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2012 Federal Trust and Estate Planning Opportunities - Comments from the 46th Annual Philip E. Heckerling Institute on Estate Planning - Part 2

Apr 2, 2012
  1. Portability: The New Estate Planning Wonder Drug?
  2. IRA Distribution and Rollovers
  3. Powers of Appointment and Decanting
  4. The Last Picture Show: What should be done with the Artwork
  5. Techniques and Troubles of Giving Away the Family Home


The 46th Annual Heckerling Institute (“Institute”) on Estate Planning was held in January 2012 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. The information in this Outline cannot be reproduced or copied in any form without the express permission of the Heckerling Institute on Estate Planning at or via telephone at 305.284.4762. Further, this Summary should not be reproduced in any form without the express permission of EisnerAmper. Part I was released on March 26, 2012. This issue focuses on Part II, Review of Selected Vehicles for 2012 Implementation.

Any tax advice in this communication is not intended or written by EisnerAmper t 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 is not rendering any specific advice to the reader.

This Summary should not be reproduced in any form without the express permission of EisnerAmper.

PART II: Review of Selected Planning Vehicles for 2012 Implementation

 1. Portability:  The New Estate Planning Wonder Drug?

The “portability” of estate tax exemptions is about simplifying estate planning for married couples. Many estate tax advisors view estate planning for a married couple as a two-pronged problem.  First, without portability, to use the applicable estate exclusion amount of the first spouse to die, property must be set aside (using the decedent’s estate tax exemption ($5.12 million in 2012)) so that the property it not subject to estate tax; this won’t happen if all of the decedent’s property is instead left to the surviving spouse.  Second, the couple’s property must be titled between them so that both of their exclusions can be used, regardless of who dies first.   Since the advent of the unified transfer tax system and the unlimited marital deduction, typical estate planning for married persons has involved creating a credit shelter trust upon the death of the first spouse, and titling property appropriately between the spouses so that the exclusion amount can be used regardless of which spouse dies first.

The Institute speaker said that in his experience, the use of credit shelter trusts is not a major issue to a husband and wife; they generally accept the benefits of credit shelter trusts quite readily once it is explained to them.  The problem more often than not is that clients are reluctant to retitle assets to accommodate use of the exclusion. Happily married couples typically want to own their assets jointly.  Not so happily married couples don’t want to share or retitle their assets.  Also, it may be administratively inconvenient for couples to retitle assets. Not wanting to retitle assets is the most common reason that a married couple’s exclusion amounts are not fully utilized. Portability provides an option for those situations where clients are resistant to retitling assets, or simply don’t get it done, and the estate exclusion remains unused.   

IRC Sec. 2010(c)(2) creates the concept of portability by creating two components to the applicable exclusion amount:  the sum of the basic exclusion amount and, in the case of a surviving spouse, the deceased spousal unused exclusion amount (“DSUEA”).  This means that when a spouse dies and does not fully utilize his or her estate tax exclusion, that unused exclusion is now available to the surviving spouse, and is not wasted. 

Portability exists for gift tax as well as estate tax purposes, which means that DSUEA can be used for lifetime gifts.   However, because there is no portability for generation-skipping transfer tax (GST) purposes, the surviving spouse cannot use the deceased spouse’s unused GST exemption.

Once passed on to the surviving spouse, the DSUEA is not eligible for inflation adjustment.  The Institute speaker believes that the key limitation on portability is the fact that the surviving spouse can only use the unused exclusion of his or her last deceased spouse, regardless of whether the last deceased spouse has any unused exclusion, or the portability election was made by the executor of the last deceased spouse.  The Institute speaker said that Congress didn’t want surviving spouses to be able to accumulate DSUEAs from multiple predeceased spouses. 

To take advantage of portability, the executor of the deceased spouse must timely file a federal estate tax return (Form 706) and elect to make the deceased spouse’s unused exclusion portable.   This election is irrevocable, and Notice 2011-82 provides some guidance on how to make the election.  The Notice indicates there will be no “check the box” election although there has been a lot of discussion about whether the Treasury will offer a simplified Form 706.  If the portability election is made, there is no statute of limitations for examining the predeceased spouse’s Form 706 for purposes of determining if the DSUEA is accurate; however, the normal statute of limitations applies for all other purposes. 

There are matters that need clarification with respect to portability. One issue is the need to clarify whether a surviving spouse who remarries can pass his or her unused exclusion amount, including any portion of it that is DSUEA, to the surviving spouse of the remarriage.   An example in the JCT Technical Explanation supports this position, but the statutory language does not; it provides that only the surviving spouse’s unused exclusion amount is portable.  This is important because if DSUEA cannot be passed on, advisors and clients need to know whether DSUEA is deemed used before or after the surviving spouse’s own exclusion when making lifetime gifts.  If DSUEA is not portable and is deemed to be used first, the surviving spouse can make tax-free gifts using DSUEA to avoid losing it upon remarriage if she predeceases the second spouse.  However, if DSUEA is deemed used only after the surviving spouse’s own exclusion, the surviving spouse will have to use both her own exclusion and DSUEA to make lifetime gifts to ensure DSUEA isn’t lost. The Institute speaker said that all commentary submitted by the ABA and ACTEC to the IRS has suggested that the surviving spouse be allowed to use the DSUEA first if this is an issue.

The Institute speaker pointed out some additional unanswered questions that involve the recapture of DSUEA.  If the surviving spouse uses DSUEA to make gifts, will that DSUEA be recaptured if the surviving spouse remarries and the new spouse dies first with less DSUEA than what the surviving spouse has already used?   If this is the case, estate tax presumably will be payable on gifts in excess of the second spouse’s DSUEA when the surviving spouse dies.  If the applicable exclusion amount is reduced from $5 million to $1 million after 2012, but portability is preserved, it is likely that the surviving spouse’s DSUEA will also be reduced.  And if the surviving spouse made gifts using the higher DSUEA, will the excess amount be taxable when the surviving spouse dies?

The Institute speaker advised that portability should not be used as the primary means to preserve the predeceased spouse’s exclusion amount.  This is because if portability sunsets at the end of 2012 as currently scheduled, it disappears, along with any accumulated DSUEA.   However, this doesn’t mean portability should be ignored.   In larger estates, where there is unused exclusion upon the first spouse’s death, portability should be elected.  In smaller estates, where the combined estate of both spouses is well below the threshold for paying federal estate tax, consideration needs to be given to whether it is worth filing a Form 706 to make the portability election if no practical short form return is available.  

The Institute speaker did not view portability as a substitute for credit shelter planning, and emphasized the superiority of credit shelter trust planning, except perhaps in the case of clients whose assets largely consist of retirement assets.  The Institute speaker favored credit shelter trusts for a variety of reasons. First, DSUEA is not indexed for inflation, whereas a credit shelter trust creates the opportunity for sheltered growth, potentially over many years.  Second, the predeceased spouse’s GST Exemption is not portable, but the GST exemption can be used by the credit shelter trust.  Third, upon remarriage, DSUEA could be lost if the second spouse predeceases with less DSUEA.  By contrast, credit shelter trusts are not affected by the surviving spouse’s remarriage; and the surviving spouse can accumulate multiple credit shelter trusts (from future spouses) if she remarries multiple times.  Fourth, credit shelter trusts provide creditor protection benefits.  Fifth, credit shelter trusts can be used to avoid potential audit issues. The Institute speaker said that he has used credit shelter trusts to remove assets from the estate tax system sooner rather than later, for instance, because of concerns about valuation issues.  It is a lot easier to transfer those assets to a credit shelter trust on the death of the first spouse, when no estate tax is payable and  the  IRS is less likely to audit the estate, than on the second spouse’s death when estate tax is payable.

The Institute speaker said the primary advantage of portability is simplicity.  This is attractive for smaller estates.  Another advantage is basis step-up.  With a credit shelter trust, trust assets are protected from estate tax but there is no basis step-up at the surviving spouse’s death.  With portability, assets can be protected from estate tax by DSUEA and receive a step-up in basis at the survivor’s death.  The Institute speaker said that he thought this was an overstated benefit.  If the predeceased spouse’s assets appreciate significantly, it is true that the unrealized gain will be sheltered from income tax by the step-up on the second spouse’s death; this appreciation, however, may generate estate tax on the second spouse’s death because there may not be enough exclusion to cover it.  Furthermore, if a portfolio of securities is used to fund the credit shelter trust and those assets are actively traded so that there is turn-over in the account, as opposed to a “buy and hold” strategy, there may not be that much built-in appreciation at the surviving spouse’s death. Finally, if clients reside in a state with a state estate tax, there is no portability of the state estate exclusion, and unnecessary state estate tax may be triggered at the surviving spouse’s death if a credit shelter trust is not used at the first spouse’s death. 

Observation: On February 17, 2012, the IRS released Notice 2012-21, which grants executors of certain estates, who didn’t timely apply for an automatic extension of time to file a federal estate tax return, a 6-month filing extension for purposes of electing portability. 

To be eligible for this extension, an estate must satisfy the following three requirements: 

  1. The decedent was survived by a spouse, 
  2. The decedent died after December 31, 2010, and before July 1, 2011, and  
  3. The decedent’s gross estate did not exceed $5 million. 

This notice is intended to help executors of decedents who died during the first half of 2011 and whose estates were under the $5 million estate tax filing threshold.   These executors may not have known that it was necessary to file an estate tax return to make the portability election, and therefore did not timely file for an automatic 6-month filing extension. 

An executor who wants to take advantage of this Notice must file the application for a 6-month extension to file (Form 4768) no later than 15 months after the decedent’s death (i.e.,  the extended due date for the estate tax return).   The Form 4768 can even be filed at the same time as the estate tax return as long as both are filed within 15 months of the decedent’s death.  The executor should include the following notation at the top of Form 4768:  “Notice 2012-21, Extension for Good Cause Shown” or otherwise notify the IRS on or with the Form 4768 that it is being filed pursuant to this Notice.  In addition, if prior to the issuance of this Notice, an executor of a qualifying estate filed an estate tax return after the 9-month due date, but within 15 months of the decedent’s death, without having requested an extension, the executor may file Form 4768 in accordance with this Notice, and the extension will be granted retroactively.

 2. IRA Distributions and Rollovers: Integrating With Estate Planning

There is added importance to integrating income and estate tax in planning for retirement plans.  Too often the topics are addressed independently, whereby the advice may be to maximize retirement plan (IRAs and other retirement vehicles) contributions and balances in order to minimize income tax.  However, owners of IRAs and other retirement plans cannot gift retirement assets. Upon the death of the IRA owner, there is no step up in the basis of IRA assets, and pre-tax distributions to IRA beneficiaries are fully taxable.  Because of the difference in income tax and transfer tax ramifications regarding IRAs, an integrated approach is needed, in order to minimize total tax liabilities and maximize the IRA balances transferred to beneficiaries,  especially considering the fact that in an AXA study, 87% of children liquidate IRAs within one year of their parent’s death. Clearly tax efficient liquidation of IRA balances should be one of the primary objectives of IRA owners and beneficiaries. 

As cited earlier, portability for married couples solves an income tax problem and provides more flexibility regarding retirement asset planning.  Although the use of portability may or may not be recommended, there could be some benefits derived from it usage.  Integrating estate tax considerations with retirement asset planning and portability should be carefully evaluated   currently and through December 31, 2012 due to the uncertainty of whether portability will continue into 2013 and future years.

A. Portability Considerations and IRA Distributions

  1. In common law states portability is a significant development, as the technique has more impact compared to utilization in community property states.


    • Husband is a physician with $10 million estate; his wife has no assets. If his Wife dies first, there is an estate tax problem if the Wife’s estate tax  exemption is not utilized; all of the husband’s assets are subject to estate tax. Portability solves this problem, since the Wife’s unused exemption amount will be portable to the Husband, even though she had no assets.  If the Husband dies first there is no necessity to utilize a trust as a beneficiary of the retirement assets.
    • An understanding of some of the IRA distribution rules, and rules governing the transfer of IRA assets following death, are necessary in order to properly minimize total income and transfer tax liabilities. A primary question to be addressed is when distributions have to be made.
      • Generally, when you retire distributions have to begin. Congress defined the date when IRA retirement distributions must commence as April 1 following the year the IRA owner attains age 70½ years of age (“the Required Beginning Date” (RBD)).
        • If the IRA owner does not commence IRA distributions by the  RBD, the IRS can invoke penalties attributable to a late IRA distribution; generally the penalty is 50% of the required distribution amount. However, where a retirement plan  participant continues to work for company (plan sponsor) and does not own 5% or more of the company, a participant can defer plan distributions beyond the RBD.
      • After death, an IRA owner has to liquidate the IRA since it is no longer a “retirement” account.
      • There is a uniform life expectancy table cited in the IRC regulations that is applied to the retirement account balance, based on the age of the IRA owner, in order to determine the amount of an IRA balance that must be distributed (as a minimum amount) annually (to an IRA owner).
        • There is an exception to the above minimum distribution rules  if the IRA owner’s spouse is 10 years younger (than the IRA owner).
  2. If an IRA participant is in his 70s, the annual minimum distribution amount ranges from 3% to 5% of the IRA balance.  These distribution percentage rates are fairly reasonable, and if the plan is earning an average 7% total return (yield and appreciation) on IRA investments, the participant would fail to invade principal of the retirement account until their 80s.
  3. Upon the IRA owner’s death, a planning technique that can be utilized is a stretch IRA, which allows an IRA beneficiary to distribute IRA balance over their life expectancy. The determination of life expectancy means that half of the beneficiaries will die before their life expectancy age, and half will die after their life expectancy age.  As a typical life expectancy is the mid-80s,   the objective is to stretch IRA distributions to this life expectancy.

B. IRA Distribution Requirements upon the Death of an IRA Owner

  1. In this circumstance, does the IRA beneficiary qualify to take distributions over his or her life expectancy?
  2. Designated Beneficiary (“DB”) is a term for a real person.  If the beneficiaries are a daughter and a charity, there are two beneficiaries, but the charity is not a DB.


    An individual died on January 12, 2012. The DB testing date is the “determination date” of September 30, 2013; i.e., September 30 of the year after the year of death. Therefore, the estate has 2012 and nine months of 2013 (the next year) to eliminate a “problem” beneficiary, such as the charity who is not a DB.

    Three approaches are possible when desiring to eliminate a beneficiary who is not a DB:

    • The non-DB (i.e., the charity) can disclaim.
    • Cash out the non-DB, i.e., a charity.  The charity can be paid out so that all remaining beneficiaries are natural persons, or DBs. 
    • Separate the IRA into sub-accounts.  This is useful if there is a wide age disparity between beneficiaries.
      • Distributions following the account owner’s death are based upon the DB’s age at September 30 of the year following the year of the IRA owner’s death.
  3. The surviving spouse can elect a rollover. There are times when this is not advisable; such as when the surviving spouse is a young spouse, and has to wait to attain his or her IRA distribution date (age 59½); however, in this instance if maximizing an IRA balance and deferring IRA distributions is an objective, this circumstance may be favorable.


    • If the participant, or a surviving spouse who rolls over the IRA, takes a distribution from the IRA at age 49 he or she would pay a penalty attributable to a premature distribution.  If surviving spouse rolls over the late spouse’s IRA and the surviving spouse is under age 59½, it may make sense to leave enough money in the decedent’s account to cover the surviving spouse’s financial needs until age 59½ so to avoid the penalty attributable to a premature IRA distribution,  since distributions after death from the participant’s account fails to incur a penalty.
    • If the surviving spouse is the only beneficiary of decedent’s account he or she can recalculate required distribution amounts based on their life expectancy, and the IRA potentially may never be fully exhausted.
    • For IRAs only, there is a special provision for surviving spouses.
  4. Trust as IRA beneficiary

In this instance, to apply appropriate IRA distribution rules, the nature and ages of trust beneficiaries must be considered; this is referred to as the “Look Through” method.

  • The IRA administrator must receive a copy of the trust instrument or certification as to who the beneficiaries are.
  • For ERISA purposes, there are two types of trusts, an accumulation trust or a conduit trust, with the latter being the most popular.  In a conduit trust the money that leaves the retirement account cannot accumulate, it merely flows through to the beneficiary.
  • A Charitable Remainder Trust (“CRT”) can also be used as a third type of trust to serve as a beneficiary of a retirement account.  A CRT is a tax exempt trust, and it can receive the distribution from the retirement plan.  The CRT’s current beneficiary (for example a surviving spouse) receives a stream of payments for life, and at death the remainder goes to charity.  A two-generation CRT can be constructed for an older surviving spouse as another attractive technique; in this instance, instead of stretching the IRA (assume a balance of $100,000) over life expectancy of the natural person beneficiary (a spouse), the IRA balance can be distributed to a CRT with a 5% payout percentage.  The CRT will pay 5% to the surviving spouse for her life, and then on her death it will pay 5% to the children for their lives, and finally it will be distributed to charity.  The concept is to remove the money from the ERISA paradigm and into the charitable trust paradigm. 

C. Planning Concepts

  1. A spouse establishes a rollover IRA.  She  can take out distributions, which will be in the range of 3% to 5% annually. Upon her death her children can take the remaining IRA assets over their life expectancies.  If the IRA goes to a bypass trust, is the trust structured as an accumulation trust or as a conduit trust?  If it is an accumulation trust, then the trust balance must be liquidated  over the surviving spouse’s life.  With a conduit trust you have a longer period to distribute assets.
  2. As stated above, a CRT can pay an annuity to a surviving spouse for her actual life.  At her death, the annuity is paid to the children over their actual lives.  Care must be taken so that the rules regarding the amounts that are required to go to charity are met.
    • Consider that 57% of decedents die after age 80 and 19% die after age 90.
  3. A CRT can be useful in conjunction with a retirement plan, when the objective is to ultimately benefit the children from a prior marriage. The CRT is tax exempt and can provide a solution for an estate that is top heavy with retirement assets. For the investment adviser, it is easier to manage the standard CRT 5% fixed payout, in contrast to the increasing and high IRA payouts noted above. Alternatively, the 5% CRT payout can result in significant assets being paid to the children if that is a planning objective.

 3. Powers of Appointment and Decanting

This area is intriguing and in a state of flux due to taxpayers wanting to (i) have control over the disposition of assets, and (ii) work around the irrevocable provisions in a trust document; these objectives are sought because of changes in family circumstances. In this regard, a Power of Appointment is very important.

A. Definitions

The traditional meaning of a Power of Appointment (POA) is the ability to designate recipients of property.

For over 60 years, the American Law Institute has addressed POA matters under the Powers of Appointment Act (as revised by the National Conference of Commissioners on Uniform State Laws). The POA Division under the POA Act includes Sections 17. 1 to 23.1. Sec. 17.1 initially  changed the traditional position that a power held in a fiduciary capacity was not a POA. This was changed after the tentative draft to provide that a power held in a fiduciary capacity is a Power. A fiduciary cannot exercise (or fail to exercise) a Power arbitrarily.  In the history of English law, powers of appointment were primarily the outgrowth of efforts to circumvent the rule that many of the most important types of interests in land could not be devised. Despite this rule, which was not firmly abrogated until the second half of the 17th century, it became possible for an owner to achieve the practical equivalent of a devise by granting the property in the owner’s lifetime to be appointed by the owner’s will. The exercise of the power was effective, although a devise would have been void. In modern times, the use of powers of appointment is not to circumvent any rule of law, but to serve worthy family and tax purposes. Powers of appointment are used routinely in modern estate-planning practice. They are created in trusts to build flexibility into the estate plan and to achieve or avoid certain tax consequences. In its initial draft, the Restatement took the position that if a person held a POA in a fiduciary capacity, it was not treated as a POA. This was changed after the tentative draft to provide that a power held in a fiduciary capacity is a Power. 

In current practice, a Will document must manifest an intention to create a POA. There are no “magic” words to create a Power of Appointment or the need to specifically use the words “Power of Appointment” to create a power.  However, it is advisable to create the Power using the phrase “Power of Appointment” so that it is clear that what is being created is in fact a Power of Appointment.   

  1. Powers of Appointment, although they may have significant tax implications, are governed by state law.
  2. A Power of Appointment in general is not transferable and there is a view that a Power does not constitute an interest in the property that is the subject of the Power.  However, see IRC Sec. 2523(b)(2), which may create a gift tax issue regarding a POA.
  3. How the Power can be exercised is governed by state law.  The types of Powers, and matters relating to them, are controlled by state law, but which state law will govern?  Is it the law of the state where the person holding the Power resides, or the state where the person resided who created the power?
    • Where (a state jurisdiction) the Will is admitted to probate might impact the right and manner of exercise of the Power granted under that Will.
    • Which state law do you look to regarding probate ?  You can designate  in the instrument and create (define) the Power itself, and which state law governs.
  4. Tax effects of Powers of Appointment
    • Although not a property right, there can be income, gift and estate tax consequences.
    • The Supreme Court had ruled that a presently exercisable general Power was not to be included in the estate; therefore, in order to be able to tax the Power holder, IRC Sections 2041 and 2514 had to be enacted.

The discussions at Heckerling outlined the types of Powers and whether they were imperative (whether one had to be exercised, or one that does not have to be exercised); whether they are exclusive of beneficiaries or nonexclusive, whereby upon exercise, the assets must go to all of the beneficiaries.  The speaker mentioned the nuances between presently exercisable compared to postponed Powers, and importantly for tax purposes, the discussion concerned the difference between general vs. non-general Powers of Appointment.

  • The general and non-general or limited Power of Appointment came from common law notion of what is a “general Power of Appointment.”
  • The Supreme Court has said property subject to a presently exercisable general Power is not a property interest.  This was the common law for hundreds of years.  Congress adopted the common law definition of a general Power that is exercisable in favor of a person, his estate, creditors, or creditors of his estate.
  • Limited Power is also called “Special Power.”
  • A Power of Appointment as a matter of law in many states, may be “general” unless you can demonstrate that it is not.  To avoid a Power being a general Power, consider a state such as Maryland, which has a presumption that a Power is not a general Power unless language is construed to make it a general Power. Alternatively, language must be precise in an instrument so that a provision plainly states a POA is not a general Power.
  • Questions that arise about general and limited Powers include (i) how would a Power exercisable upon the donee’s death, in favor of donor’s descendants, be characterized, (ii) can one appoint oneself as holding a Power, (iii) if one, as the Power holder, is included in the permissible class, will that automatically make the power in question a general Power?

In PLR 2002210018, intent was only to give the property to descendants then living.  It was held to be a non-general Power of Appointment.

  • Exercise caution to be sure that the Power is not exercisable in favor of the donee/holder.  One approach is to cite in an instrument that on death the Power is exercisable only for any living descendant, so a decedent cannot exercise; however, this would exclude future born children and grandchildren if the exercise could only be in favor of “living descendants.”  An alternative would be to provide a power to  descendants, but not to the (i) Power holder, (ii) Power holder’s estate, (iii) Power holder’s creditors, or (iv) creditors of the Power holder’s estate.  An instrument should explicitly state that the Power is a limited or special Power, so to overcome the presumption that a Power is, as a general matter of many state’s laws, assumed to be a general Power.

B. The “Relation-back” doctrine needs to be understood. 

The speaker made the following points and queries.

  1. When the Power holder exercises a Power they are acting in a role as an agent of the person creating the Power.  It is akin to being made the agent.
  2. This can have important administrative and jurisdictional impact. For instance, what if father creates a Power and gives son Power of Appointment in son’s Will to specify who obtains the property via a special Power (e.g., among descendants then living).  Many issues arise as to how the son exercises the Power.  Has son violated the rule against perpetuities by the manner in which he exercised the Power?  Which court has jurisdiction -- the father’s jurisdiction or the jurisdiction where the son resides and dies and where the son’s Will is admitted to probate (son says in his Will to exercise Power to his descendants)? Which surrogate’s court is going to determine matters concerning a trust the son created by exercise of the Power of Appointment under the son’s Will that was granted under the father’s Will?  By the relation-back doctrine, it will be the father’s Will in most jurisdictions, unless state law has changed (e.g., New York changed this law about 25 years ago), or unless the governing instrument (father’s Will) provides otherwise.
  3. A planning alternative is to specify in the instrument which court will govern.
  4. Self v. United States (135 CL Ct 371 (1956)). A special Power was exercisable at any time in favor of the children.  Holder exercised Power for children, however the IRS argued that by exercising the Power during lifetime for children, there was a gift when father/holder gave 25% of the trust corpus, because father/holder lost 25% of his income interest. The Court disagreed, and held that the Power holder was merely an agent for the donor so that there was no gift. See also Estate of Regester v. CIR, 83 TC 1 (1984); the Court held that if a holder exercises a special Power of Appointment during his or her lifetime, it is a gift if it reduces your income interest.

C. Decanting

Decanting is the Power to transfer assets held by a trust, to a different trust that the grantor, or someone else (even the fiduciary) creates for one or more beneficiaries of the trust.  The power to decant is a Power of Appointment.  The restatement 17.1 provides that decanting will be considered a Power of Appointment.  Decanting Powers are a Power that the trustee can exercise.  If the fiduciary can invade principal, then the trustee may be able to decant.  Decanting can be used to address changes in law.  If the governing instrument allows the trustee to pay property over to another “new” trust, this Power may be able to cure issues or inadequacies within the existing or “old” trust.

A pivotal case is  Phipps v. Palm Beach Trust Co., 142 Fla. 782, 196 So. 299 (1940). As a matter of Florida common law, a decanting transfer can be done.  However, there is some suggestion that this has been the law throughout the entire U.S.

In Weidenmayer v. Johnson, 106 N.J. Super. 161 (App. Div. 1968) the New Jersey Courts permitted indirect decanting, which treated giving funds to a beneficiary as equivalent to a transfer in further trust.  The New Jersey Court held that it did not matter whether or not the decanting was benefiting the beneficiary financially, because they were benefiting the beneficiary emotionally.  The beneficiary wanted to provide for his wife; achieving this goal sufficed even without financial improvement to the beneficiary. In 1992 the New York decanting statute was enacted.  The legislature stated that with the enactment of the statute, it was confirming already existing common law.

Tax effects of decanting:

  • The law is presently unclear. The problem with decanting is the IRS believes that there are substantial income and gift tax issues that have failed to be addressed.
  • The consequences of exercising a special Power of Appointment may provide a paradigm.
  • IRA Notice 2011-101 states the IRS requests advice on 13 selected decanting issues.  Generally these relate to the elimination or creation of an interest for a beneficiary, or if the duration of a trust has changed. What are the tax effects of these?  ACTEC has prepared a white paper for this.
  • There may be an income tax where the property is sold or exchanged for another asset. See the Cottage Savings case.
  • There can be gift tax consequences as well.
  • Decanting may raise Generation Skipping Tax grandfathering issues.  If a trustee holds the Power pursuant to a decanting statute, the Power to decant had to be present in the governing law when the trust was established.  If the statute was created after the trust was created, then there is no grandfathering.  The issue is whether common law permitted decanting prior to creation of trust?

 4. The Last Picture Show: What should be done with the Artwork?


In this Heckerling session, the speaker observed that gifts of artwork to noncharitable beneficiaries are generally not effective transfers where optimal transfer tax minimization is desired.  Further, there are issues in connection with how to best gift the artwork among various beneficiaries, transfers using partnerships and trusts, the costs associated with obtaining a qualified appraisal, and the filing gift and estate tax returns and disclosure considerations. Also, noncharitable beneficiaries may not want the artwork, and may be inclined to sell it and split the proceeds amongst themselves. The federal tax rate on the sale of artwork, generally computed on the difference between the proceeds and the donor’s cost basis, is 28 percent (in addition to state tax liabilities); and of course federal gift tax can apply on transfers by donors during lifetime.

On the other hand, the lifetime transfer of artwork to domestic charitable organizations that display and make use of the artwork in furtherance of an exempt purpose will save the individual donor income taxes because of the allowable charitable income and estate tax deduction. Therefore, properly structuring the transfer as a charitable conveyance will yield favorable tax results to the donor; however, if the contribution is not made correctly, no charitable contribution tax deduction is allowed. Contributions to foreign exempt organizations will not yield any tax benefits to a donor.

A testamentary transfer of artwork to domestic charitable organizations will save the decedent’s estate a meaningful amount of estate taxes (depending upon the value of the artwork)  since the full fair market value of the artwork at the decedent’s date of death is an allowable estate tax deduction. A testamentary transfer can be especially beneficial, since the transfer would relieve the estate of raising cash necessary to pay the estate tax on at least a portion (estate assets not comprised of artwork) of the estate’s net assets.

A. How to Complete an Intervivos Charitable Transfer

Before making a lifetime donation of the artwork to the charity, the donor must consider and  determine:

  • The status of the charitable organization. Charitable organizations can be either public or private. Public charities generally receive part of their support from the general public; these include churches, schools, museums, and other publicly supported organizations, private operating foundations, and private foundations that distribute all of their receipts each year; private charities are typically private nonoperating foundations. It is important to verify the status of the charity; this can be achieved by requesting a copy of the IRS Determination Letter from the charity, confirming the charity’s inclusion in the IRS Publication 78 Cumulative List of Exempt Organizations, or obtaining verification letters from the IRS. If a donor makes a contribution of artwork to a private foundation, the donor will receive a tax deduction only to the extent of the cost of the artwork, whereas a contribution of the same appreciated artwork to a public charity will result in a tax deduction for the full fair market value, provided that the artwork is used in connection with the exempt purposes of the charity.

Observation: Verification of an organization’s tax-exempt status can also be made by use of third party websites, such as Guidestar. Further, donors can deduct up to 30% of their adjusted gross income (AGI) in the year they donate the artwork to a public charity, compared to only 20% of their AGI if the donation is made to a private foundation. Any excess charitable amount may be carried forward for five years.

  • The type of property to be contributed. Artwork usually is “capital gain property,” which is any property the sale of which at its fair market value at the time of the contribution would have resulted in long-term capital gain.

The Institute speaker indicated that property is capital gain property if it:

    • is a capital asset under IRC Sec. 1221,
    • has appreciated in value,
    • is a collectible under IRC Sec. 408(m), and
    • has been held by the donor for more than one year.

A contribution of capital gain property provides favorable tax treatment to the donor, since the full fair market value of the property is tax deductible. If the artwork is ordinary income property (such as inventory), the deduction is limited to the lower of the fair market value or cost. Other types of ordinary income property include (a) property created by the donor, (b) property received by the donor as a gift from the creator, or          (c) property owned for one year or less. See IRC Sec. 1221(a)(3).

  • Whether the collection satisfies the “related use” rule. The related use rule applies to capital gain property that is “tangible personal property,” which includes artwork not created by the donor. The related use rule requires that the use of the artwork by the charitable organization be related to the purpose or the function constituting the basis for the donee’s exemption under IRC Sec. 501. If the use of the property received (donated) is unrelated to the exempt purposes of the donee organization, the amount of the charitable deduction is reduced by 100 percent of the appreciation in the value of the artwork. This is effectively a deduction for the cost of the property, which can be deducted by the donor up to 50 percent of  his or her AGI.

Example 1: If a painting is contributed to MoMA (a public charity) and MoMA does from time to time display the donated painting prominently, the related use test is met. The contribution is deducted by the donor to the extent of the full fair market value of the property, up to 30 percent of donor’s AGI limitation. Example 2: If the painting is donated to the Red Cross, also a public charity, which has the intention of selling the painting, the charitable deduction is reduced to the donor’s cost basis of the artwork, and is deducted by the donor up to 50 percent of the donor’s AGI limitation. The IRC regulations provide that the related use rule will be met if the donee sells, or otherwise disposes, of only an insubstantial portion of a collection of artwork. There have been a number of private letter rulings in this area which provide further guidance: PLR 7751044; PLR 8009027; PLR 8143029; PLR 8208059; PLR 9131053; PLR 9833011. Contributions of artwork to universities can be deducted at full fair market value if the related use test is made; for instance if there is an art curriculum and the artwork is used in connection with the art courses.

  • Whether there is a qualified appraisal prepared by a qualified appraiser. Final IRC regulations encompassing the rules of IRC Sec. 155(a) of the Tax Reform Act of 1984 apply to charitable contributions (made after December 31, 1984) by an individual, closely held corporation, personal service corporation, partnership, or an S corporation. The regulations provide that any single item of property (or similar items of donated property that are aggregated), other than money or publicly traded securities in excess of $5,000 must be substantiated by a qualified appraisal.

Example: In the same year, a taxpayer makes a donation of rare books to Museum A for $2,000, as well as $2,500 to Museum B and $900 to Public Library C. These donations are aggregated since the same type of property was donated, and because the total is $5,400, the taxpayer must meet the following substantiation requirements:

  • Obtain a qualified appraisal for the property contributed. A qualified appraisal is one prepared by a qualified appraiser not earlier than sixty days before the date of the contribution. The appraisal must contain a detailed description of the property, the physical condition of the property, the date of the contribution, terms of agreement as to how the property is to be used or disposed of, contact information of the appraiser, as well as his/her background and qualifications, fair market value and methodology, fee arrangement between donor and appraiser, and the appraiser’s signature. The qualified appraisal must be received by the taxpayer before the due date of the return, including extensions.
  • Attach a fully completed appraisal summary (Form 8283, Noncash Charitable Contributions Appraisal Summary) to the income tax return on which the donor claims the deduction. The Form 8283 must be signed by both the appraiser and the charitable organization. It is no longer necessary to attach a copy of the full appraisal to the return for donation of artwork with an aggregate value of $20,000 or more; on February 1, 2011 the IRS changed the threshold for artwork subject to review by the Art Panel from $20,000 to $50,000. If the Form 8283 is not attached to the return or is incomplete, the IRS can disallow the charitable deduction. However, IRC Regulations Sec. 1.170A-13(c)(4)(iv)(H) does allow the taxpayer to submit the form within ninety days after the IRS requests it. The IRS will not disallow the deduction if there is a good-faith omission. Note that the appraisal fee cannot be based on a percentage of the appraised value of the property. The donor should maintain complete and accurate records on the details of the contribution.

B. Impact of the Pension Protection Act of 2006 (PPA) on the Art World

New Sec. 170(e)(7)(A) provided that if a charitable organization receives appreciated tangible personal property as a charitable contribution, and disposes of the property within three years of receiving it, the donor may not derive any tax benefit beyond a tax deduction in the amount of the property’s basis. This rule does not apply if the donee organization certifies that the property has a related use. The donee charity is required to file Form 8282 if it disposes of the property within the three year period. If no donee certification is provided, the deduction is limited to basis. If the donated property is disposed of by the donee organization within the three year period, the donor must include as ordinary income for the year in which the disposition occurs, an amount equal to the excess of (i) the amount of the deduction previously claimed by the donor as a charitable contribution over (ii) the donor’s basis in such property at the time of the contribution. This recapture of a tax benefit in a subsequent year does not apply if a certification is made to the IRS (by the donee organization). These rules do not apply for contributions of exempt use property with a claimed value of $5,000 or less.

There is a new related use penalty for fraudulent identification of exempt use property. Any person who identifies applicable property as defined in IRC Sec. 170(e)(7)(C) as having a related use, and who knows that it is not actually intended for such use, is subject to a $10,000 penalty.

Effective for returns filed after February 16, 2007, the qualified appraisal must contain a declaration that he/she understands that a substantial or gross valuation misstatement, resulting from an appraisal of the value of property that the appraiser knows or should have known would be used in connection with a return or claim for refund, may be subject to a civil penalty under IRC Sec. 6695A. This civil penalty is in addition to a statement that the appraiser understands that intentionally false or fraudulent overstatement of the value of the appraised property may subject the appraiser to civil penalty under IRC Sec. 6701 for aiding and abetting an understatement of tax liability.

The donor must check the credentials of the appraiser to be sure that he/she is an expert in the item being appraised. If the donor chooses unwisely and the appraiser is later found to not be a qualified appraiser, the entire charitable deduction is lost, since it will then be too late to correct the defect.

Notice 2006-98 issued by the IRS in October 2006 offered guidance on the new appraisal rules introduced by the PPA. The Notice provides that the appraisal will be considered to be a qualified appraisal if it is in accordance with generally accepted appraisal standards. It also provides guidance on what constitutes a qualified appraiser.

Partial Inter Vivos Charitable Transfers

PPA Sec. 170(o) provides that a donor’s initial contribution of a fractional interest in artwork is determined by applying a fractional interest donated by the full fair market value of the property. For subsequent contributions of the same property, the fair market value of the donated item is limited to the lesser of (1) the value used for purposes of determining the charitable deduction for the initial fractional contribution; or (2) the fair market value of the item at the time of the subsequent contribution. Further, the donor must complete the donation of his/her entire interest in the artwork before the earlier of (1) ten years from the initial fractional contribution or (2) the donor’s death. If the donee charity is not in existence in the later years, the collector’s remaining interest can be donated to another IRC Sec. 170(c) organization. The charity must have substantial physical possession of the artwork during the donor allowed possession period (maximum of ten years) and related use of the art. Further guidance on what constitutes substantial physical possession is needed. If this rule is not followed, the deductions will be recaptured plus interest and an additional tax of 10 percent.

Example 1

The donor contributes a 50 percent interest in a painting worth $1,000,000 and is able to claim a $500,000 charitable deduction. Ten years later, the donor contributes the remaining 50 percent interest in the same painting, which is now worth $2,000,000. The donation in year ten is limited to 50 percent of the initial fair market value of $1,000,000, which is $500,000, and not 50 percent of the $2,000,000 current value.

Example 2

The donor contributes a 50 percent interest in a painting to a museum worth $1,000,000 and claims a $500,000 charitable income tax deduction on his return. The donor dies four years later still owning the remaining 50 percent interest in the painting; the painting at the date of the donor’s death is worth $2,000,000. The donor’s estate tax charitable deduction is limited to $500,000, which is 50 percent of the initial value of $1,000,000 for the 50 percent interest. This results in the estate having a 50 percent interest in the painting with a $1,000,000 date of death value ($2,000,000 multiplied by 50 percent) for which the estate was only entitled to a $500,000 deduction resulting in the estate paying an estate tax on the remaining $500,000. This is a trap for the unwary, and was an unintended result by the legislation. The Tax Technical Corrections Act of 2007 repealed this provision, so that the special valuation limitation does not exist for estate and gift tax purposes.

When the donor dies, the value of the remaining fractional interest in the artwork is included in the donor’s estate. It is difficult to argue that if the retained undivided interest is bequeathed to a noncharitable beneficiary, there should be a discount for the minority undivided interest retained (Rev. Rul. 57-293, 1957-2 C.B. 153). In Estate of Robert C. Scull v. Commissioner (67 T.C.M. (CCH) 2953 (1994)), the value of the decedent’s 65% undivided interest in an art collection was reduced by 5% to reflect the uncertainties involved in any acquisition of the interest, which was the result of an ongoing divorce proceeding. However, usually before a charitable organization accepts a fractional gift, it desires to have assurances that it will receive the balance of the undivided interest when the donor dies. The charity would not want to be left owning a fractional interest in the artwork with the donor’s heirs fighting over the remaining fractional interest.

The Institute speaker suggested reviewing PLR 9303007, PLR 200223013 for further guidance.

C. Retained Life Estate—the Future Interest Rule

IRC Sec. 170(a)(3) postpones any income tax charitable deduction for a gift of a future interest in tangible personal property until there is no intervening interest in, right of possession of, or enjoyment of the property held by, the donor or the donor’s spouse or any of the donor’s brothers, sisters, ancestors, or lineal descendants. A future interest refers to situations in which a donor purports to gift artwork to a charity, but has an understanding, arrangement or agreement with the charity that has the effect of reserving to or retaining in the donor a right to the use, possession, or enjoyment of the property (IRC Regulation Sec. 1.170A-(a)(4), 1.170A-13(b)(2)(G), and 1.170A-13(c)(2)(D)).


In 2010, the donor transfers artwork to a museum but retains a right to the use, possession, and enjoyment of the painting during his/her lifetime. No charitable deduction is allowed in 2010. In 2012, the donor relinquishes this right. If the value of the painting is $100,000 in 2012, a deduction of $100,000 is allowed, subject to the applicable percentage limitations. This situation poses a trap for the unwary; the donor may have a gift tax liability. Under IRC Sec. 2522(c)(2) and Regulations Sec. 25.2522(c)-3(c)(1), there is no gift tax charitable deduction for a transfer of the remainder interest in artwork. Since a transfer of the remainder interest has taken place, there is a transfer subject to the gift tax. See Regulations Sec. 25.2511-1(e) and Rev. Rul. 77-225, 1977-2, 1977-2 C.B. 73.

Observation: The Institute speaker discussed the use of charitable remainder trusts and artwork, and the particular challenges resulting from the need to create a reasonable amount of income or gain from the sale or disposition of trust assets. See Rev. Rul. 73-610, 1973-2 C.B. 213. One solution is to sell the artwork within the first year of the trust’s term or to fund the trust with additional assets, such as publicly traded securities (PLR 9452026). Creating a charitable remainder trust to sell artwork in the first year can be a useful planning technique. The sale of low basis property will not result in a current tax; the capital gain is deferred and an annuity is created for the donor. The amount of the charitable deduction allowed may be limited to the cost which is allocable to the remainder interest in the artwork since the artwork will be sold, and the related use rule will not apply.

Testamentary charitable remainder and/or lead trusts may be an effective estate planning tool for the donor who is reluctant to gift artwork during his/her lifetime. For instance, if the donor  desires to have art collection remain as a single collection after his/her death, but does not want to make an outright bequest to one charity, the use of a the lead trust for one-half of the collection and the remainder trust for the second half of the collection can be a viable solution. An estate tax charitable deduction would result, which would substantially reduce the estate taxes payable. The remainder trust would create an annual cash flow for the decedent’s children and the lead trust creates cash flow for the charity.

D. Private Operating Foundations (POFs)

Contributions of artwork to a POF are deductible to the extent of its full fair market value, so long as the specific donation requirements are satisfied. POFs are organizations that devote their assets or income to the active conduct of a charitable purpose, rather than making grants to other charitable organizations. To qualify as a POF, the organization must satisfy the income test and either the asset test, the endowment test, or the support test.

E. Copyright Interests

If the donor desires to bequeath artwork to a charitable organization, the bequest should be specific enough to clearly identify the property to be gifted. The bequest should also include any copyright interest, in order to avoid an inadvertent split interest transfer under IRC Sec. 2055(e)(4)(C). Further, the donor should consider alternative charitable organizations if the designated charity renounces the artwork.

IRC Sec. 2055(e) and 2522(c), as amended by the ERTA, generally permit a charitable gift or estate tax deduction for the transfer by gift or bequest after December 31, 1981 of artwork, but not its copyright, to a charitable organization. The tax regulations have traditionally treated artwork and the copyright as two interests in the same property. However, the United States Copyright law treats a work of art and the copyright as two separate property interests. This inconsistency resulted in the donor not being able to secure the charitable deduction of the artwork gifted to charity if the decedent retained the copyright interest for his/her heirs since this was not a complete transfer of the property.

IRC Sec. 2055(e)(4) was amended to provide that for estate tax purposes, a work of art and its copyright are treated as separate properties in certain cases. Therefore, a decedent transfer a work of art to a charity with his/her estate retaining the copyright interest so long as the transfer satisfies the estate tax related use rule of IRC Sec. 2055(e)(4)(C).

On the other hand, an artist who bequeaths his art under a will to a charity must either transfer the artwork and the copyright or transfer the work and retain the copyright interest if the related use rule of IRC Sec. 2055(e)(4)(C) is satisfied.

F. Intrafamily Transfers

A transfer of an art collection to a family member must be evidenced by a deed of gift with a signed acceptance, the filing of a gift tax return, proof of delivery of the collection to the new owner and the changing of the related property insurance policy (if existing) to the new owner. This will avoid the argument that the donor retained a lifetime use of the collection, which would make it includible in the donor’s estate under IRC Sec. 2036(a).

G. The Stone Case

In Robert G. Stone v. United States (2007 U.S. Dist. KEXIS 38332 (N.D. Cal., May 25, 2007); 2007U.S. Dist. LEXIS 58611 (N.D. Cal., August 10, 2007); 2009 U.S. App. LEXIS 6347 (Ninth Cir. March 24, 2009)), the Court allowed a 5 percent discount to an estate that owned an undivided 50 percent interest in nineteen paintings that were left to family members. This case is the first to reflect on whether or not to allow a valuation discount based on lack of control, minority ownership, and the lack of possessing a 100 percent interest in (with respect) to artwork, as has been the case for real estate. The estate had claimed a 44 percent discount for the undivided 50 percent interest in the paintings. The IRS stated that art is simply not fungible and that the discount should be not more than two percent. The Court opined that a hypothetical willing seller, who is under no compulsion to sell, would seek to gain consent from the other co-owner to sell the collection and divide the proceeds in accordance with their ownership percentages. The Court stated that the estate’s appraisal methodology was flawed because it did not take into consideration the fact that art collectors are typically drawn to the aesthetics of the art, and not simply drawn to art as an investment. The Court felt that the discount should be no larger than five percent.

The case demonstrates that artwork is viewed differently than real estate, or a closely held business. Also, funding a family limited partnership with artwork generally does not work, as discounting is not allowed for artwork. There can also be the issue of an IRC Sec. 2036(a)(2) inclusion in the estate if the donor retains possession of the artwork.

 5. Techniques and Troubles of Giving Away the Family Home

The Institute speaker commented  that clients transfer their family home (e.g., principal residence or vacation home) to their children and grandchildren for a variety of reasons.  Some clients do it for estate planning purposes, as it removes the home and any future appreciation from their estate.  Other clients do it because they can’t or won’t give away other assets, such as non-assignable retirement plans, securities that will be used to fund their retirement, or stock and options in a public company of which the client is an officer and where any transfer of the securities would have to be disclosed.  Even so, many clients want to give the family home to their children for sentimental reasons.  They want their children and grandchildren to continue to enjoy the home even after their death.

Nevertheless, there are many practical problems that arise and need to be addressed when transferring a home.  They include the following: (i) Do the children want the home? (ii) Can the client use the home after transferring it? (iii) Who will pay the costs of maintaining the residence?  (iv) How will disputes over use be resolved?

A. Do the children want the home?

Just because the home may have sentimental value to the client doesn’t mean his/her children feel the same way about it.  Or, two of the children may want the home but one does not.  In this case, is it fair to leave the home  to all three children when it is worthless to one of them?  One solution would be to give the home to the children who want it, and give assets of equal value to the child who doesn’t want it.

B. Can the client use the home after transferring it?

If the client gives away the home, he can continue to use it, subject to a number of caveats.  One of  the biggest obstacles is IRC Sec. 2036, which provides that if a donor transfers property but retains use of the property for his life, regardless of whether it is an express or implied understanding, then the property is includible in the donor’s estate; however, there are ways to avoid estate tax inclusion.

First, the client could retain an ownership interest in the property, for example, by giving away only 50% of the property.  By virtue of his joint ownership, the donor would be entitled to use the residence.  However, the donor and donee should not own the property as joint tenants with rights of survivorship.  With this type of ownership, the transfer to the donee constitutes a taxable gift but doesn’t provide any estate tax benefits because the full value of the property will be includible in the donor’s estate except to the extent the donee paid for his interest.  Instead, the donor should structure the ownership as a tenancy in common to avoid having the interest that he gives away included in his estate.  Even with a tenancy in common, it is important that the donor not have exclusive use of the residence, and that the other owners have the same access and right as the donor to use the residence, in order to avoid having the gifted portion of the property included in the donor’s estate.

Second, the client could transfer the home to a trust for the benefit of his spouse and children.  As the beneficiary of the trust, the spouse could use/live in the residence, and as part of that use, allow the donor to stay with her without causing the home to be includible in the donor’s estate.

Third, the client could lease the home from the donee and as long as the rent is at the market rate, the home will not be includible in the donor’s estate.  The Institute speaker said that determining such rate can be difficult, especially if the home is in a residential neighborhood where rentals rarely, if ever, occur.  In addition, the Institute speaker recommended that if a lease arrangement is contemplated, the donor should transfer the home to a grantor trust.  Because transactions between a grantor and his grantor trust are disregarded for income tax purposes, the rent will not be taxable income to the trust; by contrast, if the donor directly leases the property from his children, the rental income will be taxable to them.  In addition, a grantor trust simplifies the lease arrangement in that the trust is the sole lessor, and there is no need to negotiate the lease with and pay rent to multiple children.

C. Who will pay the costs of maintaining the home?

The Institute speaker provided a few solutions to how the costs of maintaining the home can be paid.  If the home is leased, the rental income may be sufficient to cover expenses.  However, if the expenses of the home exceed the rental income or the home is not leased, family members will need to fund  these expenses, a condition  that could end up being a source of conflict.  Some family members may not be able to afford to fund the expenses, or they may disagree about the nature of any renovations based on their personal preferences; further, some family members may not want to pay expenses because they don’t use the home as much as others.  The Institute speaker recommended always giving money with the home.  If the home is given to a trust, he recommended endowing the trust with the funds necessary to pay anticipated expenses by means of a bequest or life insurance.  Another alternative is to charge family members an annual fee and/or usage fee to use the home.

D. How will disputes over use be resolved?

The Institute speaker recommended implementing a use agreement to avoid disputes among the donees with respect to when and how long they can each use the home.  Another benefit of such an agreement is that if the donor is a co-owner, the agreement can demonstrate that the donor did not transfer the property and then retain exclusive possession of it, which would cause the home to be includible in his estate.  The Institute speaker recommended building the use agreement into the transfer, rather than leaving it up to the donees to agree on the terms because it could cause conflict.  If the home is transferred to a trust, the rules regarding beneficiaries’ use can be included in the trust agreement.  Another approach is to transfer the home to a partnership or LLC, and include in the agreement  rules and terms regarding use of the home and how expenses will be paid.  The donor could then transfer LLC interests to a trust.  Even though the trust is likely to terminate at some point and distribute  trust  assets, the home will still be subject to the same use agreement if it is in the LLC.  Finally, a use agreement should specify the following: (i) the frequency and duration of each party’s use of the home each year; (ii) a system to reserve dates to use the home; (iii) a system for paying costs such as utilities, taxes and maintenance; (iv) usage fees; (v) the vote required to renovate or improve the home; and (vi) the vote required to sell the home.

E. Transferring the home

The Institute speaker said that if after a discussion of the practical issues involved with transferring a home, your client still wants to do it, there are a number of ways it can be done in a tax-efficient manner.

  1. Gift

    The client can simply give away the home.  In this case, the Institute speaker recommended making the gift to a trust because: (i) the donor’s spouse can be a trust beneficiary, and the grantor can thereby live with her without paying rent; (ii) it provides protection against beneficiaries’ creditors; (iii) leasing the property is simplified because there is only one lessor; and (iv) if the trust is a grantor trust, lease payments aren’t taxable income to the trust.  He further remarked that making a gift of a home and then leasing it back is a means of transferring wealth to the donees if the lease payments exceed the costs of maintaining the home, because this excess goes to the donees at no gift tax cost.

  2. Transfer Partial Interests

    The client could give away a partial interest and retain the balance, thereby continuing to use the home without paying rent, or he could give away the entire home by giving partial interests to multiple donees.  Either approach can reduce the gift tax value of the residence because of the valuation discounts applicable to partial interests.  The Institute speaker said that for several reasons, it is better to first transfer ownership of a home to a limited partnership or LLC and then transfer interests in that entity to one or more recipients.  These reasons include: (i) support for valuation discounts of an entity interest is more readily available; (ii) liability protection; (iii) leasing arrangements are simpler because there is one lessor; and (iv) if the donor buys back the residence from the entity, the purchase price will be its full, undiscounted value but if it is partially owned by several parties, the donor will only pay the discounted value and thus, undo the benefit of taking the discount on the gift. 

  3. Sale

    The Institute speaker recommends that if the client decides to sell the home, he sells it to a grantor trust so that gain isn’t triggered, and if he leases it back, the rent won’t be taxable to the trust.

  4. Qualified Personal Residence Trust (“QPRT”)

    Next, the Institute speaker discussed using a QPRT as another way of transferring the home.  A QPRT is a trust to which one transfers a residence and retains the right to live there for a term of years, after which the residence passes to children or a trust for their benefit.  However, if the grantor does not survive the trust term, the home is includible in his estate and this technique will have accomplished nothing.  The QPRT (i) delays the transfer  of the  home because the donor can use it rent-free for a period of years, and (ii) reduces the value of the gift because the donor doesn’t give away a home today as his  children won’t receive it until the end of the QPRT term.  The value of the gift is a function of the term of the QPRT (e.g., the longer the term, the smaller the gift), the Sec. 7520 rate (e.g., the higher the Sec. 7520 rate, the smaller the gift), the grantor’s age (e.g., the older the grantor, the smaller the gift because the odds of the grantor surviving the trust term are smaller).  It may be surprising, but a QPRT can be appropriate for an older client.  This is because a short-term QPRT for an older client can produce a relatively small gift.

    The Institute speaker covered some important rules governing QPRTs.  A QPRT can only hold one residence which must be the principal residence or one other residence of the grantor.  Some say that an individual can only have two QPRTs for two residences, and never create another.  However, the Institute speaker disagrees with this position and said that there is no limit on the number of QPRTs that one can create; it’s just that an individual can’t have more than two QPRTs at the same time.  For example, an individual can create two QPRTs and as soon as one finishes, he can create a third if he has another residence.

    A QPRT can hold cash only in certain limited circumstances.  It can hold cash for up to six months of expenses (e.g., taxes) and can hold cash for up to three months to purchase a residence.  If the home is sold, the trust can hold the sales proceeds for up two years, after which the trust must either purchase another home, distribute the sales proceeds to the grantor, or convert to a GRAT.

    QPRTs, and any grantor trusts into which they pour, must prohibit the sale of the home to the grantor or the grantor’s spouse.  This is to prevent the grantor from repurchasing the home in a non-taxable transaction by purchasing it from his grantor trust and retaining it until his death at which time the home’s basis will be stepped up to fair market value.

    Following the QPRT term, there are several ways the grantor can continue to use the residence without the causing the home to be includible in his estate.  He can lease it back.  Another alternative is to include the grantor’s spouse as a beneficiary of the successor trust named as the remainderman of the QPRT.  In this case, the grantor can live in the home with his spouse without paying rent.  The Institute speaker said that in many cases, it may be preferable to not include the spouse as a beneficiary of the successor trust so that the grantor has to pay rent to use the home, something that can be a significant wealth transfer strategy.

    A strategy involving QPRTs is to transfer interests in a single residence to more than one QPRT with different expiration dates. For example, one could be for 10 years and another might be for 15 years.  This can reduce the mortality risk of the QPRTs, as well as the gift amount. In addition, spouses could each transfer one-half of their residence to separate QPRTs for the same term of years.  If the spouses aren’t the same age, this will also reduce the mortality risk and the gift amount.  Furthermore, in both cases, the partial interests transferred to the QPRTs should be eligible for valuation discounts. 

    In addition, the Institute speaker discussed joint purchase QPRTs, which have been addressed in a few private letter rulings.  This is how it typically works: Parents and children contribute cash to a QPRT for the purchase of a home.  Their cash contribution is based on the value of their respective interests using the Sec. 7520 tables.  The trust uses the cash to purchase a home from the parents or a third party. The parents retain the right to live in the home for their lives and after both parents’ death, the children receive the property.  The rulings concluded that there’s no gift upon the creation of the trust because the arrangement qualifies as a QPRT and the parties paid what their respective interests are worth under the Sec. 7520 tables.  The IRS also held that the trust property will not be includible in the parents’ estates under IRC Sec. 2033 because their interests in the QPRT terminate at their deaths.  Thus, by creating a joint purchase QPRT, the couple retained the right to live in the residence for their lives without paying rent, avoided paying gift tax on the transaction, and eliminated the possibility that the QPRT would fail if they died prematurely.  Nevertheless, the rulings have not addressed the applicability of Sec. 2036.  The Institute speaker said that he does not think that Sec. 2036 applies because it requires a transfer with a retained interest and this is an exchange.  Because the IRS held in the rulings that there was no gift, everyone must have paid full consideration and Sec. 2036 therefore cannot apply.  The Institute speaker said that these joint purchase QPRTs are a good alternative, but that it is important that the valuation of the interests be accurate.

  5. Remainder Purchase Marital Trust

    Finally, the Institute speaker discussed the Remainder Purchase Marital (“RPM”) Trust as an alternative to the QPRT.  The RPM Trust structure is as follows: Grantor transfers property, such as a residence, to a trust for his spouse, who has the right to the income from or use of the property for life or a term of years, and simultaneously sells the remainder interest to a trust for his children.  The spouse’s interest qualifies for the gift tax marital deduction and the home is not includible in husband’s estate under Sec. 2036 because he did not retain an interest in the trust.  The RPM Trust eliminates the mortality risk associated with a QPRT and the other QPRT limitations don’t apply to it.  For example, the trust can hold cash, there is no prohibition on the trustee selling the home back to the grantor, the trust can sell the home and reinvest the proceeds in something other than a home, and is not limited to holding one home.  The biggest risk is divorce because the trust can’t have a divorce clause and qualify for the marital deduction; if the couple divorces, the husband will have to find someplace else to live.

    Finally, sales or even gifts to family members can trigger local transfer taxes or revaluation for local property tax purposes.  Be sure to check these rules when structuring a transfer of a residence.

Federal Trust and Estate Planning Opportunities - Comments from the 46th Annual Philip E. Heckerling Institute on Estate Planning - Part 1

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