could argue that the grantor’s annuity interest is not a “qualified interest” and that for purposes of determining the amount of the grantor’s gift, the annuity interest is valued at zero. It is always best for the trustee to pay the annuity with interest as soon as possible. A drafting solution is to consider a provision stating that if an annuity payment is not timely made, the GRAT terminates as to assets having a value equal to the annuity amount, and the trustee thereafter holds those assets as the grantor’s agent rather than as trustee. Thus a “deemed annuity payment” is made, even when not actually made. 
  • A GRAT can only be funded at inception and the trust document must prohibit additional contributions. The grantor may actually fund the trust over several days, due to logistics or inadvertencies. However, the IRS may contend that the GRAT is disqualified and the grantor’s annuity interest is not a “qualified interest,” resulting in a gift by the grantor of the full value of the assets transferred to the GRAT, and with no reduction for the value of the grantor’s retained annuity interest. The solution for this issue is to create multiple GRATs, with separate trusts to be utilized for separate gifts of property. An alternative might be to treat the subsequent funding as a loan to the trust instead of as a contribution, or simply return the additional funding to the grantor. 
  • The grantor might be paying expenses that should have been paid by the GRAT. This circumstance could be considered an additional contribution that could disqualify the GRAT. The solution would be to treat the amounts as a loan with prompt repayment, or with long term arms’ length repayment terms.

Installment sale considerations: Installment sales can effectively freeze the value of an individual’s estate. A typical installment sale transaction is structured as follows: 

  • The individual creates a grantor trust for the benefit of family members and funds the trust--typically with an initial contribution equal to 10% of the initial notional fair market value of the property to be acquired (a limited partnership interest for example) by the trust via purchase. 
  • Continuing, the individual sells limited partnership interests to the trust in exchange for a promissory note, which is secured by the trust assets, and which will bear interest at the applicable federal rate (the AFR under IRC Sec. 7872), and otherwise possess arm’s length terms. 
  • The result is a freeze of the value of the assets; if the asset appreciation outperforms the loan’s AFR, the excess appreciation is transferred to the family (trust beneficiaries) devoid of gift tax. Further, the sale is not recognized because the trust is a grantor trust and the grantor (not the beneficiaries) is taxed on trust income.

Normally, for gift tax purposes, the value of transferred property is its fair market value at the time of the transfer. However, IRC Section 2701 provides different valuation rules if the donor transfers an interest in a corporation or partnership to a member of his or her family, and retains certain kinds of interests in the transferred property. In this case, the IRS will argue the actual property value (due to retained controls held by the transferor) could be significantly higher than the asserted fair market value. Solutions include avoiding the transfer of IRC Section 2701 property, adjusting the purchase price to consider a higher IRC Section 2701 valuation if asserted, or transferring a vertical slice of the seller’s interests in the entity so as to prevent application of IRC Section 2701. A further solution is to draft formula clauses within the sale/transfer agreement.

If an installment sale is underwater (the installment sale note receivable amount exceeds the value of the property sold) due to economic conditions, it might be best to renegotiate the note, or contribute the note to a GRAT, or sell the note to a grantor trust. Or, one could unwind the transaction.

Qualified Personal Residence Trusts (“QPRT”): This trust can be an effective means to shift wealth to family members, while the grantor retains a limited interest in the property for a term of years, and the remainder interest in the property is transferred to intended beneficiaries. In order for the QPRT to be successful, the grantor must survive the trust term. Once the grantor’s retained term interest ends, the QPRT ends and the residence is distributed to the remainder beneficiaries - for example, adult children. The grantor can stay in the residence after the trust term only if he or she pays fair rent to the remainder beneficiaries. If the grantor stays in the residence subsequent to the trust term and does not pay fair value rent, the IRS can argue that the entire value of the residence should be brought into the estate under IRC Section 2036.

4. Strategies for Avoiding a Step Down in Basis in Death  

With the recent decline in the capital markets and in real estate, and the uncertainty of future legislation to retain or even increase the $3.5 million estate tax exemption amount, individuals in poor health may desire to avoid a step down in basis upon an anticipated death of the individual rather than saving estate taxes. The possible solutions include: 

  • Sell the asset to an unrelated person during lifetime, so the loss can be realized. 
  • Gift or sell the asset to the spouse before death, so that there is no income recognition and the carryover basis is retained. 
  • If a gift is made to someone other than a spouse, upon a subsequent sale the donee has the donor’s basis for determining gain, but the fair market value of the asset is the lower of fair value or cost for the purpose of determining a loss. In this instance the donee would not be able to take advantage of the full loss if the property is sold at a value above the original basis. 
  • If the sale is to a related party, the seller cannot take a loss when the property is sold. However, the loss is preserved for use by the purchaser in the event of a subsequent disposition to an unrelated party. 

5. Estate Planning in the Shadow of the One-Year Repeal of the Estate Tax and GST in 2010  

An Institute commentator stated “things are really bad when you cannot even say ‘It is what it is!’” As discussed earlier, Congressional activity in 2010 remains uncertain as to whether the eventual legislation will comprise a reinstatement of prior tax laws, or a wholly new tax regime. There could also be new reporting requirements in 2010 and thereafter with the advent of new legislation. Planning Considerations in Light of Current Uncertainty: 

  • Formula provisions in documents may be irrelevant if there is no estate tax; this can also impact the GST tax exemption. Also, the state marital deduction may be allowed for QTIP bequests only if the estate makes the federal QTIP election. Credit shelter trusts and marital trust plans can also be problematic. Charitable trusts based on formula clauses are problematic since there is no estate charitable deduction. In the case of charitable remainder trusts, there are regulatory issues. A potential solution may be for the individual to set up a Charitable Remainder Unitrust now, and let the will provide for additional funding at death--this will save the charitable deduction which is intervivos. 
  • QTIP trusts with disclaimers may be a viable solution as the will can leave remainder to the QTIP, and provide that any assets disclaimed by the spouse will be transferred to a bypass trust citing the spouse as a potential beneficiary. The spouse can then disclaim any assets in excess of the amount needed for the $3 million spousal basis adjustment. If desired, the spouse could also disclaim any assets for which a marital deduction is not needed at the first spouse’s death, and if there is no estate tax applied to the decedent’s estate. The key to maximizing planning flexibility during uncertainty is to use a QTIP bequest for the spousal bequest. This is because, by using a QTIP: 
    •  Assets in a QTIP trust for which an estate tax marital deduction is not allowed at the first spouse’s death are not includible in the surviving spouse’s estate under IRC Section 2044. So, if there is no estate tax at the first spouse’s death and all of the estate is left to a QTIP trust and the estate tax is reinstated before the death of the second spouse, there should be no inclusion of the QTIP assets in the second spouse’s estate. The QTIP acts like a credit shelter trust. 
    • The estate should qualify for the $3 million spousal adjustment. Leaving all of the estate to a QTIP trust means that the assets would qualify for the $3 million spousal basis adjustment. The disadvantage however is that leaving all the assets to a QTIP trust does not permit distributions directly to descendants; if the spouse desires to transfer assets from the trust to the children, the spouse would have to receive a distribution and then make a subsequent gift to the children. Alternatively, one can gift assets to children while the spouse is alive; this is achieved by arranging for the spouse to purchase a portion of the children’s remainder interest. When IRC Section 2519 applies to a QTIP, the IRS has stated the purchase by the spouse of a remainder interest is a taxable gift. IRC Section 2519 will not apply to a testamentary QTIP created by a 2010 decedent because no marital deduction would be permitted for property transferred to it. The use of invasion powers gives mixed results.

Charitable goals may need to be revisited. There may be nontax reasons to make gifts. Alternatively, a strategy may be to gift funds of the estate to the children, and enable them to gift funds to charity and obtain an income tax deduction.

There are state tax issues to consider. Currently, 11 states have QTIP elections in place. As stated earlier in this Outline, by utilizing a QTIP, state inheritance and estate taxes can be minimized where there is no 2010 estate tax. With respect to lifetime transfer planning, since the gift tax rate has now been reduced from 45% to 35% in 2010, it may be beneficial to make large gifts this year in excess of the $1 million exemption. There is the risk however that a 2010 change in the estate and gift tax law may be retroactive to January 1, 2010, thereby increasing the 2010 gift tax rate. IRC Section 2511(c) treats transfers in trust in 2010 and thereafter as taxable gifts unless the trust is treated as wholly owned by the donor. Consider incomplete gifts.

6. Non-Tax Issues in Business Succession Planning  

Conflict is likely to occur in a family business when the owner and other family members do not agree on the mechanisms to transfer ownership and control of the business, and the related valuations. The conflict often arises between older and younger generations, family members in the same generation, and between family members and non-family employees and shareholders.

Family Owned Business Owners Considerations in Succession:  

  • Should the business be sold during the owner’s lifetime? 
  • Should the business be continued after the death of the owner? 
  • Will value be transferred or control transferred, or both ? 
  • Who will manage the business post transfer ? 
  • Who will control the business after the change in ownership? 
  • Considering business interests transferred, will the owner’s children be treated equally in the distribution of the non-business assets in the business owner’s estate? 
  • What provisions will be made for the present owner after the transfer of the business?

The Institute cited it is estimated that 85% of the crises faced by family businesses are in connection with succession issues. A 2007 study found that 40% of business owners expect to retire within 10 years, while 30% have retirement plans. Therefore, as conflict is inevitable, a business owner must prepare and execute an effective plan in order to successfully transfer wealth. A family business is defined to be one in which a family has effective control of the strategic direction of the business, and the business is a significant component of the family’s wealth and identity.

More than 90% of U.S. businesses are owned by families. 23 million family businesses account for 40% of our nation’s private sales, and account for 97% of all employers. 78% of all the jobs created in the U.S. from 1977-1990 were created by family businesses. Over 150 of the Fortune 500 companies are family businesses. Only 30% of family businesses will pass to the second generation; 12% will pass to the third generation and only 3% will reach the fourth generation. The reason for the low succession percentage is the lack of proper planning.

Challenges to Family Business Succession Planning:  

  • There is a smaller pool of potential successors. Not all family members are interested in the business, and yet there could be a reluctance to fill management positions with experienced non-family members. Nepotism and sibling rivalries are factors. 
  • There is a failure to separate a family’s home and work life. 
  • Succession in family businesses can involve a large age differential, and differences in values regarding work and family life and wealth creation. 
  • A family business is usually an emotionally-charged environment; clashes can result. Tensions can result from an older generation’s reluctance to retire, and how and when and to whom monies are to be distributed. There are frequently control issues and the fear of crippling effects of estate and gifts taxes. 
  • Senior family business owners may be unable to let go of their responsibilities and roles. Loss of power of the business can be equated with the loss of power in the family. There can be a reluctance to delegate powers to others. 
  • There can be an aversion to succession planning. A 2003 study found that 50% of 387 small family businesses had succession plans, and of those amounts 31% stated that they were uncomfortable with making the necessary succession decisions, while 14% found the topic to be difficult to deal with.

Family Conflicts in Succession Planning Include the Following:  

  • Entrepreneurs can be ambitious, energetic, compulsive, stubborn, poor at delegation, and dominating. 
  • The spouse may control the business after the death of the owner. 
  • The children may not have really struggled in a professional career, and therefore have not developed the adequate leadership and management skills and experience necessary to run the business. 
  • Sibling rivalry and competition for parental approval may exist.

The basic forms of family business structures include control held by a single owner, sibling partnerships having an acknowledged leader or shared leadership, or a cousin consortium usually of the third generation.

Three types of succession transitions were identified:

  • Recycling succession, where senior leadership is replaced without changing the basic form of the business structure. This is the most successful type of transition. 
  • Evolutionary succession, which is a conversion from single control to a sibling partnership--a team now makes decisions. When a sibling partnership converts to a cousin consortium, one must coordinate complex business decisions among a diverse group of people. 
  • Devolutionary succession where there is a transition from a complex form to a simpler form. This can occur when siblings sell shares in the business to one sibling. 

Challenges include the fact that businesses can still be controlled by their founder and be in the controlling owner form. Minority shareholders can be problematic. For sibling partnerships the issue is whether they can collaborate. Other issues include differing expectations, salaries and benefits, and business owners that do not contribute to the business. Possible solutions include:

  • Transfer the business interests equally, which could result in tension if the children cannot collaborate. 
  • Transfer business interests to the children active in the enterprise, and make equalizing transfers of other assets to inactive children. Liquidity issues can pose a problem to this approach. 
  • Transition business equity to all of the children, but with redemption provisions.

Other issues include the role of women in family businesses. Women own one third of all U.S. businesses, with 24% having a female president or CEO. Other issues include step-family, in-laws and divorce.

Summary: To develop an effective succession plan, the family should obtain a commitment from all of the family members to set aside competitive views, and collaborate. A mission statement and strategic plan for the family business should be developed, as well as a statement of core values. Further, a personal development plan for each family member who works in the business should be created and followed. A formal governance structure for the business should be developed, including a board, family forum or family council with official duties, and setting overall expectations for the business and family members. Team advisors--such as the family’s accountant, attorney, insurance agent, financial advisor and family business consultants--should be used.

7. Planning with Prenuptial Agreements  

Overview: Prenuptial agreements typically contain waivers by one of the spouses (parties) of support rights and property rights. Often, one of the parties provides consideration for the other party’s waiver. Husband and wife generally owe each other mutual obligations of support under laws of domiciles, unless they have entered into a written agreement to the contrary. The support obligation arises immediately upon marriage and is often imposed long after the marriage has terminated. Even if there is a pre-nuptial agreement waiving the light of support by one of the spouses, such a waiver will generally be disregarded if he or she is incapable of self-support and is in danger of becoming a public charge. Also, one must look to state laws when planning with prenuptial agreements. 

Interspousal transfers during marriage in satisfaction of each spouse’s support obligation will not result in income or gift taxes. Parties to a prenuptial agreement will frequently provide for spousal support payments to be made from one spouse to the other in the event of divorce or separation. The amount and duration of such payments may be fixed at the time of the agreement, or based on a formula. Such payments could be considered taxable alimony provided that the payments are made in cash, received by the spouse or former spouse, or made under a divorce or separation instrument; any agreement should be clear on tax treatment. Obligations typically end upon the earliest to occur of the death of the payor spouse, or the death or remarriage of the supported spouse.

Payments in satisfaction of a spouse’s support rights under the prenuptial agreement should be deductible by the decedent’s estate under IRC Section 2053(a)(3); however this would not apply to the extent that a claim is supported by adequate consideration in money or money’s worth. The relinquishment of support rights is treated as consideration of money for gift tax purposes. It can also result in valuation issues in the estate tax context if payments made to the transferee spouse cease upon the occurrence of a particular event after the transferor spouse’s death. Final regulations under IRC Section 2053 issued October 20, 2009 and effective for decedents dying on or after that date limit the estate deduction to amounts actually paid.

Child support payments are not income tax deductible and are not made part of a prenuptial agreement. Payments for support of minor children are not taxable gifts. Prenuptial agreements will frequently provide for one or more transfers from one spouse to the other in exchange for the recipient’s spouse’s release of certain property rights that could otherwise arise upon the divorce or the transferor’s death. This is a likely arrangement if one or both spouses have children from a previous marriage, or if there is a substantial disparity in their assets or resources. The prenuptial agreement can also provide for an immediate payout after marriage; or, the parties could consider a transfer or exchange of property prior to the marriage. Payments can be made over various intervals, and for a period of years.

Prenuptial agreements could also have a provision requiring one spouse to establish a trust for the benefit of the other. This can be setup either during or after the marriage. For income tax purposes, such income in a trust would be subject to income tax as a grantor trust under IRC Section 671. Divorce could change tax treatment of said trust.

An “estate trust” is for the benefit of the spouse that provides for payment of all trust property, principal and accumulated income, to his or her estate upon his or her death. To qualify for the marital deduction, the terms of the trust must prohibit distributions to anyone other than the transferee spouse during his or her lifetime, even if directed by the transferee spouse. It is not necessary that the transferee spouse have any right to receive distributions at any particular time.

The “general power of appointment trust” gives the transferee spouse a power of appointment exercisable in favor of himself or herself, or estate.

The general power of appointment trust is not often used in connection with prenuptial agreements because it gives the transferee spouse absolute control over the final dispositions of trust principal.

The “QTIP Trust” is similar to a general power of appointment trust, in that the QTIP trust must pay all of its income at least annually to the transferee spouse. There are differences between the two, however: 

  • The terms of a QTIP trust must prohibit anyone, including the transferee spouse, from directing payments of trust property to someone other than the transferee spouse during the spouse’s lifetime. 
  • There is no requirement that the transferee spouse be given any control over the selection of the beneficiaries to receive trust property at his or her death. 
  • In order to qualify for treatment as a QTIP trust, the transferor spouse must elect to have the trust property treated as qualified terminable interest property.

Establishing prenuptial agreements has far reaching ramifications and should be carefully drafted as part of planning.

8. Planning with QTIP Trust Assets  

Assets in QTIP trusts are great candidates for lifetime transfers since the assets will be subject to federal estate tax on the surviving spouse’s death. There are two issues to consider: 

  • The trustee has fiduciary duties to the spouse and to remainder beneficiaries. Therefore, assets are not readily available for lifetime transfers as are assets held by GRATs. 
  • It may be desirable to distribute trust assets to the surviving spouse so that he or she can engage in lifetime estate planning transactions. However, the trust instrument may not allow distributions to the surviving spouse, or there could be other restrictions. While an alternative may be to make sales to family members and freeze partnerships, the IRC Section 2519 rules come into play. 

Under IRC Section 2056(b)(7), an estate marital tax deduction is allowed for “qualified terminable interest property” provided that the following requirements are met: 

  • The property is includible in the decedent’s gross estate and passes from the decedent to or for the benefit of the decedent’s surviving spouse. 
  • The surviving spouse must be entitled to receive a qualifying income interest in the property for his or her life. 
  • No person has a power to appoint any part of the property to anyone other than the surviving spouse. 
  • The executor of the decedent’s estate must elect to treat the property as QTIP property in the decedent’s estate tax return.

A typical QTIP trust instrument requires payment of all trust income to the surviving spouse at least annually. The spouse’s use of income distributed from a QTIP trust for gift tax planning purposes should not implicate IRC Section 2519. However, distributions for use by his or her issue or for gifts could have gift tax implications.

If a spouse can withdraw the principal of a QTIP trust, he or she can use such withdrawn assets for gift planning. A spouse’s power to do this is contemplated in Regulations Section 20.2056(b)-7(d)(6). If the surviving spouse is legally bound to transfer the distributed property to another person without full and adequate consideration in money or money’s worth, the requirement of IRC Section 2056(b)(7)(B)(ii)(II) is not satisfied. Therefore, a trust instrument that is intended to qualify for QTIP treatment cannot require that property be withdrawn by or distributed to the surviving spouse, to then be used by the surviving spouse to make a gift.

If the QTIP trust instrument does not permit principal distributions, or the trustee refuses to make principal distributions to the spouse to allow him or her to make gifts, the spouse has other options. If the spouse can transfer or release his or her qualifying income interest in a QTIP trust, the spouse may be able to effectively trigger a gift of some or all of the QTIP trust assets without the trustee having to make a distribution to the spouse. Under IRC Section 2519, if the spouse disposes of his or her income interest, he or she is deemed to have disposed of all interests in that property other than the qualifying income interest.

If he or she makes a gift or releases the qualifying income interest, then the gift is taxable under IRC Section 2511. Also, under IRC Section 2519, the spouse will be deemed to have disposed of all other interests in that property. This is a net gift, as long as there is no waiver of his or her right to reimbursement from the donees of the gift taxes triggered by IRC Section 2519. 

To trigger IRC Section 2519, the spouse only needs to release or transfer his or her income interest in the property for which the QTIP election was made. He or she can do this as long as the trust instrument does not have a spendthrift clause. This could be beneficial in 2010 since the gift tax rate is currently only at 35%. If there is a spendthrift clause, one may be able to disclaim the income interest under state law, under IRC Section 2518 (nonqualified disclaimer). One may have to look at the time frame to reasonably disclaim. There is also an issue of prior acceptance. A solution might be to enter into a transaction with the remainder beneficiaries such as a sale of the income interest, purchase of a remainder interest or commutation of a marital trust in a way to do a taxable gift under IRC Section 2519. Treasury Regulations Section 25.2519-1(a) provides a harsh result for a spouse when he or she partially disposes of an income interest in a QTIP trust.

Therefore, the donee spouse is treated as making a gift under IRC Section 2519 of the entire trust less the qualifying income interest and is treated as having transferred the entire trust corpus from which the retained income interest is payable. There is a solution: obtain an IRS ruling to split the QTIP into two trusts and gift from one and keep the other intact.

Freeze transactions: Consider a sale of QTIP trust property to family members, in exchange for a note of equivalent value, where the transaction involves a deferred repayment schedule with a fixed return. Another possible technique is to make a loan of cash held in the trust, to a family member; the trustee can sell QTIP trust assets to family members or trusts for their benefit. The trustee could form a preferred partnership with other family members or family trusts. With any of these potential solutions, be aware of a potential taxable gain on the disposition of the subject property sold.

Issues: The IRS may assert IRC Section 2519 treatment. If the spouse disposes of an income interest in some of the assets in the QTIP trust, he or she will be deemed to dispose of all of the assets of the trust under IRC Section 2519(a). This may result if in a sale or freeze, the value is less than the fair market value. Also, there may be income tax issues on the sale of assets.

The conversion of one QTIP property for another (sale within the trust and then a reinvest) is not a disposition. In general, for federal estate tax purposes, QTIP trust assets includible in a surviving spouse’s gross estate under IRC Section 2044 are not aggregated with other assets includible in the surviving spouse’s estate. Thus, planning considerations exist with respect to converting property interests held by a QTIP trust to fractional or minority interests prior to the surviving spouse’s death.

9. Crummey Powers  

A typical gift to an irrevocable trust is a gift of a future interest that is not eligible for the annual gift tax annual exclusion. A Crummey power grants short term demand power (lapsed at the end of the year of the gift) over annual gifts to a trust up to the annual exclusion amount.

The IRS requires a notice of the power and a notice of a gift be conveyed to a beneficiary. A written notice to a beneficiary is better than his or her actual knowledge of the withdrawal right, and language in the documents should leave the option for oral notice open.

The power of withdrawal should begin with the date of the transfer by the donor. A power withdrawal commencing after the donor’s transfer date (i.e., the date of subsequent notice) might create a future interest at the initial date of transfer and until the later date, thus resulting in no gift. The beneficiary must have a reasonable opportunity after notice to exercise his/her demand before it lapses. Typically, 30 days notice is reasonable, with the usually range anywhere from 30-90 days. The lapse date should run from the date of the gift and not the notice date. Further, the notice of future gifts cannot be waived by the beneficiary and still qualify for the gift tax annual exclusion. The beneficiary must have substantial economic interest in the trust (lifetime interest or vested interest). The Estate of Cristofani v. Commissioner, 97 T.C. 74 (1991), provided that this is not applicable even for remote contingent beneficiaries. The IRS has acquiesced this case, but later technical advice memorandums were more aggressive on prearranged understandings not to exercise.

In Estate of Kohlsaat v. Commissioner, 73 T.C.M. 2732 (1997), the court disagreed with the IRS, stating that the fact that none of the beneficiaries exercised their withdrawal powers does not imply that the beneficiaries had agreed not to do so, and the court refused to infer such an understanding.

The court noted that the evidence did not establish an understanding that the contingent beneficiaries would not exercise their rights, and in fact, several credible reasons were offered by the trust beneficiaries as to why they did not exercise the rights. The Estate of Holland v. Commissioner, 73 T.C.M. 3236 (1997) also supported the taxpayer. In Estate of Trotter v. Commissioner, T.C. Memo 2001-250 (2001), “paper rights” were asserted where no one was expected to exercise the power and thus the power had no economic substance.

Gift tax consequences for the power holder: Should the withdrawal power for each beneficiary be limited by the 5 + 5 exception? There is no gift tax if there is a lapse of the Crummey power. The beneficiary should acknowledge receipt but not waive the withdrawal power. The IRS has stated that there is only one 5 + 5 exception each year for each beneficiary who lets his or her Crummey withdrawal powers lapse, even if it is set up by unrelated people (Revenue Ruling 85-88). 

The dilemma for the grantor of an irrevocable trust is whether to shelter the full $13,000 (in 2010) of annual gifts, or limit the shelter to the 5 + 5 exception to protect the beneficiary. There are several solutions for this dilemma:

  • Use of the “special power solution,” where the beneficiary’s gift tax exposure can be eliminated by giving him or her a special power of appointment over his or her trust property.

This solution would work if the trust only had one beneficiary with a withdrawal power, but would be very hard to draft if there are multiple beneficiaries with withdrawal powers in a single trust; in such a case, separate trusts or separate shares within a single trust may be necessary. However, separate trusts could cause administrative problems and lack of equality for after-born children beneficiaries. 

  • Use of a “general power solution” where gift tax is eliminated by giving him/her a general power of appointment, or by making the beneficiary’s estate the ultimate trust beneficiary. 
  • The “hanging power solution” may be the best approach since only the amount of the withdrawal power up to the 5 + 5 exception lapses in any one year, and the excess carries over to the next year.

The carryover power will lapse in subsequent years to the extent gifts in those years are less than the 5 + 5 exception. This is useful when a single trust has multiple power holders, and the 5% portion of the 5 + 5 exception will be measured against all trust assets and not just a separate share for each powerholder beneficiary.

Issues Impacting Irrevocable Life Insurance Trusts (“ILIT”): Is the annual gift tax exclusion available if the only asset in the ILIT is the policy? The solution might be to funnel the premium payments through the trust, where the donor makes a gift to the trustee and the trustee holds the money until the lapse of the withdrawal power after notice is given to beneficiaries; the trustee then pays the premium. Another solution might be to have a power to withdraw the insurance policy, which will allow the annual exclusion to apply. A third solution is to simply have a cash side fund or liquid seed.

Estate Tax Issues: If a beneficiary should die while possessing a Crummey withdrawal right which has not lapsed, the property subject to the withdrawal right will be includible in his or her gross estate as a general power of appointment.

The risk of possessing a general power of appointment at the date of death is reduced by limiting the Crummey withdrawal power to a specific period of time, since the direct inclusion would only occur if the beneficiary died within that period of time. 

An unlapsed hanging power at the date of the beneficiary’s death would also be included in his estate.

Further, any property which was subject to a general power of appointment which was released or allowed to lapse by the possessor of the power will be includible in the possessor’s estate, or if the transfer of such property will be includible in the possessor’s estate under IRC Sections 2035 to 2038, or if the property had been owned by the possessor before the transfer to the trust. Thus, the annual lapse of the Crummey withdrawals will be subject the property covered by the powers to inclusion in the beneficiary’s estate.

If the Crummey power for each beneficiary is limited to the greater of $5,000 or 5% of the value of the trust property subject to the power, the lapse of the power will result in no inclusion in the beneficiary’s estate, under IRC Section 2041(b)(2).


This Outline cites many topics discussed at the 2010 Heckerling Institute. This Outline was edited by Timothy P. Speiss MST CPA PFS, 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 xpress permission of the University of Miami School of Law Heckerling Institute on Estate Planning and EisnerAmper LLP. 

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